Mr. Greenspan presents the views of the Federal Reserve Board on some
broad issues associated with financial modernization Testimony of the Chairman of the
Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on
Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services
of the US House of Representatives on 13/2/97.
Madam Chairwoman, members of the Subcommittee on Financial Institutions and
Consumer Credit, it is a pleasure to appear here today to present the views of the Federal
Reserve Board on some broad issues associated with financial modernization. The unremitting
pressures of technology and the market are drastically changing the financial landscape and
eroding traditional positions of competitors, inducing new competitive strategies and
participants, forcing new regulatory responses, and building pressures on the Congress to shape
developments in the public interest.
Madam Chairwoman, I know that you have been an active sponsor and supporter
of legislation to modernize the financial system. The Board also has been a strong proponent
both of expanded financial activities for banking organizations and enhanced opportunities for
nonbank financial institutions to enter banking. We continue to support financial modernization
because we believe it would provide improved financial services for our citizens. Moreover,
both our experience and analysis suggest that the additional risks of new financial products are
modest and manageable. Indeed, technology already has resulted in a blurring of product and
service-defining lines so dramatic as to make many financial products virtually indistinguishable
from each other and the old rules inapplicable. In the process, we have already seen the public
benefits, benefits that removal of old barriers could only enhance.
But, as we proceed down the path of reform, reforms both desired for their
benefits to the public and required by global markets and new technologies, the Board urges that
any modifications be tested against certain standards. In particular, the Board believes that the
changes we adopt should be consistent with (1) continuing the safety and soundness of the
banking system; (2) limiting systemic risks; (3) contributing to macroeconomic stability; and
(4) limiting the spread of both the moral hazard and the subsidy implicit in the safety net.
Thus, if my comments today sound cautious, I want the subcommittee to
understand that my observations do not reflect opposition to further freeing of constraints on
financial competition. To the contrary. We strongly urge an extensive increase in the activities
permitted to banking organizations and other financial institutions, provided these activities are
financed at nonsubsidized market rates and do not pose unacceptable risks to our financial
system. While a level playing field requires broader powers, it does not require subsidized ones.
Safety Net Implications
In this century the Congress has delegated the use of the sovereign credit -- the
power to create money and borrow unlimited funds at the lowest possible rate -- to support the
banking system. It has done so indirectly as a consequence of deposit insurance, Federal Reserve
discount window access, and final riskless settlement of payment system transactions. The
public policy purpose was to protect depositors, stem bank runs, and lower the level of risk to
the financial system from the insolvency of individual institutions. In insuring depositors, the
government, through the FDIC, substituted its unsurpassable credit rating for those of banks.
Similarly, provisions of the Federal Reserve Act enabled banks to convert illiquid assets, such as
loans, into riskless assets (deposits at the central bank) through the discount window, and to
complete payments using Federal Reserve credits. All these uses of the sovereign credit have
dramatically improved the soundness of our banking system and the public's confidence in it.
In the process, it has profoundly altered the risks and returns in banking.
Sovereign credit guarantees have significantly reduced the amount of capital that banks and
other depositories need to hold, since creditors demand less of a buffer to protect themselves
from the failure of institutions that are the beneficiaries of such guarantees. In different
language, these entities have been able to operate with a much higher degree of leverage -- that
is, to obtain more of their funds from other than the owners of the organization -- than virtually
all other financial institutions. At the same time, depositories have been able to take greater risk
in their portfolios than would otherwise be the case, because private creditors -- depositors and
others -- are less affected by the illiquidity of, or losses on, the banks' portfolios. The end result
has been a higher risk-adjusted rate of return on depository institution equity.
Moreover, the enhanced ability to take risk has contributed to economic growth,
while the discount window and deposit insurance have contributed to our macroeconomic
stability. But all good things have their price. The use of the sovereign credit in banking -- even
its potential use -- creates a moral hazard that distorts the incentives for banks: the banks
determine the level of risk-taking and receive the gains therefrom, but do not bear the full costs
of that risk. The remainder of the risk is transferred to the government. This then creates the
necessity for the government to limit the degree of risk it absorbs by writing rules under which
banks operate, and imposing on these entities supervision by its agents -- the banking
regulators -- to assure adherence to these rules. The experience in the 1980s with many insured
thrift institutions showed just how dangerous lax enforcement of supervisory rules can be. In the
end, some hard lessons were learned, many of which were legislated into the FDIC Improvement
Act of 1991.
