Mr. Chairman, Members of this Committee, I appreciate the opportunity to discuss the Administration's views on financial modernization, including HR 10, and HR 665, introduced this week by Mr. LaFalce.

Mr. Chairman, as we approach financial modernization legislation, the Administration's overall objective has always been to do what best serves the interests of consumers, businesses and communities, while protecting the safety and soundness of our financial system. We will support legislation that achieves those aims.

Let me begin by noting that the U.S. financial system is stronger and more competitive than ever. Abroad, the United States is dominant in investment banking and highly competitive in other segments of financial services. U.S. commercial banks are more competitive today than at any time I can remember. The problem our financial services firms face abroad is more one of access, than lack of competitiveness.

Financial modernization is occurring already in the marketplace through innovation and technological advances. With the lessening of regulatory barriers, financial services firms are offering customers a wide range of financial products. Banks and securities firms have been merging; banks are selling insurance products; and insurance companies are offering products that serve many of the same purposes as banking products -- all of which increases competition and thus benefits consumers.

Financial modernization will continue in the absence of legislation, but it can, with good legislation, occur in a more orderly fashion. Treasury has long believed in the benefits of such legislation, but we have also been clear that if this is going to be done, it needs to be done right.

Let me also say that while we favor financial modernization legislation, it does seem to me that when you look at the developments around the world over the last couple of years, and when you look at the size of mergers here in the United States over the same period, there are legitimate concerns about financial modernization with respect to economic concentration and systemic risk.

Let me turn now to the bills before this committee. Both bills, HR 10 and HR 665, take the fundamental actions necessary to modernize our financial system by repealing the Glass- Steagall Act's prohibitions on banks affiliating with securities firms and repealing the Bank Holding Company Act prohibitions on insurance underwriting. Beyond that, however, there are significant differences between the two bills.

Today, I would like to focus on the Administration's concerns about HR 10. As you know, the Administration would have vetoed HR 10 had it passed in the last Congress, and we continue to oppose HR 10 in its current form. We have three basic objections to this bill -- its prohibition of the use of subsidiaries by banks, its weakening of the effects of the Community Reinvestment Act (CRA), and its expansion without reform of the Federal Home Loan Bank System.

First, the bill would prohibit financial services firms that include banks from conducting new financial activities through bank subsidiaries -- and force them to conduct those activities exclusively through bank holding company affiliates. Subsidiaries and affiliates are absolutely identical with respect to the ability of a bank to transfer any subsidy that may exist in the bank. And subsidiaries and affiliates are absolutely identical with respect to safety and soundness except in one respect, which I will discuss in a moment, in which subsidiaries are actually superior with regards to banks' safety and soundness. The LaFalce bill, which allows banks to conduct merchant banking and securities activities through a subsidiary, contains the following rigorous safeguards that produce this result:

• Every dollar a bank invests in a subsidiary would be deducted from the bank's regulatory capital, just as is the case with every dollar a bank pays as a dividend to its parent holding company for investment in an affiliate. A bank would have to be well-managed and well-capitalized before and after such investment is deducted from its capital and on an ongoing basis.
  
• A bank could not invest any more in a subsidiary than it could pay as a dividend to its parent holding company for investment in an affiliate.
  
• The rules governing loans from a bank to a subsidiary would be exactly the same as they are for a loan from a bank to an affiliate.

Thus, there are no public policy reasons to deny the choice of a subsidiary; however, there are four important policy reasons to allow that choice.

First, financial services firms should, like other companies, have the choice of structuring themselves in the way that makes the most business sense and this, in turn, should lead to better service and lower costs for their customers.

Second, the relationship between a subsidiary and its parent bank provides a safety and soundness advantage. Firms that choose to operate new financial activities through subsidiaries are, in effect, keeping those assets available to the bank rather than transferring them outside the bank's reach. If the bank ever needed to replenish its capital, the bank's interest in the subsidiary could be sold solely at the behest of the bank. If the bank were ever to fail, the FDIC could sell the bank's interest in the subsidiary in order to protect the bank's depositors and the deposit insurance fund. For this reason, the FDIC, a neutral observer with a paramount interest in this issue, its current chairman and three former chairmen -- two Democrats and two Republicans -- have stated that the subsidiary option is actually preferable from the standpoint of safety and soundness and protecting deposit insurance funds. I would also like to observe that currently, under the Federal Reserve's jurisdiction, foreign banks underwrite and deal in securities through subsidiaries in the United States, and U.S. banks conduct securities and merchant banking activities abroad through so-called Edge Act subsidiaries.

