FROM THE OFFICE OF PUBLIC AFFAIRS

JOHN D. HAWKE, JR.

HOUSE BANKING AND FINANCIAL SERVICES

Mr. Chairman and members of the Committee, I am pleased to appear today with Secretary Rubin to discuss the Treasury Department’s draft proposal for financial modernization. The full text of our proposal appears as part of the report that we are submitting to the Congress pursuant to section 2709 of the Economic Growth and Regulatory Paperwork Reduction Act of 1996.

As Secretary Rubin has testified, we believe that American consumers will benefit significantly from legislation that brings increased competition to the financial services industry. Our proposal would achieve that result by eliminating barriers to affiliations between banks and other financial services firms, and by broadening the ability of banking organizations to offer financial products and services. Specifically, we recommend that Congress repeal sections 20 and 32 of the 1933 Glass-Steagall Act, which restrict affiliations between commercial banks and securities firms, as well as section 4 of the Bank Holding Company Act of 1956, which narrowly limits the permissible activities of bank holding companies.

In place of these old restrictions, we propose that Congress adopt a far less restrictive regime for companies that want to own banks. We also propose that the authority of banks to engage in financial activities through financial subsidiaries be broadened. These changes would allow financial services companies that are, or include, banks the freedom to choose between the holding company affiliate and the bank subsidiary as the organizational format for expanded financial activities. We have structured the proposal to provide similar protections for the bank and the deposit insurance funds irrespective of the choice of format. Let me expand briefly on the rules we would apply.

The "Qualifying Bank Holding Company" ("QBHC")

The proposal sets out three main prerequisites for a company owning a bank to engage in activities that are not permissible for a national bank to engage in directly:

First, it must be engaged in activities that are "financial in nature."

Second, all of its subsidiary banks must meet -- and remain in compliance with -- the highest supervisory standard of capitalization, the "well capitalized" standard, and they must be, and stay, well managed.

Third, it must execute an undertaking that if any bank subsidiary falls below the well capitalized level it will restore the bank to that level or divest it under circumstances in which the divested bank will be well capitalized immediately following the divestiture.

All bank holding companies would continue to be regulated and supervised by the Federal Reserve Board, but they would be free to diversify their financial activities within the limits described in the legislation without further application requirements.

The Financial Subsidiary

Alternatively, national banks (and state banks to the extent permitted by state law) may elect to conduct financial activities not permissible for national banks themselves through their own financial subsidiaries. Three conditions would apply if this format were chosen:

First, as in the QBHC setting, the parent bank would be required to be and stay well capitalized and well managed.

Second, the amount of the bank’s equity investment in the subsidiary would be excluded from the bank’s capital for purposes of determining compliance with the well-capitalized standard. Thus, if the subsidiary were to fail, the bank’s regulatory capital would be unaffected.

Third, after excluding the bank’s equity investments in financial subsidiaries, the limits on affiliate transactions in sections 23A and 23B of the Federal Reserve Act would be applicable to dealings between the bank and the subsidiary. Thus loans and other extensions of credit by the bank to the subsidiary would have to be conducted at arm’s length, could not exceed 10 percent of the bank’s capital, and would have to be fully collateralized. (In addition, the bank’s covered transactions with all affiliates, including the subsidiary, could not exceed 20 percent of the bank’s capital.)

Subsidiaries of national banks would be permitted to engage in the same financial activities as QBHCs, including insurance underwriting and agency operations, and the full range of securities activities, including merchant banking. (The permissible activities of subsidiaries of state banks would depend on state law and review by the FDIC.)

The "Banking and Commerce" Issue

As Secretary Rubin has indicated, a major question that will face the Congress in considering expanded activities for bank holding companies is the extent to which -- if at all -- they should be permitted to engage in nonfinancial activities. Congress has a range of choices in this regard, and our proposal sets forth two possible models that might be drawn upon as the Congress debates this issue.

The first is a "basket" concept, similar to that suggested in some pending bills. Under this approach, a company could only be a QBHC if a predominant percentage of its domestic gross revenues -- the exact number to be determined by Congress -- were derived from financial institutions and other financial activities. If this eligibility threshold were met, the remainder of the QBHC’s revenues could derive from nonfinancial activities. However, in order to assure that the nonfinancial "basket" could not be used to create very large combinations of banking and commercial or industrial companies, we would prohibit a QBHC from acquiring any nonfinancial company that had total assets in excess of $750 million -- a number that approximates the 1,000 largest nonfinancial companies in the United States. We would also prohibit banks from making loans to, or investing in, their commercial affiliates.

