As Congress considers financial modernization legislation, 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. Over the past two years, this has proved to be one of the most divisive issues in the legislative process.

The Treasury 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 permitted to conduct in the past. We propose allowing financial services firms to conduct such activities through holding company affiliates or through subsidiaries of banks.

But some participants in the debate take a different view. They insist that Congress allow such new activities only in holding company affiliates. They brand the subsidiary structure as overly risky. And 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.

The opponents of the subsidiary structure have particularly emphasized this subsidy objection. Here's what one of them says:

"A subsidiary is clearly the most attractive [form of affiliation] for the bank because it is the best vehicle for transferring the safety net subsidy: the capital invested in the subsidiary is totally funded by the bank and thus benefits dollar for dollar from the bank subsidy. The subsidiary option would thus be the choice de jure of intelligent bank management, causing all of the things that one should worry about. It would give the sub a funding cost competitive advantage vis-a-vis independent rivals and even bank holding company affiliates. It would, in addition, distort incentives for risk taking because of that direct lower cost of capital, as well as because creditors of the sub would presume parent bank assistance in times of stress, since losses at the sub fall directly on the parent bank's capital. As long as there is a safety net, the bank subsidiary approach to financial modernization is a truly bad idea ..." (Meyer 1999, 5)

I want to focus here on several aspects of the subsidy objection that have not received adequate scrutiny.

I'll begin by briefly outlining the subsidiary structure and its merits, including the ways in which it protects bank safety and soundness and the federal deposit insurance funds better than the affiliate structure.

I'll then turn to the question of subsidy. First, I'll examine the potential for subsidy in banks' relationship to the federal government. I'll summarize the main ways that the government can be seen as subsidizing banks, the explicit and implicit costs that the government imposes on banks, and the debate over the size and competitive significance of any net subsidy. Second, I'll describe how the Treasury's proposal would prevent banks from spreading a subsidy to subsidiaries any more readily than to affiliates so that denying firms the subsidiary option would do nothing to curtail the amount or spread of any subsidy. Third, I'll explain why unsecured creditors impose higher funding costs on a holding company than on its banks, why a bank faces higher funding costs if it conducts a given activity through an affiliate than through a subsidiary, and why these funding-cost differences far from being perverse are consistent with reduced risk to the deposit insurance fund. And fourth, I'll note how policymakers concerned about any subsidy can take straightforward steps to correct it.

More broadly, I'll contend that opponents of the subsidiary option have in effect made it a scapegoat for some unrelated policies that needlessly increase the government's gross subsidy to banks, and thus increase the potential for banks to receive some appreciable net subsidy. Instead of reexamining those other policies, the opponents characterize the subsidiary structure as the test of whether we'll have an efficient, free-market financial system or subsidy-bloated crony capitalism. But the potential for net subsidy comes from those other policies. The attack on the subsidiary is misplaced. To borrow a phrase from the Gospel of Matthew, the opponents "strain out a gnat and swallow a camel" (Matthew 23:24).

A. The Subsidiary Structure

The Treasury has proposed, and in H.R. 10 the House Banking Committee has adopted, rigorous safeguards on a bank's exposure to a subsidiary engaged in new financial activities.

First, require the bank to be and remain well-capitalized (i.e., in the highest regulatory capital category) and well-managed (i.e., with a satisfactory examination rating for management), and provide for sanctions if it fails to do so.

Second, require the bank to deduct from its regulatory capital every dollar of the bank's equity investment in the subsidiary and to remain well-capitalized even after the deduction. Thus, even if the subsidiary were to fail and the bank's equity investment in it were to prove a total loss, the bank should still be well-capitalized.

Third, prohibit the bank from making an equity investment in a subsidiary that would exceed the amount that the bank could pay as a dividend.

