FROM THE OFFICE OF PUBLIC AFFAIRS

I've been asked to speak this morning about whether financial modernization legislation is within reach.

I'll give you my answer in a moment. But first I want to note the importance of distinguishing between financial modernization legislation and real financial modernization. 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 lose sight of this point. They equate Afinancial modernization@ with the legislative process. Fortunately, that is not the case. I say Afortunately@ because over the years the progress of legislation intended to facilitate financial modernization has been torturously slow. It has often involved two steps forward and one step back, two steps forward and three steps back. It has also involved a lot of self-defeating behaviorCthe equivalent of shooting yourself in the foot or holding your breath till you're blue in the face.

The federal laws governing what companies can affiliate with banksCnotably the Glass-Steagall Act and the Bank Holding Company ActCare badly outdated. They contemplate 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 squadCin which everyone hits the target but no one comes out ahead.

And that brings me to my short answer to the question posed at the beginning. Yes, financial modernization legislation is within reach. But whether it actually becomes law will depend on what people do when they get their hands on it. I'd now like to develop that answer more systematically.

Propitious Developments

Sweeping developments over the last two decades have eroded much of the old opposition to financial modernization legislation. Let me note just some of those developments.

The different types of financial services have continued to convergeCspurred by competition, technological advances, and financial innovation. No longer is there a clear-cut separation between banking products and securities, between securities and insurance, or between banking and insuranceCmuch less between securities and financial futures. These different types of financial products now overlap at the margin, sometimes very significantly. Derivatives exemplify this kind of overlapCa hybridization that transcends traditional pigeonholes.

The various types of financial services firms increasingly compete with each other across an increasingly wide range of geographic and product markets. Gone are the days when only banks offered checking accounts. Gone are the days when consumers saw thrifts as providing the best available return on savings. Gone are the days of branching restrictions on banks and thrifts. Gone are the days when Glass-Steagall helped securities firms reap oligopoly profits. To a greater degree than at any time in living memory, the different types of financial services firms accept that they will, and should, compete against each other.

Firms also see new avenues for cooperation. Fifteen years ago, many insurance companies looked at banks and saw only a competitor. Now many insurance companies look at banks and see the potential for a lower-cost distribution system.

Even without legislation, the law governing financial services has undergone a profound liberalizationCa liberalization that, although imperfectCtakes some account of the changes occurring in the marketplace. The Glass-Steagall Act, once likened to a high stone wall, has become more akin to a screen door. And the restrictions on bank insurance activities have also suffered considerable erosion. These legal developments have, in turn, helped undercut the incentives to defend what remains of the old barriers. It's one thing to defend castle battlements, but who ever fought for a screen door?

As the old inter-industry battles have ebbed, so also has the old rhetoric exaggerating the risks of inter-industry affiliations. No longer do we hear the securities industry, or its legislative allies, argue that allowing affiliations between banks and securities firms would take us back to the Great Depression. No longer are debates dominated by the unexamined assumption that banking is intrinsically safe and nonbanking activities are intrinsically risky.

Nor does the trauma of the thrift debacle skew consideration of financial modernization legislation as it did in the early 1990sCafter a cascade of financial failures had bankrupted the old thrift deposit insurance fund, depleted the FDIC's Bank Insurance Fund, and left many observers with a gnawing dread about what or who might fail next. Regulators responded by tightening supervision. Congress enacted reforms like prompt corrective action, least-cost resolution, and risk-based deposit insurance premiums. The upshot was to curtail excessive risk-taking, reduce the subsidy-value of deposit insurance, and strengthen market discipline. Bank capital rose, bank failures plummeted, and the Bank Insurance Fund rapidly reached its target reserve level. These favorable developments do not warrant complacency. But by banishing the sense that public policy had failed and left our financial system in free-fall, those developments have helped create a favorable climate for financial modernization legislation. So, more generally, has the macroeconomic prosperity of the past seven years.

The climate for legislation has been shaped, then, by favorable developments that include the convergence of financial services, the proliferation of new financial products, the erosion of old legal barriers, increased competition (within and between industries), increased willingness to compete, and a renewed sense of confidence.

Against this background, a broad consensus has emerged among the major segments of the financial services sector. These segments agree on the desirability of reforming outdated laws like the Glass-Steagall Act and the Bank Holding Company Act. And they also agree on the general contours of an acceptable reform package.

Current Bills

But it very much remains to be seen whether financial modernization legislation will become law during this Congress.

The House Banking Committee has developed a very good financial modernization bill. It approved that bill by a 51-8 voteCwith broad, bipartisan support, including strong support from the Administration.

The Senate Banking Committee has had a very different process, and produced a very different bill. That bill squeaked through on an 11-9 party-line vote. In the Administration's view, that bill is badly flawed. First, the bill undermines the Community Reinvestment Act. Second, it denies financial services firms the normal freedom that American businesses have to organize themselves in the way they judge best. Instead, for no compelling reason, the bill forces good assets into holding company affiliates. In so doing, it reduces diversification in banks' assets and income, and puts the assets in question beyond the reach of the FDIC. Third, the bill provides significantly increased leeway for affiliations between banks and nonfinancial firms. And fourth, the bill provides inadequate consumer protectionsCfor example, by not requiring that securities sold to bank customers be suitable for those customers.

Disagreement over these aspects of the Senate bill poses significant impediments to financial modernization legislation. But there are more. For example, such legislation should get rid of statutes, like the Glass-Steagall Act, that divide markets and stifle competition. Yet both bills include some anti-competitive provisions, notably provisions discriminating against national banks.

More broadly, potential impediments to financial modernization legislation extend beyond substantive policy disagreements. The impediments include a tendency to underestimate the fragility of the legislative process. We've seen that tendency repeatedly over the years, with people who want or need legislation overplaying their hands and ending up with nothing. Like the members of a circular firing squad, they hit their chosen targets but still come out behind.

Conclusion

In conclusion, I believe financial modernization legislation is within reach. Many of the surrounding circumstances are more favorable than ever before. But whether such legislation actually becomes law will greatly depend on the choices that various participants in the legislative process make over the coming months. The House Banking Committee has shown the way. Its bill has broad, bipartisan support. Such a bill can win support in both Houses, and from a wide spectrum of financial institutions and other interested persons. It can be enacted into law. We in the Administration will work to move it forward.