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For release on delivery 10:00 a.m . , E.S.T. November 18, 1987 Testimony by Alan Greenspan Chairman, Board of Governors of the Federal Reserve System before the Subcommittee on Financial Institutions Supervision, Regulation & insurance Committee on Banking, Finance & Urban Affairs United States House of Representatives November 18, 1987 Mr. Chairman, members of the Committee, it is my pleasure today to present the Federal Reserve Board's views on modernizing our financial system to adapt it to the important changes in technology and competition that transformed financial markets here and abroad. have already You have set an agenda for a searching inquiry into the proper organization and functions of depository institutions, and it is important that this work be completed promptly so that the process of evolutionary development of our financial system may go forward in an orderly way. Committee and The foundation now being laid in the Senate in this Banking Committee provides an historic opportunity to take a crucial first step that can set our course for the future. The Board has for some years taken the position that our laws revision. regarding financial structure need substantial Developments have significantly eroded the ability of the present structure to sustain competition and safe and sound financial institutions in a fair and equitable way. is essential that the Congress put It in place a new, more flexible framework. Recently, a great deal of attention has been focused, properly we think, on revising financial structure. the laws that govern our The aim of these proposals is to permit -2- the affiliation of a broader variety of financial and commercial organizations with banks, while attempting to assure that affiliated relationship. banks are not adversely affected by this Much of this thinking has now centered on a specific proposal by Senate Banking Committee Chairman Proxmire to permit the affiliation of banking organizations with securities firms that is now prohibited by the Glass-Steagall Act. Our own analysis of the broader proposals leads us to the conclusion that they have many positive elements that deserve continuing attention, but that it would be appropriate at this time suggestion to concentrate attention on the to repeal the Glass-Steagall Act. that this action would respond effectively specific It is our view to the marked changes that have taken place in the financial marketplace here and abroad, and would permit banks to operate in areas where they already have considerable experience and expertise. Moreover, repeal of Glass-Steagall would provide significant public benefits consistent with a manageable increase in risk. Accordingly, we would Committee should recommend that this law should prevents firms bank holding engaged activities. focus suggest in on the attention the Glass-Steagall be repealed companies securities We prefer that of the Act and we insofar as it from being affiliated with underwriting this comprehensive and dealing approach to the -3- piecemeal removal of restrictions on underwriting and dealing in specific types of securities commercial paper. such as revenue This limited approach would bonds or artificially distort capital markets and prevent financial institutions from assuring benefits to customers by maximizing their competitive advantage in particular markets. A very persuasive case has been made for adoption of the repeal proposal. It would allow lower costs and expanded services for consumers of financial services through enhanced competition in an area where additional competition would be highly desirable. It would strengthen banking institutions, permitting them to compete more effectively at home and abroad in their natural markets for credit that have been transformed by revolutionary developments technology. in computer and communications It could be expected to result in attracting more equity capital to the banking industry where more capital is needed. In sum, the securities activities organizations can provide important impairing soundness of banks the safety and conducted by experienced of banking public benefits without if they are managers, in adequately capitalized companies, and in a framework that insulates the bank from its securities affiliates. In reaching these conclusions we are guided by the principles set down in the Bank Holding Company Act of 1970 which requires the Board to consider, in determining the -4- approprlateness of new activities for bank holding companies, whether they will produce greater convenience, efficiency. benefits increased to the public competition, or It also asks us to evaluate whether may be outweighed such gains as in these gains by possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices. These are the principles that Congress has set down to guide the evolution of the banking system. sense then and they make good sense today. have interpreted these principles They made good Over the years we to be consistent with our efforts to promote competitive and efficient capital markets and to protect impartiality in the granting of credit, to avoid the risk of systemic failure of the insured depository system, and to prevent the extension of the federal safety net to nonbanking activities. fully consistent with in our view achieving these goals is permitting bank holding companies to engage in securities activities. In short, in my testimony today I will explain why we believe that changes in the Glass-Steagall Act will have major public benefits. I will also explain why we believe that with the right structure and careful implementation, the changes in the law that we support can be accomplished without adverse effects. The major modification would public be lower benefit customer of Glass-Steagall costs and increased -5- availability of investment banking from increased competition and services, both the realization of possible economies of scale and scope from coordinated commercial and investment banking services. the bank entry of holding resulting companies provision of We believe that into securities underwriting would, in fact, reduce