Fourth, restrict the bank's transactions with the subsidiary. Specifically, subject all of those transactions except equity investments (which would come under the capital-deduction requirement) to the same stringent restrictions and requirements as apply to the bank's transactions with affiliates under sections 23A and 23B of the Federal Reserve Act (12 U.S. Code  371c, 371c-1). Thus those rules would govern any loans or other extensions of credit from the bank to the subsidiary, any guarantees by the bank for the benefit of the subsidiary, and any purchase of assets by the bank from the subsidiary. The total amount of these transactions with the subsidiary could not exceed 10 percent of the bank's capital, and the total amount of these transactions with all of the bank's subsidiaries and affiliates combined could not exceed 20 percent of the bank's capital. All such transactions between the bank and the subsidiary would have to be on market terms and fully secured by specified types of high- quality collateral.

B. Merits of the Subsidiary Structure

The subsidiary structure builds on 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 the four safeguards outlined above. Under this approach, conducting an activity in a subsidiary would pose no greater risk to the bank 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 regulatory 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 regulatory capital.

The FDIC, which has a paramount stake in protecting bank safety and soundness and the federal deposit insurance funds, has emphasized the virtues of the subsidiary structure (Helfer 1997, 35-36, 61-72; Tanoue 1998, 5-7, Appendix A). A subsidiary's earnings accrue directly to the benefit of the parent bank, and help diversify the bank's earnings. More importantly, if the bank ever gets into trouble, the bank's depositors and the FDIC have a claim on the bank's ownership interest in the subsidiary; that interest can be sold to replenish the bank's capital or reduce the FDIC's loss. By contrast, forcing assets out of the bank and into a holding company affiliate would deprive the bank of the earnings from those assets and put them beyond the reach of depositors and the FDIC.

Let's turn now to the question of subsidy, beginning with the key benefits that banks receive from the federal government.

A. Federal Subsidy of Banks: Sources, Offsetting Costs, and Competitive Significance

1. Elements of Subsidy

The government does provide banks with valuable benefits. Federal Reserve Governor Meyer's definition of the federal "safety net" provides a useful starting point for examining these benefits:

"We insure, or guarantee, some of [banks'] claims; we provide banks access to liquidity when they need it, through the discount window where they can borrow when in temporary difficulties; we provide banks access to a payments system that can transfer funds rapidly, allowing their customers instant liquidity; and we supervise them so that bank customers can feel more confident about dealing with them. Collectively, we call all of these benefits the 'safety net'. Collectively they permit banks to obtain funds more cheaply than would otherwise be the case. Or put differently, an important by-product of our decisions to stabilize banks and to protect those that deal with them is that the banks receive a subsidy from the government in this case a lower cost of funding." (Meyer 1999, 2)

As we look more closely at the four benefits identified by Governor Meyer, a pattern emerges: the subsidy results primarily from the government's decision to underprice those benefits.

First, FDIC insurance is underpriced. It is valuable, and yet most FDIC-insured institutions now receive it without having to pay premiums. Legislation enacted in 1996 and strongly opposed by the Treasury (e.g., Hawke, September 1995; Hawke, October 1995) precludes the FDIC from imposing premiums on passably healthy depository institutions if the deposit insurance fund will exceed the statutory target of having $1.25 in reserves for each $100 of insured deposits. Specifically, well-capitalized depository institutions pay no premiums unless regulators find them to have significant financial, operational, or compliance weaknesses (12 U.S. Code  1817(b)(2)(A)). This exemption from premiums currently applies to 9,924 of the 10,486 FDIC-insured institutions (95 percent), and those institutions hold some 97 percent of domestic deposits at FDIC-insured institutions.

Second, the Federal Reserve discount window is underpriced in the sense that banks' access to the window particularly the potential for a solvent bank to liquefy its assets during a financial emergency has a value exceeding the cost of foregone interest on required reserves.

Third, Fedwire daylight overdrafts are probably underpriced, as they incur charges at an annual rate of only 0.27 percent. Banks get the benefit of immediate finality while paying only part of its value.

Fourth, some federal bank regulators although authorized to recoup the costs of examinations through user fees (12 U.S. Code  326, 1820(e), 1844(c)) have chosen not to do so.