The subsidy to the banking and other depositories created by the use of the
unsurpassable sovereign credit rating of the United States government is an undesirable but
unavoidable consequence of creating a safety net. Indeed, one measure of the effectiveness of a
safety net is our ability to minimize the subsidy and limit its incidence outside of the area to
which it was directed. Some of the value of the subsidy has been passed to depositors of, and
borrowers from, banks, for example, as well as to the original bank shareholders. But, the United
States government has been remarkably successful in containing the value of most of the subsidy
within depository institutions. The bank holding company organizational structure has, on
balance, provided an effective means of limiting the use of the sovereign credit subsidy by other
parts of the banking organization. To be sure, bank holding companies have indirectly benefited
from the subsidy because their major assets are subsidiary banks. The value of the subsidy given
to the subsidiary banks has no doubt been capitalized in part into the share prices of holding
companies and has improved their debt ratings, lowering their cost of capital. But, holding
companies also own nonsubsidized entities that have no direct access to the safety net.
Accordingly, both bank holding companies and their nonbank subsidiaries have a higher cost of
capital than banks.
This is clear in the debt ratings of bank subsidiaries of bank holding companies,
which are virtually always higher than those of their parent holding companies. Moreover,
existing law and regulation under Sections 23A and 23B of the Federal Reserve Act require that
any credit extended by a bank to its parent or affiliate not only be totally collateralized and
subject to quantitative limits, but also be extended at arms-length and at market rates, making a
direct transfer of the safety net subsidy difficult.
It is true that a bank could pay dividends from its earnings, earnings which have
been enhanced by the safety net subsidy, to fund its parent's nonbank affiliates. However, the
evidence appears to be that such transfers generally do not occur. Existing holding company
powers are limited and do not offer a broad spectrum of profitable opportunities. Accordingly, it
is not surprising that data for the top 50 bank holding companies indicate that transfers from
bank subsidiaries to their parents which, like dividends, embody the subsidy, appear to have
approximately equaled holding company net transfers to their own shareholders and long-term
creditors. This indicates that few subsidized dollars in the aggregate found their way into the
equity accounts of holding company nonbank affiliates from the upstreaming of bank funds.
We must, I think, be continually on guard that the subsidy provided by the safety
net does not leak outside the institutions for which it was intended and provide a broad subsidy
to other kinds of activities. Put another way, we must remain especially vigilant in maintaining a
proper balance between a safety net that fosters economic and financial stabilization and one that
benefits the competitive position of private businesses for no particular public purpose. As I
noted, safety net subsidies have costs in terms of distorted incentives and misallocated resources.
That is why the Congress must be cautious in how the sovereign credit is used.
It has been suggested that the bank holding company structure imposes
inefficiencies on banking organizations, and that these organizations should thus be given the
option of conducting expanded financial activities in a direct subsidiary of the bank. The bank
subsidiary may be a marginally more efficient way of delivering such services, but we believe it
cannot avoid being a funnel for transferring the sovereign credit subsidy directly from the bank
to finance the new powers, thereby imparting a subsidized competitive advantage to the
subsidiary of the bank. One can devise rules -- such as 23A and 23B -- to assure that loans from
the bank to its own subsidiaries are limited and at market rates. One can even devise rules to
limit the aggregate equity investment made by banks in their subsidiaries. But one cannot
eliminate the fact that the equity invested in subsidiaries is funded by the sum of insured
deposits and other bank borrowings that directly benefit from the subsidy of the safety net. Thus,
inevitably, a bank subsidiary must have lower costs of capital than an independent entity and
even a subsidiary of the bank's parent. Indeed, one would expect that a rational banking
organization would, as much as possible, shift its nonbank activity from the bank holding
company structure to the bank subsidiary structure. Such a shift from affiliates to bank
subsidiaries would increase the subsidy and the competitive advantage of the entire banking
organization relative to its nonbank competitors.