underwriting spreads and, in the process, lower financing costs to businesses large and small, as well as to state and local governments. bank holding company subsidiary participation In addition, in dealing in currently ineligible securities is likely to enhance secondary market liquidity to the benefit of both issuers and investors. These, we believe, are important public benefits that will assist in making our economy more efficient and competitive. Studies of the market structure of investment banking suggest that concentrated. provided at least The most portions presented conclusion that corporate securities The five industry are in this regard is Report of the House committee on Operations, which concentrated. this recent evidence in the September Government of largest data supporting underwriting underwriters of paper account for over 90 percent of the market; its is highly commercial the five largest underwriters of all domestic corporate debt account for almost 70 percent of the market; and the five largest underwriters of public stock issues account for almost half of the market. -6- I would emphasize that concentration per se need not lead to higher consumer costs, because the possibility that new firms will enter a market competitive prices. the Glass-Steagall industry Act activities network be sufficient to achieve However, it is just in this regard is particularly bank holding companies with securities may and their their more generally, constraining, existing broad would expertise financial be the that because in many skills and most likely potential competitors of investment banks if not constrained by law. It is also important to emphasize that the changes in the Glass-Steagall Act that we support would be likely to yield cost savings in local and regional corporate underwriting and dealing markets. At a minimum, local and regional firms would acquire access to capital markets that is similar not only to the access now available that currently available to large corporations, but also to to municipalities whose general obligations bonds are underwritten by local banks. Another area of substantial expected public benefit is the encouragement of the free flow of investment capital. we at the Board and the Congress have stressed Both the importance of improving the capital ratios of banking organizations and it can reasonably organizations attractive be assumed that expansion into securities markets investments. Equally would of banking make them important, banks more and -7- securities firms would be free to deploy their capital over a wider range of activities designed to serve the public better. There is another important Glass-Steagall Act should be changed. reason why the Developments in computer and communications technology have reduced the economic role of commercial banks banking. These and enhanced permanent environment for conducting by statutory the and function fundamental of investment changes in the financial business cannot be halted prohibitions, and the longer the law refuses to recognize that fundamental and permanent changes have occurred the less relevant competitive hold it will be as a force fairness in our the present structure for stability and financial markets. Attempts in place will be defeated the inevitable loopholes that innovation necessity will develop, although to through forced by competitive there will be heavy costs in terms of competitive fairness and respect for law which is so critical to a safe and sound financial system. The which I have significance referred of is technological that the financial intermediaries has been financial intermediation is information. the role of banks as undermined. ability to The heart to obtain and of use The high cost of gathering and using facts in the past meant that banks and other from their cumulative making key developments significantly intermediaries store of knowledge could profit about borrowers by more informed credit decisions than most -8- other market participants. These other market participants were thus obliged to permit depository intermediaries to make credit decisions in financial markets and therefore allow bank credit to substitute for what would otherwise be their own direct acquisition of credit market instruments. Computer and telecommunications altered this process dramatically. technology have The real cost of recording, transmitting, and processing information has fallen sharply in recent years, lowering the cost of information processing and communication for banks. But it has also made it possible for borrowers and lenders to deal with each other more directly in an informed way. computers On-line data bases, coupled with powerful and wide-ranging telecommunication facilities, can now provide potential investors with virtually the same timely credit and market information that was once available only to the intermediaries. These developments mean that investors are increasingly able to make their own evaluations of credit risk, to deal directly increasing with borrowers institutionalization and, especially of individuals' with the savings, creditors are in a position to develop their own portfolios and strategies to balance and hedge risk. bank Thus, the franchise of intermediation, the core element of a bank's comparative advantage, and its main contribution to the economic process -credit evaluation and the diversification of risk -- has been -9- made less valuable by this information revolution. new financial technological products that have resulted innovation and that challenge Examples of from this traditional bank loans abound -- the explosion in the use of commercial paper, the rapid growth of mortgage-backed securities and the recent development of consumer receivable-related Our concern providers of loan-backed securities (CRR) securities. is that credit these consumer There are many others. real changes utilize or financial in the way that intermediaries has reduced the basic competitiveness of banks and that the trend toward direct investor-borrower linkages will continue. Banks, of course, have not stood still while these vast changes were taking place around