Hearing on Financial Services Modernization

Prepared Testimony of Mr. Marc E. Lackritz
Securities Industry Association

10:00 a.m., Thursday, February 25, 1999

Mr. Chairman and members of the Committee, I am Marc Lackritz, President of the Securities Industry Association ("SIA").(1) I appreciate the opportunity to present SIA's views on the Financial Services Modernization Act of 1999. Mr. Chairman, SIA commends you for holding hearings so early in the session. We believe legislation is desperately needed to modernize the regulation of the United States financial services industry. We are optimistic that this year Congress will pass, and the President will sign into law, widely supported legislation. We look forward to working with you and all the members of your Committee to achieve this result.

Mr. Chairman, my message today is simple. The securities industry strongly supports financial services modernization legislation, and urges this Committee, the Senate and the House to pass it promptly. Last year, a unique opportunity for the passage of financial services modernization legislation was created when large segments of the banking, securities and insurance industries were able to reach a series of compromise positions on issues that previously had divided them, and that previously had prevented legislation from being enacted. We believe the opportunity created last year for passage of financial services modernization legislation still exists, and we urge the Senate to capitalize on that opportunity and act swiftly to pass legislation this session.

SIA believes that there is more than one approach that can result in legislation being enacted into law. For the securities industry to support the legislation, it should satisfy certain fundamental principles. For the legislation to be successful, it should incorporate some of the compromise provisions agreed to by industry groups and members of this Committee. These provisions, particularly the functional regulation of bank securities activities, are not only good public policy, they also remove the industry stumbling blocks that have derailed this legislation many times in the past.

The Senate has the opportunity to build upon the momentum generated last year and act swiftly to pass legislation. To lose this opportunity would be highly unfortunate for the financial services industry, which is laboring under an antiquated and often counterproductive regulatory system. Moreover, it would be a disaster for the American public, who, as consumers of financial products and services, are not receiving the benefits of competition and innovation that would result from financial service modernization legislation.

Congress is the only body that can comprehensively alter the regulatory system in a manner that is fair to all segments of the financial services industry and in the best interests of financial services consumers. SIA believes that legislation that is fair to all segments of the financial services industry is in the best interests of financial services consumers. And the need for prompt financial services modernization legislation is compelling.

Today, financial institutions are affiliating with one another at a dizzying speed under a regulatory system that was intended to ban such affiliations. These affiliations are the result of ad hoc decisions by banking regulators that have permitted banking organizations to acquire securities firms, while securities firms generally remain prohibited from acquiring commercial banks. Moreover, even if a securities firm were to acquire a bank, the combined entity would become subject to the Bank Holding Company Act, even though that law was not designed to accommodate many of the ordinary and customary activities of securities firms (such as securities underwriting and dealing, merchant banking, venture capital, commodities and various other activities). Also, many of the current restrictions on bank affiliates were imposed prior to the invention of computers, fax machines, ATMs, the Internet, and various other technological innovations that have transformed the financial services industry. Such impediments make little sense in today's technologically sophisticated, highly competitive and global financial world.

Still, financial services providers continue to affiliate under the current regulatory framework despite outdated restrictions that drive up the cost of affiliations and limit the competitiveness of the combined firms. In the last two years, banks have acquired more than 50 securities firms. Financial services firms affiliate in response to their customers' and clients' demands and to remain competitive in the financial marketplace. The financial services industry will continue to evolve regardless of whether financial services modernization legislation is enacted. It is simply not desirable or possible to maintain the status quo. The fundamental policy question for Congress is not whether these affiliations should occur, but what regulatory system should govern the combined entities. Surely, it should not be the current patchwork regulatory scheme that gives some financial institutions unfair and irrational competitive advantages over other financial institutions, and that permits many financial activities to be conducted outside of the supervision of the appropriate financial regulator. SIA believes these combined entities should be regulated under a system similar to that proposed in the draft legislation recently released by the Chairman's staff. Providing financial services in functionally regulated entities that may affiliate with one another in a holding company structure will enhance the competitiveness of all financial services firms and ensure investor protection.

The U.S. securities industry is perhaps as competitive as any industry in the world. It is in part a result of that competition ­ including the ability to affiliate with entities other than banks ­ that the U.S. capital markets are the world's largest and most liquid. In the securities markets, one need only look at the vast choices in products, services, providers, and methods of compensation to see how competition has greatly benefited investors. Consumers can invest in stocks, bonds, and thousands of mutual funds. They can choose a full-service provider or a financial planner to receive advice on managing their assets. More independent and knowledgeable investors can use a discount firm to execute their transactions. Or they can make their trades electronically over the Internet for a fraction of the cost of just a few years ago. Investors can choose to compensate their broker in a traditional commission arrangement, a flat fee basis, or as a percentage of assets under management. These changes greatly benefit investors and are the direct result of a highly diverse, competitive industry that is willing and able to invest the capital needed to meet the demands of its customers. Passage of financial services modernization legislation would bring the benefits of competition, including cost savings estimated at $15 billion over three years, to the financial services marketplace.