I am aware that these are often viewed as only highly technical issues, and hence
ones that are in the end, of little significance. I do not think so. The issue of the use of the
sovereign credit is central to how our financial system will allocate credit, and hence real
resources, the kinds of risk it takes, and the degree of supervision it requires. If the Congress
wants to extend the use of the sovereign credit further, to achieve a wider range over which the
benefits of doing so can accrue, it ought to make that decision explicitly, and accept the
consequences of the subsidy on the financial system that come with it. But, it should not, in the
name of some technical change, or in search of some minor efficiency, inadvertently expand the
use of the sovereign credit. This issue would not be so important were we not in the process of
addressing what must surely be a watershed in the revamping of our regulatory structure. We
must avoid inadvertently extending the safety net and its associated subsidy without a thorough
understanding of the implications of such an extension to the competitive balance and systemic
risks of our financial system.
Central to the Board's choice of a financial structure is its desire for one that will
be most effective in fostering both a viable financial system and a vibrant economy. These
objectives, in our view, would be thwarted if the safety net subsidy directly benefited new
activities. With the safety net comes the moral hazard of which I spoke earlier, and its attendant
misallocation of resources, and uneven competitive playing field. If the government subsidies
directed to banks were channeled to bank subsidiaries, in my judgement, both the benefits and
enumerated costs to the financial system and the public would occur.
If banks were permitted to engage in new activities in their own subsidiaries,
inevitably virtually all holding companies would shift those activities now conducted in holding
company affiliates to bank subsidiaries, eviscerating the holding company structure. Were such
shifts to happen solely as the result of operational efficiencies, no one, including the Board,
should mourn the demise of the holding company. But if, as I suspect, such shifts occurred
because of the attraction of a government subsidy, we should be concerned because the insidious
effects of such subsidies would have spread. The evidence from flows between banks and their
parents, relative bond ratings, and the administration of Sections 23A and B of the Federal
Reserve Act, all strongly suggest that the holding company structure is far more capable of
containing the sovereign credit subsidy whose purpose is support of the safety net, not providing
expanded competitive advantage.
As new activities hopefully expand for banking organizations, we believe that it is
essential that we assure they are financed at market rates, not subsidized ones. This will not
always be easy. Containment of subsidies is often implemented through firewalls and other
devices which could also inhibit the very synergies which the expansion of activities is meant to
achieve. But we have dealt with these trade-offs before and should be able to in the future as
well.
Umbrella Supervision
Whether new activities are authorized in bank subsidiaries, bank holding
companies, or both, Congress, in its review of financial modernization, must consider legal
entity supervision versus umbrella supervision. The Board believes that umbrella supervision is
a realistic necessity for the protection of our financial system and to limit any misuse of the
sovereign credit.
The bank holding company organization is increasingly being managed so as to
take advantage of the synergies between its component parts in order to deliver better products
to the market and higher returns to stockholders. Such synergies cannot occur if the model of the
holding company is one in which the parent is just, in effect, a portfolio investor in its
subsidiary. Indeed, virtually all of the large holding companies now operate as integrated units
and are managed as such.
As bank holding companies began to widen their activities, and as new
technologies permitted not only the development of new products but also the systems for
controlling them, the banking organization was impelled to develop centralized risk control
techniques that crossed legal entities. Today, risk management for the entire company is
increasingly centralized not only at the larger and more sophisticated banking organizations, but
at other large financial services providers as well. This development reflects the demands of the
marketplace, which views banks and their affiliates and other financial businesses and their
affiliates as integrated organizations in terms of financial condition, management, and
reputation.
