FROM THE OFFICE OF PUBLIC AFFAIRS

John D. Hawke, Jr.

House Commerce Subcommittee on Finance

and Hazardous Materials

Mr. Chairman, Chairman Bliley, Congressman Dingell, Congressman Manton, Members of the Subcommittee, I appreciate this occasion to discuss with you the Treasury’s approach to financial modernization. We believe Congress has the best opportunity it has had in many years to enact historic and long-overdue legislation benefitting American consumers and strengthening our nation’s financial system. We look forward to continuing to work closely with Members to develop mutually acceptable legislation.

American consumers will benefit significantly from legislation that brings increased competition to financial services by eliminating outdated barriers and permitting affiliations among commercial banks, securities firms, and insurance companies. We believe it is not unreasonable to expect that increased competition in the banking, securities, and insurance industries will ultimately save consumers billions of dollars per year.

I would like to begin by discussing briefly the need for financial modernization legislation, and what the Treasury views as the essentials of real financial modernization. I will then explain the key elements of the draft legislative proposal that we presented to the Banking Committee on June 3, 1997. We are happy to provide a copy of that draft along with highlights of the proposal. I will conclude by discussing some of our concerns about H.R. 10 as reported by the Banking Committee. We have set forth these concerns in a more detailed separate paper accompanying this written statement.

II. THE NEED FOR FINANCIAL MODERNIZATION

Why do we press the case for financial modernization now? As Secretary Rubin has stated, our nation’s financial system is strong. Record numbers of Americans have access to credit. We have the most reliable, liquid, and transparent financial markets in the world, and our financial institutions have been exceedingly innovative, allowing them to function effectively in a highly competitive global economy.

Yet we still operate under an outdated legal and regulatory structure. In the past, the businesses that make up our financial services industry were highly segmented. Federal statutes, notably the Glass-Steagall Act and the Bank Holding Company Act, reinforced this segmentation by classifying and regulating banks, securities firms, and insurance companies as separate and distinct businesses.

These laws might have been appropriate when we had a dramatically different marketplace and financial system, but there have been enormous changes in recent decades. Technological innovation and the appearance of new financial products and services have increasingly blurred the old lines that separated products offered by banks, securities firms, and insurance companies. And regulatory and judicial rulings continue to erode many of the barriers separating different segments of the financial services industry.

We need to modernize the financial regulatory and legal environment so that financial services providers can: (1) operate on a level playing field; (2) offer products and services without maneuvering through a maze of archaic laws; (3) and diversify their sources of earnings in a way that makes our financial system even stronger and better protects the federal deposit insurance funds and the taxpayers who stand behind them.

We need a financial structure that provides lower costs, increased access, better services, and greater convenience to consumers. The Commerce Department’s Bureau of Economic Analysis estimates that in 1995 American consumers spent nearly $300 billion on fees and commissions for brokerage, insurance, and banking services. That figure would more than double if we were to include the fees and commissions paid by companies. With the efficiencies that could be realized from increased competition among banking, securities, and insurance providers under our proposal, it is not unreasonable to expect that consumers may ultimately save as much as 5 percent -- or $15 billion per year in the aggregate. Savings to the public as a whole would be substantially greater. The bulk of these savings should come as increased competition prods financial services firms to adopt best practices and puts downward pressure on prices.

Consumers -- as well as farmers and small businesses -- would also benefit from a greater choice of products offered by a wider range of institutions, and our proposal could improve access for under-served consumers by lowering delivery costs and giving new competitors incentives to seek out opportunities that protected competitors previously ignored. Indeed, we are already seeing some evidence that this is happening.

III. ESSENTIALS OF REAL FINANCIAL MODERNIZATION

Financial modernization legislation must be forward looking and even-handed. Legislation that proposes to freeze the status quo, or seeks to turn back the clock to advantage particular competitive interests, or discriminates against any segment of the financial services industry, or imposes rigid organizational constraints in order to maintain a particular regulatory structure, would be inconsistent with real financial modernization.

If we are to have a strong, safe, and competitive financial services industry in the 21st century, financial modernization legislation must recognize that financial services providers are one industry. All participants should be able to offer the full range of financial products and services, accompanied by prudential safeguards. Financial products should be subject to consistent regulation, regardless of the type of firm that offers them.

We have developed a set of principles that we believe can serve as a guide for forward- looking legislation that truly modernizes our financial services industry, allowing it to remain innovative and function efficiently in a highly competitive global market. Such legislation must:

· Protect the safety and soundness of our financial system and the federal deposit insurance funds. Financial services companies, subject to strictly enforced safeguards to protect the federal deposit insurance funds, should be allowed to engage in the full range of banking, securities, and insurance activities. More diversified sources of earnings will help enhance the safety and health of the financial services sector and protect U.S. taxpayers from the risk of a financial crisis.

 

· Provide adequate consumer protection. Financial modernization must assure that the interests of consumers are appropriately protected by promoting transparency and disclosure, and by deterring deceptive practices.

