Hearing on Financial Services Modernization

Prepared Testimony of Mr. Michael Patterson
Vice Chairman
J.P. Morgan and Company

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


Mr. Chairman and Members of the Committee, I am Michael Patterson, Vice Chairman of J.P. Morgan & Co. and Chairman of the Financial Services Council. I am pleased to be here today to testify on the recently released "staff discussion draft" of a basic bill for modernizing financial services. We commend you and the Committee for your timely consideration of the issues surrounding financial modernization.

The Financial Services Council differs from other associations that will come before you to discuss financial modernization because it represents the views of companies active in all sectors of the financial services industry, rather than in one specific industry sector. Our membership includes banks, securities firms, insurance companies and diversified firms that engage in both financial and nonfinancial activities. Members of the Financial Services Council compete head to head every day for the opportunity to serve consumers and investors. But we share the conviction that fundamental reform of America's financial laws is necessary to allow U.S. financial services firms to provide their customers with a full range of products, greater convenience, more innovation, and lower costs, and to enable U.S. firms to compete on fair and equal terms in domestic and international markets.

For more than a decade, it has been apparent that consumers and markets would benefit by unshackling the financial services industry from an antiquated legal structure. The provisions of the Glass-Steagall Act and the Bank Holding Company Act, some of them enacted more than 65 years ago, were designed in response to a marketplace that no longer exists. There is a consensus shared by most financial firms and their customers, as well as policymakers, that these rules restrict competition, reduce consumer choice, and are not necessary to protect consumers or insured financial institutions. Treasury Secretary Rubin testified in 1997 about the savings to consumers that would result from reform of our depression era financial laws. He stated that "it would not be unreasonable to expect ultimate savings to consumers of 5 percent from increased competition in the securities, banking and insurance industry -- as much as $15 billion per year. These savings would be substantially greater if you include costs to companies, as well as consumers."

This Congress has a unique window of opportunity to pass major financial reform this year, and we think it imperative to do so. Unlike years past, when we urged financial reform on the basis of predictions of rapid changes in the financial markets, you are now addressing this legislation in the context of accelerating global financial industry consolidation. Over the past year, we have witnessed our international competitors both consolidate their resources and acquire a number of American financial institutions. Despite the consolidation that also is occurring in the U.S., many of the largest and most diversified financial services companies today are still headquartered outside this country. We must not allow obsolete laws to inhibit the global preeminence of U.S.-based financial corporations and of our nation's financial markets.

The rapid evolution and convergence of banking, securities and insurance will not cease; and it is important that the Congress act to establish a regulatory framework that enables American firms to respond efficiently and effectively to the imperatives of the marketplace, while providing for appropriate supervision of large and complex institutions. Should Congress fail to act, the restructuring of the global financial industry will simply proceed while American institutions remain handicapped by antiquated laws.

The goal should be to enhance the global competitiveness of American firms, while advancing competition and consumer choice here at home. This draft legislation does much to achieve this balance, strengthening our ability to compete with foreign financial institutions here and abroad and granting new competitive opportunities to financial companies here at home. The ultimate beneficiaries of this increased competition are consumers, who will have more convenient access to a greater number of products and services at lower prices.

Much of the industry infighting that has plagued the debate on this legislation is resolved. As was illustrated by consideration of H.R. 10 last year on the House floor, there is broad support for the fundamental principle behind this bill - - that banks and securities firms and insurance firms should be allowed to affiliate. Though some disagreement on regulation of holding companies remains, the issues are not many and can be resolved. Now is the time to put in place a workable system that will set the framework for the delivery of financial services in the new century.

Glass-Steagall and the Bank Holding Company Act

Our current financial laws were shaped in an economic era vastly different from today's. Some resulted from a misguided attempt to remedy the ills that led to the Great Depression. Others were enacted in the years that followed. Virtually all of the laws governing our financial structure were established long before the development of technology, financial products and capital markets that prevail today. While consumer needs and the marketplace have changed dramatically, our laws remain unchanged. The central component of financial modernization is the repeal of sections of the Glass-Steagall and Bank Holding Company Acts that serve artificially to segregate our financial services industry into distinct sectors.

Glass-Steagall and Section 20 Affiliates

The Glass-Steagall Act was enacted in the wake of the stock market collapse of 1929 and deep distrust of our financial sector. Glass-Steagall generally prohibits banks from underwriting or dealing in securities and from affiliating with firms that are "engaged principally" in those activities.

Glass-Steagall never completely separated banks from the securities business. For example, it permitted banks to underwrite and deal in U.S. government bonds and municipal general obligation bonds. Twelve years ago, banks were authorized to establish affiliates ­ known as Section 20 subsidiaries ­ to engage in securities activities that were ineligible to be conducted directly by a bank, for example the underwriting of corporate securities. Today, Section 20 affiliates of bank holding companies may derive up to 25% of their gross revenues from bank-ineligible underwriting activities, and some of the leading underwriters are now bank affiliates. There have been numerous acquisitions of American broker-dealers by banks in recent years. At the same time, several securities firms have established banking operations through grandfathered limited purpose banks (CEBA banks) and some have, or recently have applied for, federal thrift charters.