To understand the risk controls of the bank, we have first to come to grips with
the fact that the organization is interested in risk and its control, not by instrument or legal
entity, but for the entire business. This type of control is being adopted by more and more
organizations each year, and can only increase as more activities are authorized by the regulators
and the Congress. Regulatory policies and operating procedures have had to respond to these
realities, to focus on the process of decisionmaking for the total organization. Thus, the Federal
Reserve -- the historical umbrella supervisor -- also has found it necessary to concentrate more
on the process that banking organizations use to manage market, credit, operating and exchange
rate risk, and less on the traditional after-the-fact evaluation of balance sheets that can and often
do change dramatically the day after they have been reviewed by the supervisors. In such a
world, process, if not everything, is critical, and that process is determined increasingly at the
parent holding company for all of the units of the organization on a consolidated basis.
One could argue -- as several witnesses appearing before this subcommittee did
on Tuesday -- that regulators should only be interested in the entities they regulate and, hence,
review the risk evaluation process only as it relates to their regulated entity. Presumably each
regulator of each entity -- the bank regulators, the SEC, the state insurance and finance company
authorities -- would look only at how the risk management process affected their units. It is our
belief that this simply will not be adequate. Risks managed on a consolidated basis cannot be
reviewed on an individual legal entity basis by different supervisors.
Indeed, our experience has been that a problem in one legal entity can have a
contagion effect in other entities. If a bank affiliate begins to have difficulty, the market
evaluates the problem as the consolidated entity's problem and can bring pressure on all the
units. These pressures usually take the form of funding or liquidity difficulties, as creditors seek
to reduce their exposure to all units of an organization that seems to be having trouble. Better
safe than sorry. Indeed, it is in the cauldron of the payments and settlement system, where
decisions involving large sums must be made in short periods, that this contagion effect might be
first seen as participants understandably seek to protect themselves from the uncertainty that
accompanies this contagion effect. And that is how crises often begin.
These concerns were part of the motivation for the congressional decision just
five years ago to require that foreign banks could enter the United States if, and only if, they
were subject to consolidated supervision. This decision, which is consistent with the
international standards for consolidated supervision of banking organizations, was a good
decision then. It is a good decision today, especially for those banking organizations whose
disruption could cause major financial disturbances in United States and foreign markets. For
foreign and for U.S. banking organizations, retreat from consolidated supervision would, the
Board believes, be a significant step backward.
We have to be careful, however, that consolidated umbrella supervision does not
inadvertently so hamper the decisionmaking process of banking organizations as to render them
ineffectual. The Federal Reserve Board is accordingly in the process of reviewing its supervisory
structure and other procedures in order to reflect the aforementioned market-directed shift from
conventional balance sheet auditing to evaluation of the internal risk management process.
Although focused on the key risk management processes, it would sharply reduce routine
supervisory umbrella presence in holding companies. As the committee knows, the Board has
recently published for comment proposals to expedite the applications process, and the
legislation Congress enacted last year eased such procedures as well. Nonetheless, the Board
requests even greater modification to its existing statutory mandate so that the required
applications process could be sharply cut back, particularly in the area of nonbank financial
services.
We would hope that should the Congress authorize wider activities for financial
services holding companies that it recognize that a bank which is a minor part of such an
organization (and its associated safety net) can be protected through adequate bank capital
requirements and the application of Sections 23A and 23B of the Federal Reserve Act. The case
is weak, in our judgment, for umbrella supervision of a holding company which, because it owns
only a small bank, does not have material access to the safety net.
As I noted when discussing the safety net and bank subsidiaries, attached to all
uses of the sovereign credit come efforts by the government to protect the taxpayer. Those
entities interested in banks are really interested in access to the safety net, since it is far easier to
engage in the nonsafety net activities of banks without acquiring a bank. If an organization
chooses to deliver some of its services with the aid of the sovereign credit by acquiring a bank, it
should not be excused from efforts of the government to look out for the stability of the overall
financial system. For bank holding companies that own more than a small bank, this implies
umbrella supervision. Although that process will increasingly be designed to reduce supervisory
presence and be as nonintrusive as possible, umbrella supervision should not be eliminated, but
recognized for what it is: the cost of obtaining a subsidy.