Other significant subsidies available to banks include low-cost loans from the Federal Home Loan Bank System, which member institutions with proper collateral can use for any purpose.

2. Offsetting Costs, and the Competitive Significance of Any Net Subsidy

Although the federal government provides valuable benefits to banks not available to businesses generally and does not charge explicit prices commensurate with the value of those benefits, banks can receive those benefits only by incurring substantial costs. These offsetting costs include: (1) deposit-based assessments to cover interest payments on the so-called FICO bonds, which funded part of the thrift clean-up; (2) foregone interest earnings on required reserves; and (3) most importantly, the cost of complying with regulations. A recent study identifies the latter as including the cost of complying with regulations regarding safety and soundness, consumer protection, entry and exit, and geographic and product expansion, as well as the cost of undergoing periodic safety and soundness, compliance, fiduciary, and information-system examinations (Madjd-Sadjadi and Vencill 1999, 9).

Accordingly, one can usefully distinguish between gross and net subsidies to banks. The gross subsidy represents the total value of the special benefits that the federal government provides to banks. The net subsidy represents the difference between the gross subsidy and the offsetting costs banks must incur. And the net marginal subsidy represents the difference between the special benefits and the offsetting costs associated with banks accepting an additional dollar of insured deposits.

Even assuming a substantial gross subsidy, the offsetting costs may also be large enough to leave little or no net marginal subsidy. Thus the FDIC concludes that any such subsidy is relatively insignificant. "For well-capitalized banks," Chairman Tanoue states, "the evidence shows that if a net marginal funding advantage exists at all, it is very small" (Tanoue 1998, 6). Many independent economists agree (e.g., Shadow Financial Regulatory Committee 1997, 1999; Shull and White 1998, 474-75).

In any event, because the subsidiary structure protects the FDIC better than the affiliate structure (see Part I-B above), a bank that elects to conduct a given activity through a subsidiary rather than an affiliate reduces the risk that the bank poses to the FDIC. In so doing, the bank also reduces the gross subsidy it receives from federal deposit insurance, and thus also reduces the potential for receiving a net marginal subsidy (Helfer 1997, 69-70, 71- 72).

B. Banks Could Not Spread A Subsidy Any More Readily to Subsidiaries Than to Affiliates

Even if a net marginal subsidy does exist, the Treasury's proposed safeguards (summarized above in Part I-A) would prevent the bank from transmitting the subsidy any more readily to a subsidiary than to an affiliate. The limits on the bank's loans, guarantees, and asset purchases would be exactly the same for a subsidiary as for an affiliate. Every dollar that the bank could invest in a subsidiary could be paid out as dividends to the holding company in order to capitalize a new affiliate. There is no evidence that money paid upstream to an affiliate would carry any less of a subsidy than the same funds invested downstream in a subsidiary. And the bank's ability to provide such funds would be the same for an affiliate as for a subsidiary: the bank could not make an equity investment in a subsidiary that exceeded the amount it could pay in dividends; and the bank would have to remain well-capitalized after deducting the capital invested in the subsidiary or channeled as dividends to the holding company.

FDIC Chairman Tanoue summarizes the result as follows:

"[E]ven if a small net marginal funding advantage exists, there is no difference in a bank's . . . ability . . . to pass this advantage to both holding company affiliates and bank subsidiaries. Regulatory safeguards for operating subsidiaries . . . serve to inhibit a bank from passing a net marginal subsidy either to a direct subsidiary or to an affiliate of the holding company. Any leakage of a net marginal subsidy from the insured bank to a subsidiary or an affiliate is likely to be the same and would be de minimis." (Tanoue 1998, 6)

Thus denying financial services firms the option of the subsidiary structure would do nothing to curtail the amount or spread of any subsidy.