Bank Holding Company Act

The Bank Holding Company Act of 1956 is the other major law governing the structure of our financial services system. The Act, among other things, allows companies that control banks to engage only in activities that are "closely related to banking." Thus, companies that are engaged in commerce -- i.e., activities that are not closely related to banking -- are not permitted to own banks. The Act specifically provides that insurance underwriting is not closely related to banking. In reality, however, the barrier between banking and other financial and nonfinancial activities has never been airtight. For example, individual persons are allowed to own banks and commercial businesses. Thus, an individual that owns a bank can also own a car dealership or a shoestore. Insured financial institutions that are not "banks" under the Act, such as thrifts, credit card banks, industrial loan companies and CEBA banks, may be owned by companies that engage in commercial activities without limit. In fact, until 1970 commercial businesses could own full-service banks as "one-bank holding companies," just as they may today be a unitary thrift holding company.

Just as non-banking financial firms and some commercial companies have found ways to get into the banking business, bank regulators have allowed banks, in accordance with current laws, to expand their insurance activities ­ principally through retail sales. Increasingly, financial services are converging and providers compete across traditional industry lines. But true competition is limited by law.

Changing Marketplace

Two factors are driving these market developments -- technological advances and the needs of wholesale and retail customers. The current regulatory structure was put in place when the range of services available to the consumer, as well as the number of potential providers, was limited. Most financial services were obtained locally, more often than not from a neighborhood banker or insurance agent with whom the consumer was personally acquainted.

In today's marketplace, consumers, investors and businesses are not hesitant to obtain services from a variety of providers, some locally, and some located in distant places. While many consumers still choose to obtain services from a local source with whom they are personally acquainted, others prefer the convenience of transacting business over the telephone or via the Internet. Consumers not only have access to financial information 24 hours a day, but they can initiate financial transactions worldwide on a real-time basis.

Consumer needs have prompted the development of financial services that were unknown or only available on a limited basis not long ago -- services like mutual funds, money market accounts, credit cards, various types of mortgages, individual retirement accounts, home equity loans, stored value cards, and a variety of products geared to the business owner. Many of these new products are the result of an increasing level of competition by financial services providers across industry lines, providing alternatives to the customers they share for services once available only from a single source. For example, money market mutual funds were developed to provide an investment alternative for funds that consumers were holding in bank accounts. Banks provide loan syndications and private placements to investors that are in economic substance equivalent to bonds underwritten by securities firms. Life insurance companies developed single premium annuities to compete with bank certificates of deposits.

Delivery of these products is facilitated by increasingly sophisticated communications and information technology, which enable financial firms to handle information more efficiently and to develop improved products geared to the needs of each individual consumer and investor. Transaction costs and processing time are declining, while financial services providers are better able to access information about a customer's total account relationship in order to offer products best suited to the customer's needs.

But while technology and competition have offered the potential of better products and services, increased efficiency, and lower costs, the extent to which U.S. financial institutions and their customers can take advantage of these opportunities has been limited by statutory and regulatory constraints. For financial services firms to function efficiently in today's complex global economy, our financial services laws must be revised to accommodate the changes in consumer and business demands and their savings, investment, and capital-raising preferences. A new legal framework must recognize that the old segmentations of financial services providers no longer make sense, that financial services products now compete across traditional industry lines, and that communications and technology ensure that changes in financial services will continue to occur. It is imperative that this structure be flexible enough to accommodate future market developments without building unnecessary barriers to competition.

Pending Legislation

The staff discussion draft offers a solid foundation for reform. It addresses many of the issues surrounding the market driven integration of financial services, and would allow for the full affiliation of banking, securities and insurance under one holding company.

Unlike years past, when legislative efforts deadlocked due to inter-industry turf fights aimed at forestalling new competition, there is today less disagreement in the industry about the basic structure of modernization. Faced with the realities of rapid convergence of financial services and increased global competition, the acceptance by both government and industry of affiliations among the three main pillars of the financial services industry, with appropriate supervision, removes a long-standing barrier to the enactment of meaningful reforms.

The outstanding issues that I will comment on today are limited to three general areas: (1) functional regulation; (2) whether activities not eligible for a bank may be conducted in an operating subsidiary of a bank, as well as in an affiliate under a holding company; and (3) the need for flexibility in the definition of what is "financial in nature".