Banking and Commerce
Finally, let me turn to an issue that has bedeviled supervisory and regulatory
discussions for years: the potential separation of commerce and banking.
As I indicated earlier, it is clear that rapidly changing technologies are altering the
nature of what constitutes finance. Indeed, just as the lines between banking and other financial
institutions are often already difficult to discern, the boundaries between finance and nonfinance
are likely to become increasingly indistinct as we move into the 21st century. For example,
computer and software firms will certainly be offering ever more sophisticated financial
products. And doubtless financial firms will be offering an increasingly sophisticated array of
nonfinancial services. In addition, some of the financial firms who mainly produce products and
services that many observers believe should be permissible to banks are also engaged in, or
affiliated with, nonfinancial businesses.
Newer technologies will make it highly unlikely that the walling off of any
ownership of financial institutions by nonfinancial businesses and vice-versa can be continued
very far into the 21st century. Nonetheless, the Board has concluded that it would be wise to
move with caution in addressing the removal of the current legal barriers between commerce and
banking. The free and open legal association of banking and commerce would be a profound and
surely irreversible structural change in the American economy. Hence, we must be careful to
assure ourselves that whatever changes are made in our supervisory structure, that it not distort
our evolution to the most efficient financial structure as we move into the next century.
Were we fully confident of how the structure would evolve, we could presumably
construct today the regulations which would foster that evolution. But we cannot be certain. We
thus run the risk of locking in a set of inappropriate regulations that could adversely alter the
development of market structures. We cannot be confident we know what the true synergies
between finance and nonfinance will be in ten or even five years. Our ability to foresee
accurately the future implications of technologies and market developments in banking, as in
other industries, has not been particularly impressive. As Professor Rosenberg of Stanford
University has pointed out, ". . . mistaken forecasts of future structure litter our financial
landscape." Consider the view of the 1960s that the "cashless society" was imminent.
Nonetheless, the public preference for paper has declined only gradually. Similarly, just a few
years ago conventional wisdom argued that banks were dinosaurs that were becoming extinct.
The reality today is far from it. Even more recently, it was argued that banks and nonfinancial
firms had to merge in order to save the capital-starved banking system. Today, as you know,
virtually all of our banks are very well capitalized.
All these examples suggest that if we change the rules now about banking and
commerce under circumstances of uncertainty about future synergies between finance and
nonfinance, we might end up doing more harm than good. And, as with all rule changes by
government, we are likely to find it impossible to correct our errors promptly. Modifications of
such a fundamental structural rule as the separation of banking and commerce should
accordingly proceed at a deliberate pace, testing the response of markets and technological
innovation to the altered rules in the years ahead. The public needs to have confidence in the
regulatory structure, implying that we proceed slowly and cautiously.
Excessive delay, however, would doubtless produce some inequities. Expanded
financial activities for banking organizations requires, the Board believes, that those firms
operating in markets that banks can enter should, in turn, be authorized to engage in banking.
However, some of these nonbanking financial firms already own -- or are owned by
-nonfinancial entities. A complete commerce and banking prohibition would thus require the
divestiture of all nonfinancial activities by those organizations that wanted to acquire or establish
banks. The principle of caution suggests an approach which may prove useful. Perhaps those
organizations that either have or establish well-capitalized and well-managed bank subsidiaries
should be permitted a small basket of nonfinancial assets -- a certain percentage of either
consolidated assets or capital. A small permissible basket would establish, in effect, a pilot
program to evaluate the efficacy of further breaching of the banking and commerce wall. We
found that such a slow and deliberate policy worked well with Section 20 affiliates.
Of course, some nonbanking firms would find that their nonfinancial activities
would exceed a small basket exemption. Such excess nonconforming assets might be addressed
on a case-by-case basis with a scheduled longer-term divestiture to avoid the worst short-term
inequities. A basket clause plus case-by-case review of individual situations might also provide a
way to make available a common bank and thrift charter to those unitary thrifts that are affiliated
with nonfinancial businesses. The Board has no firm opinion on just exactly how such trade-offs
might be made, constrained only by the general concerns I summarized earlier.