The Federal Reserve Board faced a similar issue when 18 foreign banks applied to underwrite and deal in securities in the United States through subsidiaries. It found that those banks could receive an implicit subsidy from home-country safety nets similar to that under the U.S. federal safety net. It then considered whether subsidiaries of those banks would have an unfair competitive advantage. It imposed a capital-deduction requirement and other conditions "designed to ensure that . . . competitive equity, safety net [and other] objectives . . . continue to be met; . . . and that foreign bank applicants will not have any significant competitive advantage in the United States over section 20 subsidiaries and non-bank owned securities firmvs." And the Federal Reserve concluded that although the foreign banks could reap some "potential advantages . . . through this differing structure, the Board believes that any advantage would not be significant" under the circumstances (Federal Reserve Bulletin 1990, 158, 160). Pursuant to that decision, foreign banks now have U.S. securities subsidiaries with combined assets of some $450 billion.

C. Funding-Cost Differentials And Their Significance

Opponents of the subsidiary option use both an observed and an expected funding-cost differential to argue that subsidiaries would receive a subsidy not available to affiliates. But one can best understand such differentials as arising from the additional risks that the holding company or affiliate structure poses to creditors (without providing any additional protection to the FDIC).

1. Bank vs. Bank Holding Company

A bank holding company's debt generally has a lower credit rating than comparable debt issued by banks owned by that holding company. Thus the holding company faces correspondingly higher borrowing costs than its banks. Some cite these differences as proof that the bank can transfer little, if any, safety net subsidy to the holding company. But the differences prove nothing of the sort. Instead, they reflect the typical bank holding company's reliance on its banks' assets and earnings and its resulting vulnerability to any regulatory action curtailing the bank's dividends and to any liquidation of the bank.

A holding company with debt outstanding commonly relies on dividends from the bank for the cash it needs to service that debt. If the bank gets into financial trouble, regulators often curtail the bank's dividends, which may leave the holding company unable to make timely payments on its own debt. Likewise, if the bank were to fail, the holding company would be paid only out of the money remaining after the FDIC, uninsured depositors, and all other creditors of the bank were paid in full. By contrast, debt holders of the bank, although they would wait in line behind the FDIC and uninsured depositors, would be on a par with most of the bank's remaining creditors. The credit rating and cost of holding company debt reflect the risk of a dividend cut-off and the inferior position of holding company debt in any failure of the bank (Helfer 1997, 46-50).

2. Subsidiary vs. Affiliate

As I've previously explained, using subsidiaries rather than affiliates helps protect the FDIC. In the same way and for the same reasons the subsidiary structure also helps protect other unsecured creditors of the bank. By conducting an activity through a subsidiary rather than an affiliate, a firm that includes a bank places the assets associated with that activity within the reach of the bank's creditors. If the bank does poorly, the bank's interest in the subsidiary can be sold and the proceeds used to pay the bank's creditors. By contrast, conducting that same activity through a nonbank affiliate places the assets in question beyond the reach of the bank's creditors.

The resulting difference in the bank's funding costs reflects a real difference in credit risk: by placing assets within the reach of its creditors (in a subsidiary), the bank makes itself a better credit risk than it would have been had it placed those assets outside the reach of its creditors (in an affiliate). The creditors therefore reward the bank with a lower funding cost.

This result, far from being perverse, also reflects reduced risk to the FDIC. As regards the choice between the subsidiary and affiliate structures, the FDIC and a bank's other unsecured creditors have closely parallel interests. The subsidiary structure, by increasing the assets available to the bank's creditors and the FDIC, reduces risk to those creditors and the FDIC. The affiliate structure, by reducing the assets available to the bank's creditors and the FDIC, increases risk to those creditors and the FDIC.

D. Real Options for Curtailing Any Net Subsidy

1. Sensitivity of Subsidy to Changes in Public Policy

Any gross subsidy provided by federal deposit insurance has varied greatly over the years, reflecting changes not only in premium rates and banks' financial condition but in public policy towards banking. I'll illustrate some of this variation with a thumbnail sketch of some key trends over the past several decades.