In addition to institutional cost savings, a well-balanced version of financial services modernization legislation would also give customers more choices. Many individual and institutional customers worldwide are demanding to have all their financial needs met by a single firm. The ability of securities firms, insurance companies, and banks to affiliate would allow a single financial services firm to meet those needs. Individuals may choose a full-service provider because they value something as simple as a single monthly statement showing their checking account balances, securities holdings, retirement account investments and insurance policy values. Corporate customers might take advantage of banking, securities, and insurance services from one provider without having to reveal confidential information to several different entities. Many of the cross-industry acquisitions of securities firms by banks allow one institution to provide a broader range of products and services to its customers.

SIA therefore has long supported financial services modernization legislation. But any such legislation must be based on three key provisions:

Functional Regulation: One federal agency should apply the same set of rules to the same activity engaged in by any financial institution, regardless of the type of financial institution it may be. This protects investors and eliminates unfair competitive advantages.

Two-Way Street: Securities firms should be permitted to fully and freely affiliate with banks in a financial holding company, just as banks can affiliate with securities firms.

Competition Without Federal Subsidies: Securities activities should be performed in separately capitalized affiliates of banks, and those affiliates should not receive a competitive advantage from the insured deposits or credit power of a federally insured bank.

Mr. Chairman, the staff draft contains several provisions that SIA supports. First, the bill creates a new regulatory structure that would enhance the competitiveness of financial services firms by permitting securities firms, insurance companies, and banks to freely affiliate in a holding company structure. This would increase competition between financial services firms, thus reducing costs; give consumers more choices; and help the United States financial services industry maintain its preeminent status in the global economy. SIA believes this financial services affiliated structure is conceptually far superior to today's arcane system, and accurately reflects the requisite structure of today's globalizing financial services market.

Second, SIA generally supports language that would permit financial holding companies to engage in commercial activities. Under this proposal ­ which SIA urges be incorporated into this bill ­ a holding company would be permitted to engage in a limited amount of commercial activities. Immediately following the enactment of the legislation, a holding company could derive five percent of its consolidated annual net revenues from commercial activities, and this percentage would increase over time to 25 percent. SIA believes, however, that existing commercial activities of a holding company should be grandfathered, even if the revenues from those activities exceed the five-percent limit, so that securities and other financial services firms will not be required to divest existing and long-standing commercial relationships in order to affiliate with a bank. Permitting commercial affiliations by holding companies would reflect the current market practices of securities and other financial services firms, increase competition, and permit financial services firms to diversify their sources of income. Moreover, there is no reason to believe that permitting commercial affiliations will endanger banks. Indeed, the experience under the unitary thrift charter, which currently permits securities firms to own or affiliate with a thrift, is powerful empirical support for this view.

Third, SIA also supports the proposed unitary bank holding company, pursuant to which a commercial firm could acquire a single bank. SIA urges that this language also be incorporated into the legislation. SIA believes that this proposal will increase competition in the financial services industry by increasing the number of companies and management teams that can own a bank. This proposal also would increase the sources of capital that are available to the banking industry. And the unitary thrift holding company model demonstrates that this proposal can be implemented without posing a risk to the affiliated banks, because commercial firms currently can acquire a single thrift.

SIA believes it is critical that your legislation contain some of the compromise provisions that have been developed. As you know, last session SIA supported a financial services modernization bill and worked actively to pass it. That bill, while not perfect, represented a series of compromises by every sector of the financial services industry. Although there were a number of provisions that SIA believed could be improved, we supported the bill because we were committed to maintaining the delicate consensus that emerged among all the participants.

The staff draft does not include critical consensus provisions requiring the functional regulation of bank securities activities. Under the concept of functional regulation, one regulatory agency should apply the same set of rules to the same activity engaged in by any financial institution, regardless of the type of institution it may be. SIA strongly believes that the Securities and Exchange Commission ("SEC"), the securities self-regulatory organizations ("SROs"), and the state securities agencies should regulate securities activities regardless of which entity engages in those activities. Similarly, the appropriate federal or state banking regulator should regulate banking activities, regardless of which entity engages in those activities. Functional regulation assures that the most knowledgeable regulator is supervising a financial institution's activities. In the securities markets, all participants would be equally subject to the principle of complete and full disclosure and regulation by the SEC and SROs. The guiding principle of disclosure protects investors, encourages innovation, and ensures fair markets. Indeed, under this regulatory structure, the U.S. capital markets have set the global standard for integrity, liquidity, and fairness. Investors understand the protections they are afforded and market participants understand their obligations.

Moreover, functional regulation eliminates regulatory discrepancies and the resulting competitive advantages between financial services firms engaging in the same activities. Any reform legislation should mandate that all securities activities be performed outside of a bank, except for a small number of carefully defined securities activities that traditionally have been conducted in banks and regulated by SEC, SRO and state securities regulation.