Functional Regulation

It is the position of the Council that subsidiaries of a holding company should be regulated by those with the greatest experience in assessing risks associated with the activities conducted by that subsidiary. As financial services products and the technology used to deliver them become increasingly sophisticated, the advantages of specialized regulation by function become more acute. While each sector brings a different perspective, much progress has been made on this issue. In this regard, we would recommend that the Committee consider incorporating into the legislation it ultimately considers provisions that reflect the compromises among the banks and insurance companies and other industry participants over the last two years. We believe these compromises strike the delicate balance necessary today to continue to move the process forward.

Operating Subsidiaries

The "Staff Discussion Draft" would prohibit bank operating subsidiaries of institutions with total assets exceeding $1 billion from engaging in all non-agency activities that are not permissible for a national bank to engage in directly. National banks with total assets of $1 billion or less would be allowed to conduct non-real estate related activities through operating subsidiaries. While attempting to find a compromise in this ongoing battle, this proposal has yet to satisfy the reservations of either the Federal Reserve or the Treasury Department. The issue could be resolved on terms that would seem to be generally acceptable to most financial firms by adopting compromise operating subsidiary language similar to that drafted by Senators Grams and Reed last year (allowing bank subsidiaries to engage in financial activities other than insurance underwriting). However, this issue has become a philosophical battleground between two key bank regulators. Given the great progress made on all other fronts, this dispute should not be allowed to stand in the way of financial modernization. In general, a heavy burden of persuasion should accompany advocacy of regulatory limitations on the flexibility of any financial services provider to organize itself in a manner best suited to serve its customers and for its maximum efficiency.

Financial in Nature and De Minimis Non-Financial Activities

The Financial Services Council has long held the view that it is unnecessary to maintain the partial separation of banking and commerce that exists today. We, therefore, support the approach put forth in the draft allowing a bank holding company to invest some percentage of its annual net revenue in non-financial activities.

While we will continue to be advocates for the inclusion of a commercial basket in the bill that will be ultimately enacted, we understand that this issue is one that is still under much discussion. Having said that, the need for financial firms to have the flexibility to respond to the demands of their customers and technology is crucial. Thus, at a minimum, we believe that some additional flexibility should be built into the definition of "financial" in order to avoid excluding from bank ownership financial firms that engage to a limited extent in activities that might be considered non-financial.

First, it would be advantageous to remove the delays and uncertainties created by the need to seek regulatory interpretations of the permissible activities list, by expanding the list of "activities that are financial in nature" to include those currently listed in Section 102 (a)(5)(b) of the "discussion draft" (i.e., management of financial assets other than money or securities, transferring financial assets, and engaging in transactions for the account of third parties).

Additionally, we believe that the definition of permitted activities should include those that are "complementary" to financial activities, as well as any other service which the Federal Reserve Board has determined not to pose a substantial risk to the safety or soundness of depository institutions or the financial system generally.

The world of finance has changed. Information services and technological delivery systems have become an integral part of the financial services business. Financial firms use overcapacity in their back office operations by offering services to others such as telephone help lines or data processing for commercial firms. These activities may not be strictly "financial," yet they utilize a financial firm's resources and complement its financial capabilities in a manner that is beneficial to the firm without adverse policy implications.

Financial firms also engage in activities that arguably might be considered non-financial, but which enhance their ability to sell financial products. One example is American Express, which publishes magazines of interest to its cardholders ­ Food & Wine and Travel & Leisure. Travel & Leisure magazine is complementary to the travel business (an activity permitted within the definition of financial) in that it gives customers travel ideas which the company hopes will lead to ticket purchases and other travel arrangements through American Express Travel Services. Similarly, Food & Wine promotes dining out, as well as purchases of food and wine, all of which might lead to

greater use of the American Express Card. These activities are complementary to financial business and thus should be permissible for financial holding companies.

Financial firms that are not bank holding companies engage in a broad range of limited commercial activities. It makes sense for them to do so today and likely will in the future as well. We believe that financial modernization legislation should give financial firms the greatest possible latitude to make business judgements about the activities in which they engage. Their choices should be limited only when there is a compelling reason for doing so, and they should have the flexibility to innovate and provide new products demanded by the marketplace. Both businesses and consumers are ultimately hurt by legislation that unnecessarily limits consumer choice and places restrictions on how companies use their capital.


In concluding, I want to reiterate the urgency of sound financial services modernization legislation. The House passed a financial modernization bill for the very first time last year. For the Senate, this is truly an historic opportunity to capitalize on industry consensus, pass legislation and see it be enacted into law.

In this rapidly evolving and competitive market, the U.S. financial services industry must be nimble enough to meet the growing demands of consumers -- individuals, businesses, and public agencies alike. Financial modernization will allow firms to better serve their domestic customers and meet international competition in an industry that is

vital to the nation's future. But only with Congressional action can an evenhanded and comprehensive structure for the financial services industry be achieved.

Thank you Chairman Gramm for your work on this issue and for the opportunity to testify before the Committee today.

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