During the decades following the Great Depression, public policy limited competition with and among banks in the interest of preserving financial stability. Public policy restricted entry into banking. It constrained banks' geographic expansion. It capped the interest rates banks could pay on deposits. And it precluded nonbanks from offering such key products as checking accounts. These limits on competition helped limit risk to the FDIC by maintaining banks' profitability and constraining their expansion, and thus limited any gross subsidy provided by deposit insurance. They also offset that subsidy by imposing substantial implicit costs.

These constraints eroded during the 1960s, 1970s, and 1980s, as banks faced disintermediation and increasing competition from each other and from other financial institutions. Bank failures one indicator of risk to the deposit insurance fund increased, totaling 31 during the 1950s, 44 during the 1960s, 76 during the 1970s, and 1,037 during the 1980s. Indeed, bank failures increased every year from 1981 through 1989, rising from 10 in 1981 to a peak of 206 in 1989. Despite two increases in the effective premium rate, the Bank Insurance Fund's reserve ratio fell from 1.24 percent in 1981 to negative 0.36 percent in 1991. The decline in the reserve ratio indicates that premiums did not fully compensate the fund for the risks it bore and suggests that the gross subsidy had increased.

Beginning in the late 1980s, Congress and bank regulators acted to protect the deposit insurance fund and reduce both the taxpayers' potential exposure. Regulators prescribed risk- based capital standards and intensified their scrutiny of banks' asset quality. The Federal Reserve began limiting, and then charging for, daylight overdrafts. Congress enacted the FDIC Improvement Act of 1991 (FDICIA), which included reforms intended to bring the incentives of depository institutions' owners, managers, and regulators more closely into line with the interests of the insurance funds. These reforms included: (1) prompt corrective action, under which regulators must impose increasing stringent restrictions and requirements on a depository institution as its capital declines below required levels, in the interest of resolving the institution's problems at little or no cost to the insurance fund; (2) least-cost resolution, which curtailed the practice of treating some banks as "too big to fail"; (3) risk- based deposit insurance premiums; and (4) restrictions on discount-window lending to undercapitalized institutions. These and other reforms have forced banks to internalize more of the costs of their own risk-taking, and have thus reduced the insurance fund's uncompensated risk-bearing (Helfer 1997, 39-44).

The key post-FDICIA trends are consistent with a decline in the gross subsidy provided by deposit insurance: bank profitability soared; bank capital rose to the highest levels since the 1960s; the FDIC's problem bank list shrank; and bank failures fell to a tiny fraction of their level at the beginning of the decade. The Bank Insurance Fund's reserve ratio now stands at 1.38 percent, surpassing the statutory target of 1.25 percent.

2. Potential Remedies

People concerned about the spread of subsidy should deal with subsidy directly, by curtailing it at its sources: namely, in the government's decisions to underprice the elements of the federal safety net: deposit insurance, discount window access, daylight overdrafts, and some regulators' bank examinations. To the extent one wishes to reduce or eliminate any net marginal subsidy, one can do so by reducing the degree of underpricing. This approach, unlike the supposed distinction in subsidy-spreading between subsidiaries and affiliates, will actually work. There is nothing immutable about the size of any net marginal subsidy; it is sensitive to changes in public policy as illustrated by the FDICIA-era reforms and in the price of the government benefits in question. Moreover, if Governor Meyer is right about the grave consequences of the safety net subsidy, then that subsidy should be curtailed in any event, regardless of how Congress deals with financial modernization legislation.

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 structure have failed to make a coherent much less a compelling case for denying financial services firms the option of choosing that structure. On the contrary, the subsidiary structure would protect bank safety and soundness and the FDIC better than the affiliate structure. And by reducing the risk that the parent bank poses to the FDIC, the subsidiary structure would actually reduce the gross subsidy that the bank receives from federal deposit insurance. Moreover, under the Treasury's proposed safeguards, a bank could not transmit a net marginal subsidy to a subsidiary any more readily than to an affiliate. Those concerned about government subsidy to banks and the potential for its unhealthy spread should turn their attention to the real sources of any subsidy, beginning with the pricing of deposit insurance.

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