 

· Reduce costs, and improve access to financial services, for consumers, businesses, and communities. Financial modernization should promote greater access to financial services for consumers. Ending the segmentation of the financial services industry into protected components should result in more competition, broader outreach to potential customers, and lower costs.

 

· Promote innovation and enhance the competitiveness of the U.S. financial services industry. The Government should restrict financial services providers’ ability to compete freely only if necessary to further clearly defined public interests, and then only to the extent necessary to do so. Government should protect and promote competition, not competitors.

 

· Allow financial services firms to choose their corporate structures based on prudent business decisions. Financial modernization must ensure that financial services providers have the flexibility to choose, consistent with safety and soundness, the organizational form that most efficiently meets their business needs.

 

IV. THE TREASURY’S PROPOSAL

Our proposal would increase competition in the financial services industry, with resulting consumer benefits, 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 activities permissible for bank holding companies.

In place of these old restrictions, we propose that Congress adopt a far less restrictive regime both for existing bank holding companies and for other financial services firms that want to affiliate with banks. We also propose to broaden the authority of banks to conduct financial activities through subsidiaries. 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 organizational structure. Let me expand briefly on the rules we would apply.

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

The proposal sets out three main prerequisites for a company owning a bank to engage in a broader range of financial activities:

· First, all or most of its activities must be financial.

 

· 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.

B. The Financial Subsidiary

Alternatively, national banks, and state banks to the extent permitted by state law, may elect to conduct broader financial activities 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 its regulatory capital position. Thus, if the subsidiary were to fail, the bank’s compliance with the highest level of required 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 apply to dealings between the bank and the subsidiary. 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 generally be permitted to engage in the same financial activities as QBHCs, such as insurance underwriting and agency operations, and the full range of securities activities, including merchant banking. The range of activities permitted for subsidiaries of state banks would, of course, depend on state law and review by the FDIC.

C. The "Banking and Commerce" Issue

A major question that Congress will face in considering broader activities for bank holding companies is the extent to which they should be permitted -- if at all -- to engage in nonfinancial activities.

Let me say at the outset that we have not proposed to eliminate all the barriers that separate banking from purely commercial or industrial activity. Our banking system has never been characterized by such a mixing of enterprises, and we see no pressures from the marketplace demanding such a permissive rule. Our objective is far more modest: to provide a framework for bringing the various segments of the financial services industry within a common set of boundaries -- to allow insurance and securities firms to enter the banking business, just as banking organizations are expanding their insurance and securities activities, and if possible, to eliminate the disparities between the regulation of banks and thrifts. To accomplish these objectives, we need to take account of the fact that most insurance and securities firms have some degree -- generally quite modest -- of nonfinancial activity, as well as the fact that "unitary" thrift holding companies -- those owning only one thrift -- have no limits at all on their permissible activities.

Our proposal sets forth two possible models that Congress might draw upon if it shares our view that it is desirable to provide such a common set of boundaries. We would support either approach.

The first is a "basket" concept, which the Banking Committee has adopted. Under this approach, a company could qualify to own a bank only if it derived the predominant percentage of its domestic gross revenues -- the Banking Committee bill fixed on 85 percent -- from financial institutions and other financial activities. If this eligibility threshold were met, the QBHC could derive the remainder of its revenues from nonfinancial activities. However, in order to assure that very large financial firms owning banks could not use the nonfinancial "basket" to acquire very large commercial or industrial companies, we would prohibit, as does the Banking Committee bill, a QBHC from acquiring any nonfinancial company with 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 any loans to or investments in their nonfinancial 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 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 percentage of nonfinancial revenue, to own an insured bank.

On the other hand, if Congress chose not to permit any level of nonfinancial activity for companies owning banks, many securities, insurance, and diversified financial services firms would be precluded from owning banks. Under the circumstances, the ownership of a thrift institution may well be the only means such firms would have to achieve competitive equity with banking organizations having broad financial powers. Accordingly, if such a "financial-only" alternative were chosen, we believe the existing thrift holding company framework should remain unchanged, which would allow financial services firms whose nonfinancial affiliations would otherwise preclude them from owning an insured bank to affiliate with an insured depository institution.

Neither model would permit subsidiaries of banks to engage in commercial activities, but each model would permit the financial subsidiaries and holding company affiliates of banks to engage in a broad new range of financial activities.

D. Federal Reserve Regulation of Holding Companies

Under the Treasury proposal, 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 generate reports of financial information if the information were 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 (1) the holding company and the bank were large enough that systemic concerns might be presented if problems were to arise; (2) the holding company’s insured depository institutions accounted for a predominant percentage of the holding company’s total assets; or (3) an insured depository institution owned by the holding company were less than well capitalized for more than 90 days. Bank holding companies not falling within these categories 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.

