Hearing on Financial Services Modernization

Prepared Testimony of the Honorable Robert Rubin
Secretary of the Treasury

10:00 a.m., Wednesday, February 24, 1999

Mr. Chairman, Members of this Committee, I appreciate the opportunity to discuss the Administration's views on financial modernization, including the draft bill circulated by the Chairman last week.

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 lack of access, than one of 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 draft bill. The bill, rightly in our view, takes 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. The bill also continues to allow bank insurance sales unencumbered by anti-competitive restrictions. I believe we could construct a bipartisan consensus on these provisions.

That said, the draft bill and its appendix of "undecided issues" contain significant provisions that are unacceptable to the Administration, and we would oppose the bill in its current form. We have five basic objections to the draft bill and its appendix -- its prohibition on the use of subsidiaries by larger banks; its weakening of the effects of the Community Reinvestment Act (CRA); its extensive mixing of banking and commerce; its provisions with respect to the Federal Home Loan Bank System; and what we view as inadequate consumer protections.

First, the bill would prohibit financial services firms that include large banks from conducting new financial activities through bank subsidiaries -- and force them to conduct those activities exclusively through bank holding company affiliates. Although the bill does permit smaller banks -- those with under $1 billion in assets -- to engage in new financial activities through subsidiaries, it prohibits all other banks from doing so. This provision is unacceptable to the Administration.

With the safeguards we have proposed, 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, again with the safeguards we have proposed, 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 safeguards we have proposed (which the draft bill includes in part) are as follows:

I would add that these restrictions on funding the subsidiary make this proposal fundamentally different from the European model of universal banks.

I would also observe that the draft bill permits subsidiaries of small banks to engage in the activities we have proposed.

Thus, there are no public policy reasons to deny the choice of a subsidiary; however, there are three 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 safety and soundness and protecting the deposit insurance fund, 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. Foreign bank subsidiaries hold over $450 billion in assets, and Edge Act subsidiaries hold about $250 billion in assets. Thus, there is a proven history of subsidiaries conducting these activities.

Third, 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 that if the larger national banks were prohibited from engaging in new activities through subsidiaries, then gradually such banks would 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 maintains 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 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. The draft bill establishes a process whereby the Treasury could petition the Federal Reserve to act, and veto its decisions. This arrangement is less likely to produce consensus than true joint rulemaking.

Second, we favor functional regulation. We support provisions 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 the draft bill 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 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 strongly that it is important to maintain CRA, and we are opposed to any efforts to weaken CRA.

The draft legislation includes a so-called "safe harbor" provision specifying that a satisfactory CRA rating in a bank's most recent examination conclusively establishes a bank's CRA performance, unless a public comment is filed that provides substantial verifiable information to the contrary.

Of equal concern, is a so-called "anti-extortion" amendment contained in the "undecided" portion of the draft bill. We are, of course, opposed to extortion, and extortion is illegal under state and Federal law. I have been informally advised by the Department of Justice -- and I would imagine that they would be willing to share their views on this with you as well -- that this proposed addition to Federal law, with its broad and vague terms, would extend substantially beyond existing law and could criminalize normal, legitimate, arms-length transactions and productive cooperation between banks and community groups. In addition, because of the resulting uncertainty, it could chill precisely the activity that CRA is intended to encourage. For example, banks make grants to community-based organizations to conduct home ownership counseling, which increases the bank's ability to make safe and sound loans to low-income borrowers. Under this legislation, such activity could be discouraged because the participants would be uncertain about whether that activity is illegal.

Finally, we believe that any bank seeking to conduct new financial activities should be required to achieve and maintain a satisfactory CRA record. The draft bill fails to include this requirement. 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 must be connected to a satisfactory CRA performance. Achieving and maintaining an adequate CRA record furthers the long standing public purpose of banks: to serve the convenience and needs of their communities.

Our third objection to the draft bill concerns affiliations between depository institutions and non-financial firms. The "undecided" portion of the bill authorizes a "basket" of non-financial activities that can grow to 25 percent of the revenues of the organization, and would authorize new "unitary bank holding companies." The main text of the bill would continue current law as to the powers of the unitary thrift holding companies, thus allowing commercial companies to continue acquiring thrifts. In these ways, the draft bill would allow a dramatically expanded mixture of banking and commerce -- far more than any bill that Congress has considered over the past seven years. We would have serious concerns about these mixtures of depository institution activity and commerce under any circumstances, and these concerns are heightened as we reflect on the financial crisis that has affected so many countries around the world over the past two years.

Our fourth objection concerns provisions with respect to the Federal Home Loan Bank System that are also in the "undecided" section. 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.

Our final objection concerns the relative absence of provisions designed to inform and protect consumers of the new financial products authorized under the bill. If Congress is to authorize large, complex organizations to offer a wide range of financial products, then consumers should be guaranteed appropriate disclosures and other protections.

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.

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