Third, to the extent that firms choose to operate through subsidiaries, the consolidated assets of the bank will be larger than if these activities are conducted through affiliates, and that, in turn, is favorable with respect to the Community Reinvestment Act.

Fourth, one of an elected Administration's critical responsibilities is the formation of economic policy, and an important component of that policy is banking policy. In order for the elected Administration to have an effective role in banking policy, it must have a strong connection with the banking system. That connection is currently provided by the Office of the Comptroller of the Currency, which regulates national banks. We believe if subsidiaries of national banks cannot be used to engage in new activities, then gradually banks will gravitate away from the national banking system, and this critical connection will be lost.

We also believe it is very important that the Federal Reserve Board maintain its strong connection with the banking system. We believe that allowing banks the choice of conducting non-bank financial activities, either through an operating subsidiary or an affiliate, serves the purpose of having both the elected Administration and the Federal Reserve strongly involved in banking policy.

With respect to the subsidiary option, we support three additional steps.

First, we proposed last year -- and the LaFalce bill includes -- joint Federal Reserve- Treasury rulemaking to define new financial activities. We believe that this arrangement would promote consistency and would eliminate the potential for unhealthy competition or laxity in defining new activities.

Second, we favor functional regulation. We support provisions like those in the LaFalce bill, making clear that securities and insurance regulators have the same jurisdiction over subsidiaries as over affiliates.

Third, we have no objection to requiring the largest banks to retain a bank holding company, thereby assuring the Federal Reserve a central supervisory role regardless of whether the bank operates with affiliates or subsidiaries.

Our second major objection to HR 10 is its effect on the Community Reinvestment Act.

CRA encourages a bank to serve creditworthy borrowers throughout communities in which it operates. Since 1993, a greatly invigorated CRA has been a key tool in the effort to expand access to capital in economically distressed areas and to make loans to rebuild low and moderate income communities. In fact, since 1993, the number of home mortgage loans extended to African Americans increased by 58 percent, to Hispanics by 62 percent, and to low- and moderate-income borrowers by 38 percent, figures all well above the overall market increase.

We believe that any bank seeking to conduct new financial activities should be required to achieve and maintain a satisfactory CRA record. The LaFalce bill includes that requirement, which we support. Although HR 10 requires a bank to have a satisfactory CRA record when it commences new financial activity, it does not require that the bank maintain a satisfactory record. If we wish to preserve the relevance of CRA at a time when the relative importance of bank mergers may decline and the establishment of non-bank financial activities will become increasingly important, the authority to engage in newly authorized activities should be connected to a satisfactory CRA performance.

Our third major objection to HR 10 relates to the Federal Home Loan Bank System. The FHLB System is currently the largest issuer of debt in the world. Last year, it issued approximately $2.2 trillion in debt, and it currently has $350 billion in debt outstanding. Yet the System uses little of its government-subsidized debt to further the System's home ownership purpose. We recognize the desire of many Members to see the System lend more to community banks. Indeed, we believe that the System should focus on such lending, not on using taxpayer funds for arbitrage activities and overnight lending which currently constitute so much of its activities. Changing this important System perhaps should be done separately. But if it is to be addressed in this legislation, we believe changes in the FHLB System should occur only in the context of comprehensive reform.

Let me mention briefly two other areas of HR 10 where we have concerns. First, we believe that current law on bank insurance sales is pro-competition and pro-consumer and is preferable to HR 10's provisions, especially with respect to establishing safe harbors and restricting deference. Second, although creating wholesale financial institutions may be an appropriate step, we believe that developments in financial markets over the last year raise serious concerns. We need to consider carefully the consequences of giving them certain of the same benefits of the federal safety net for banks -- the payment system and the discount window, albeit not deposit insurance while subjecting them to diminished banking regulation.

Before concluding, I would like to say a few words about HR 665, the LaFalce bill. As I announced on Wednesday, we support the LaFalce bill. The LaFalce Bill allows firms the subsidiary option, preserves CRA, avoids anticompetitive restrictions on bank insurance sales, and omits other provisions of HR 10 that in our opinion do not advance the cause of modernization. However, we support this bill with the caveat that we have serious concerns about the affiliation between commercial firms and depository institutions which this bill would permit.

Mr. Chairman, let me reiterate: our nation's financial institutions are strong and highly competitive, both here and abroad. In our view, financial modernization legislation can produce significant benefits, but the job must be done right. We in the Administration look forward to working with you and others in Congress to construct good financial modernization legislation that serves the interests of consumers, businesses and communities, while protecting the safety and soundness of our financial system. Thank you very much.