If such a "basket" approach were adopted, it would provide a framework for merging the bank and thrift charters and bringing unitary thrift holding companies, which presently have no limits on their nonfinancial activities, under a common regulatory umbrella with banking organizations. It would also provide a "two-way street" that would make it possible for securities and insurance companies and other diversified financial services firms that may have some modest volume of nonfinancial revenue, to own an insured bank.

On the other hand, Congress might choose not to permit any level of nonfinancial activity for QBHCs. In this event, we believe it would be difficult to merge the bank and thrift charters and to eliminate the unitary thrift holding company, and, as a practical matter, ownership of banks may be precluded for many securities, insurance and diversified financial services firms. Accordingly, if such a "financial-only" alternative were chosen, we believe the thrift industry should remain unchanged from its present configuration, with the unitary thrift holding company format available for companies that could not qualify to own an insured bank.

Neither model would permit subsidiaries of banks to engage in commercial activities.

Federal Reserve Regulation of Holding Companies

The Federal Reserve would continue to approve the formation of, and to supervise and regulate, all bank holding companies. The Board could require holding companies to make reports of financial information if the information is not reasonably available from other sources.

Federal Reserve examinations of a bank holding company would be limited, to the fullest extent possible, to holding company units that could have a materially adverse effect on the safety and soundness of a bank affiliate. The Board would have access to examination reports prepared by federal or state regulatory agencies and self-regulatory organizations.

The Federal Reserve would be permitted to set consolidated capital requirements for a bank holding company if: the holding company and the bank were large enough so as to raise concerns if problems were to arise; the holding company’s insured depository institutions accounted for a predominant percentage of the holding company’s total assets; or an insured depository institution owned by the holding company were less than well capitalized for more than 90 days, and the holding company engages in activities not permissible for a national bank to engage in directly. Bank holding companies not meeting any of these criteria would presumptively be excluded from consolidated capital requirements, although the Board could impose such requirements (for an individual holding company or class of companies) if it determined that it was needed to avert a material risk to the safety and soundness of a subsidiary bank presented by unusual risk in the holding company’s activities, or particular characteristics of its financial structure. Where the Federal Reserve did impose holding company capital requirements, it would be required to develop rules for excluding from the holding company’s consolidated assets and capital both the assets and capital of those company components subject to capital requirements of other regulatory authorities, and the assets and capital of other company components capitalized in line with norms for firms engaged in the same line of business.

Wholesale Financial Institutions ("WFIs")

We also propose that Congress authorize wholesale financial institutions, which would be chartered either as national banks or as state banks that are members of the Federal Reserve System, but would not be FDIC-insured and could not take deposits of less than $100,000. WFIs would not be considered "banks" for purposes of the Bank Holding Company Act; thus, like unitary thrift institutions under current law, there would be no activity limits on their owners. However, WFIs would be fully regulated by the OCC and the Federal Reserve; they would have strong capital requirements, enforceable through the usual prompt corrective action remedies; the Federal Reserve would have broad authority to impose protective conditions on WFIs in connection with their use of Federal Reserve services; and WFIs would be subject to the Community Reinvestment Act.

Functional Regulation of Financial Activities

While the Federal Reserve would continue to be the regulator of all bank holding companies under our proposal, the usual regulators of nonbanking financial activities would continue to regulate those activities, whether conducted in a holding company affiliate, a subsidiary of the bank or, with some exceptions, in the bank itself.

All insurance activities, wherever they might be conducted in a banking organization, would be subject to regulation by state authorities under state insurance laws and regulation -- provided that such laws and regulations were truly nondiscriminatory. Where state law had the purpose or effect of discriminating against financial institutions, or had a disproportionately restrictive impact on financial institutions compared to other providers of insurance in the same state, that law would not be applicable to national banks. Similarly, we would retain the standard announced by the Supreme Court in the Barnett case, so that a state law that prevented a national bank from engaging in an insurance activity authorized under federal law, or significantly interfered with or impaired its ability to engage in such an activity, could not be applied to national banks. State laws relating to the rehabilitation, conservatorship, receivership, or liquidation of insurance companies would be fully preserved.