After years of negotiation, the securities and banking industries developed a set of functional regulation provisions that permitted banks to continue to engage in certain securities activities that banks traditionally had provided to their customers as an adjunct to their banking services, but required that full-scale brokerage operations be conducted outside of the bank in an SEC- and NASD-regulated brokerage affiliate. Notably, SIA is not aware of any significant opposition ­ in either the banking or securities industries ­ to these functional regulation provisions. SIA urges that these functional regulation provisions be included in any financial services modernization legislation that is introduced in the Senate.

SIA also is concerned that the staff draft would permit bank operating subsidiaries to engage in any securities brokerage activities, and in any activities that had been deemed permissible for them at the time the bill is enacted. In addition, operating subsidiaries of banks with assets of less than $1 billion could underwrite and deal in securities. And, notably, there is no express provision for functional regulation (i.e., SEC and NASD) of operating subsidiaries engaging in securities activities.

SIA strongly objects to permitting operating subsidiaries of banks to engage in securities activities. SIA believes all securities activities should be performed in separate bank affiliates owned by the bank holding company, rather than the bank itself. This would assure that all securities firms would be subject to the same regulatory system, and would protect banks and the federal deposit insurance system from the risk of failure of an operating subsidiary engaging in securities activities.

Permitting an operating subsidiary to engage in securities underwriting and dealing activities, however, is a significant increase in the securities powers of operating subsidiaries, and SIA opposes any such provision. Similarly, SIA cannot support legislation that fails to expressly provide that the SEC and NASD would fully regulate any bank operating subsidiary engaged in any securities activities. Finally, SIA is concerned with the ease with which a banking organization could set up one or more banks with less than $1 billion in assets, and conduct securities underwriting and dealing activities through operating subsidiaries of those banks, regardless of the total assets in the banks controlled by that banking organization.

SIA also urges that the staff draft be amended to provide for the creation of Wholesale Financial Institutions ("WFIs"), which would be banks that do not accept insured deposits--that is, deposits under $100,000--and whose deposits are not insured by the federal government. WFIs would provide commercial banking services to institutional customers without imposing any risk to the bank insurance fund or to U.S. taxpayers. SIA strongly supports WFIs because they would give additional flexibility to financial services firms that primarily serve institutional customers and that have no independent business interest in acquiring a bank that serves retail customers.

In addition, there are several areas of the staff draft that are similar to provisions that have been included in other financial services modernization proposals, and that SIA continues to believe could be improved. These issues include:

Amending the definition of "financial in nature" to include activities that are complementary to activities that are financial in nature, in order to allow securities, insurance, and other financial services firms to continue providing long-standing and important services to their customers. For example, a financial services firm should not be prohibited from offering to its customers, as an adjunct to its financial services, access to a web site that permits them to purchase non-financial products related to the firm (such as cups, shirts and travel bags with the firm's logo), or from expanding that service to include other non-financial products.

Broadening the description of permissible merchant banking activities to assure that current market practices are not inadvertently restricted. For example, because of the restrictions in this bill against a securities firm becoming involved in the company's day-to-day management operations, it might be unduly limited in its ability to interact with the management of a company it acquired in a merchant banking transaction. Similarly, the securities firm might be required to divest that company in a "fire sale" because of the bill's restrictions on the length of time the company could be owned.

Reducing the significant role of the Federal Reserve Board over financial holding companies. Reducing the role of the Federal Reserve Board would prevent unnecessary and counterproductive regulatory interference in the business activities of the functionally regulated subsidiaries and in the business operations of the holding company. The Federal Reserve Board's authority should be limited solely to powers necessary to protect the safety and soundness of insured depository institutions, and to protect against systemic risk.

Deleting the provisions that permit banks to directly underwrite and deal in municipal revenue bonds. Bank securities activities should be limited solely to those which banks historically and actually have performed. All other securities activities - including underwriting and dealing in municipal revenue bonds - should be conducted in an affiliated broker-dealer registered with the SEC.

Mr. Chairman, we look forward to working with you and the members of this Committee to enact financial services reform legislation this year. We believe that there remains a unique opportunity to enact such legislation, and we are determined to do all we can to take advantage of that opportunity. We hope we can build upon the momentum generated for passage of a widely supported financial services modernization bill that can quickly be enacted. And we thank you, Mr. Chairman, for making this legislation a priority.

(1) The Securities Industry Association brings together the shared interest of more than 740 securities firms to accomplish common goals. SIA member-firms (including investment banks, broker-dealers, and mutual fund companies) are active in all U.S. and foreign markets and in all phases of corporate and public finance. The U.S. securities industry manages the accounts of more than 50-million investors directly and tens of millions of investors indirectly through corporate, thrift, and pension plans. The industry generates approximately $270 billion of revenues yearly in the U.S. economy and employs more than 380,000 individuals. (More information about the SIA is available on its home page: http://www.sia.com.)

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