E. Wholesale Financial Institutions

We also propose that Congress authorize wholesale financial institutions (WFIs), 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, as is the case with 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 prompt corrective action. The Federal Reserve would have broad authority to impose safeguards on WFIs’ use of Federal Reserve services. WFIs would also be subject to the Community Reinvestment Act.

F. 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 banks.

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 would not be applied to a bank that is well-capitalized, but would apply to all others. 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 would guide the application of our proposal to foreign financial institutions operating in the United States.

G. 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. Although the Treasury supports merging the bank and thrift federal deposit insurance funds, we believe a charter and regulatory merger makes sense, as I stated earlier, only if Congress adopts a "basket" approach that would accommodate some measure of nonfinancial activity by bank holding companies. The Banking Committee has recently taken such an approach.

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 undergoing a change of control or acquiring an additional insured bank.

 

· The 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.)

 

· The FDIC’s bank and thrift deposit insurance funds ("BIF" and "SAIF") would be merged.

 

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

· Depository institutions’ ability to specialize in housing finance would be protected. Each banking agency would institute a program to accommodate voluntary specialization in housing finance and the conversion of thrift institutions to bank charters.

 

· Thrifts operating in mutual form would not be disadvantaged. 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 the 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.

 

H. 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 the 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 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.

I. 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.

J. 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.

V. CONCERNS ABOUT THE BANKING COMMITTEE BILL

We are pleased that the Banking Committee based its reported bill on the structure of our financial modernization proposal and adopted much of our draft. Our concerns about the bill arise from the inclusion of provisions that would fail to remove barriers to competition or that lack even-handedness, and thus fail to meet the essentials for a real financial modernization program. While a document accompanying this statement elaborates on such concerns, I will highlight some key concerns now:

· Insurance sales provisions in the bill would curtail competition and discriminate against national banks. Almost half the states permit their state-chartered banks to sell insurance without regard to local population size and without having to set up separate subsidiaries or affiliates. Yet the bill would retain the current rule limiting many national bank insurance agency activities to towns with 5,000 or fewer people -- a limitation that does not burden the very largest institutions, but imposes needless cost burdens on mid-sized and smaller banks. We believe this is a mistake: national banks should have full insurance agency powers, subject to appropriate safeguards. Likewise, the bill would generally prohibit national banks from selling or underwriting title insurance. This prohibition is backward-looking and inequitable, since many national banks have long engaged in title insurance activities. Paradoxically, the bill seems to permit a title insurance company to affiliate with a bank through a holding company.

 

· Unlike the Treasury’s proposal, the bill’s provisions regarding financial subsidiaries of banks do not permit flexibility for financial institutions to choose the organizational structure that best fits their needs. Banks should have authority to offer a full range of financial products and services through subsidiaries (as well as holding company affiliates) if the parent banks and their subsidiaries meet strong capital protections and other safeguards. The bill would, however, prohibit national banks from conducting merchant banking or underwriting insurance through subsidiaries, permitting such activities only in holding company affiliates. Such a prohibition is unnecessary and unfair, since parent banks and their subsidiaries would have to comply with safeguards comparable to those that would apply to banks and their holding company affiliates. Insofar as insurance is involved, the subsidiaries under our proposal would be subject to the state laws applicable to insurance providers in the state.

 

· Functional regulation provisions in the bill are generally consistent with our proposal. But unlike our proposal, the bill would not transfer oversight of bank-issued securities from the banking agencies to the SEC. We see no justification for continuing the present system of overlapping and duplicative functions in this area. In addition, the bill authorizes the Federal Reserve to decide whether a product is a "banking" product exempt from broker-dealer regulation under the Securities and Exchange Act. This would potentially give a single regulator a decisive influence over future product innovation and financial structure. We believe, and have proposed, that such decisions should more properly be the joint province of the SEC and the appropriate federal banking regulator, with the inter-agency National Council on Financial Services resolving any disagreement.

 

· Bank holding company regulation provisions give a single regulator excessively broad authority to impose capital requirements on companies owning banks. Thus securities and insurance firms that want to enter into banking, along with their affiliated businesses, would be subject to potentially burdensome new capital regulation. Congress should either retain current law in this area or adopt the more narrowly targeted conditions for imposing holding company capital requirements that we have recommended.

 

· The wholesale financial institution provisions are inconsistent with the dual banking system by giving the Federal Reserve, which regulates state member banks, virtually exclusive regulatory authority over nationally chartered wholesale financial institutions. Those provisions also fail to provide appropriate safeguards for the financial system, taxpayers, and consumers, such as those in the Treasury proposal.

 

VI. CONCLUSION

In conclusion, Mr. Chairman, let me again emphasize the importance of financial modernization legislation both to consumers and to the competitiveness of the U.S. financial

services industry. There are compelling reasons to enact legislation this year -- but not at any price. I hope my remarks have been helpful in clarifying the Administration’s priorities and key concerns. We look forward to working with you to develop mutually acceptable legislation.