Our proposal would narrow the Securities Exchange Act’s exemption of banks from broker and dealer registration to permit SEC regulation of activities other than traditional banking activities. The SEC’s capital requirements generally may not be applied to a bank that is well-capitalized. Traditional banking products would not be subject to SEC broker-dealer regulation, and the primary banking regulator and the SEC could jointly exempt new banking products. We would update and clarify the Investment Company Act’s applicability to banking activities and limit the scope of banks’ exemption from the Investment Advisers Act. We would generally have the SEC, rather than the banking agencies, handle the registration of bank-issued securities and periodic reporting by banks having securities registered under the Securities Exchange Act of 1934.

Finally, the principle of national treatment will guide the application of our proposal to foreign financial institutions operating in the United States.

Conversion of Thrift Institutions

Title III of our proposal sets forth a comprehensive program for eliminating the federal thrift charter, phasing out the separate federal regulation of thrift institutions, and bringing unitary thrift holding companies under the same regulatory structure as bank holding companies. As I stated earlier, we believe a charter and regulatory merger makes sense if Congress adopts a "basket" approach that would accommodate some measure of nonfinancial activity by bank holding companies.

Our model would accomplish the "merger" of the thrift industry with the banking industry over a two-year period after enactment. We believe that such a transition period is needed both to allow thrifts to prepare to become regulated as banks, and to permit an orderly merger of the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC).

At the end of the two-year conversion period a number of things would happen:

All federally chartered thrifts would be converted to national banks, by operation of law. (They would also have the right to elect an earlier conversion date, and they would retain the same rights they have today to convert to any other available charter prior to the end of the two-year period.)

All state-chartered thrifts would be treated as state-chartered banks for all federal bank regulatory purposes.

Unitary thrift holding companies now in existence would be given a grandfather exemption from the "basket" limitations, conditioned on their not having a change of control or acquiring an additional insured bank .

OTS and OCC would be merged, pursuant to plans developed by the Secretary of the Treasury, effective two years after enactment.

Membership in the Federal Home Loan Bank System would become voluntary for all institutions. (Mandatory membership would continue for federally chartered thrifts until the end of the two-year conversion period.)

BIF and SAIF would be merged. (The schedule established in last year’s legislation for phasing in sharing of the FICO bond interest payments would not be changed.)

Several other important provisions are proposed in connection with the conversion of the thrift industry to bank regulation:

Each banking agency would institute a program to accommodate voluntary specialization in housing finance and the conversion of thrift institutions to bank charters.

A mutual national bank charter would be made available to accommodate thrifts presently operating in mutual form, and mutual holding companies would be authorized.

With the merger of OTS and OCC, the size of the FDIC board would be restored to three members, as it was for the 56 years before the creation of OTS.

National Council on Financial Services

Our proposal would create a National Council on Financial Services, consisting of the Secretary of the Treasury, the Chairman of the Federal Reserve, the Chairs of the FDIC, SEC and CFTC, the Comptroller of the Currency, the Director of OTS, and a final member, appointed by the President with the advice and consent of the Senate, having experience in state insurance regulation.

The Council would have authority to define additional types of financial services companies’ activities to be "financial" for purposes of the QBHC test, and it could also prescribe additional safeguards to promote safety and soundness. It would also serve in a consultative role with respect to rulings by the OCC concerning the applicability of state insurance law to national banks.

Consumer Protections

The proposal would require regulators to prescribe rules regarding the retail sales of nondeposit investment products by banks and their affiliates, in order to avoid customer confusion about the nature and applicability of FDIC and SIPC insurance, and to protect against conflicts of interest and other abuses. These rules would address such matters as sales practices, qualifications of sales personnel, incentive compensation and referrals. In addition, they would require that disclosures be simple and readily understandable. Customers could prevent sharing of confidential customer information between banks and their nonbank affiliates. The National Council on Financial Services would be required to review the effectiveness of these regulations, and could prescribe more stringent rules than those adopted by the agencies.

Effective Dates

Under the "basket" alternative, the expansion of bank activities and affiliations would take effect two years after the enactment of the legislation -- at the end of the period provided for conversion of the thrift industry. If the second alternative were adopted, with the thrift industry remaining as it is today, we would propose that the expansion of powers and affiliations for banking organizations take effect nine months after the date of enactment.