them. Indeed, they have responded to the technological revolution by participating in it. Loan guarantees and other off-balance sheet arrangements, private placement of corporate debt, commercial paper placement, loan participations and sales, and interest rate and currency swaps are examples. Similarly, the foreign offices of U.S. banks and their foreign subsidiaries and affiliates have been actively engaging abroad in a wide variety of securities activities. These include securities that are ineligible in the United States for banks to underwrite and deal, such as corporate debt and equity. in the corporate debt market, for example, U.S. banks' foreign subsidiaries served lead roles in underwritings approaching $17 billion in 1986, or about -10- 10 percent of the volume of such debt managed by the 50 firms most active in the Eurosecurities market last year. These and other essentially investment banking activities have permitted banks to continue to service those customers seeking increasingly on securities markets. to rely Nevertheless, in their home market banks are sharply limited by the Glass-Steagall Act in competing for the business of acting as intermediaries in the process of environment, a providing process credit, that has in the been new financial transformed by technological change and which is a natural extension of the banking business. in short, Congress should modify structure to conform to these changes. the financial If the Congress does not act, but rather maintains the existing barriers of the Glass-Steagall Act, banking organizations will continue to seek ways to service customers who have increasingly direct access to capital markets. limits of But banking organizations are nearing the their ability to act within existing law; and spending real resources to interpret outmoded law creatively is hardly wise. Without the repeal of Glass-Steagall, banks' share of credit markets is likely to decline -- as it already has in our measures of short- and intermediate-term businesses credit. A soundly structured change in the law will allow financial markets to serve us better by lowering costs to users while strengthening financial institutions within a framework that will protect the financial integrity of banks. -11- The basic principles that I outlined at the outset require us to take into account not only public benefits but also possible adverse practices, which effects clearly including includes unsound banking the concept of excessive risk, conflicts of interest, impairment of competition undue concentration of resources. heightened occurred by on the unprecedented October 19, 1987 and These concerns have been stock and market decline the subsequent that market volatility. We had reached our decision to endorse repeal of the Glass-Steagall Act before these events occurred. our decision we had very much involved decided When we made in mind that there are risks in underwriting and dealing that we would recommend in securities and we the necessary changes only because we believe that a framework can be put in place that can assure that the potential risks from securities activities can be effectively managed. The events since October 19 have not altered our view that it is both necessary to proceed to modernize our financial system and that it is possible to do so in a way that will maintain the safety and soundness of depository institutions. Congress adopted the Glass-Steagall Act over 50 years ago because it believed that banks had suffered serious losses as a result of their participation in investment banking. Congress also thought that bank involvement in the promotional -12- aspects of the investment banking business would variety of produce a "subtle hazards" to the banking system such as conflicts of interest and loss of public confidence. In answer to these concerns we believe that experience has shown that the risks of investment banking to depository institutions are containable, that the regulatory framework established in the securities laws minimizes the impact of conflicts of interest, that the federal safety net implemented through deposit insurance and access to Federal Reserve credit will avoid the potential for panic withdrawals securities firms experience from banks losses, and if affiliated that banks can be effectively insulated from their securities affiliates through an appropriate structural framework. Bank holding company examinations indicate that U.S. banking organizations have generally shown an ability to manage the inherent risks of both their domestic and foreign securities activities in a prudent and responsible manner. Of all the domestic bank failures in the 1980s, to our knowledge none has been attributed to underwriting losses. Indeed, we are unaware of any significant losses in recent years owing to underwriting of domestically eligible securities. For that matter, research over the past 50 years concludes, contrary to Congress' view at the time, that bank securities activities were not a cause of the Great Depression and that banks with securities affiliates did not fail in proportionately numbers than banks more generally. greater -13- The investment banking experience of U.S. banking organizations in foreign markets has been favorable and their operations have been generally profitable in the last decade or so. This is not to say there have been no problems. In the mid-1970s some large U.S. banks encountered problems with their London merchant bank subsidiaries capital investments market. More recently, in the post Big Bang era, U.S. banks' securities and affiliates the in connection with venture and development subsidiaries of have the Eurobond shared in the transitional difficulties that arose in the London securities market. All of these problems appear to have been in the nature of "start-up" difficulties rather than long-term safety and soundness concerns. In these situations, and even in the perspective of the unprecedented stock market decline, risks have been contained and losses have been small relative to the capital of the bank or the holding company parent. Finally, I would note that empirical studies invariably find that underwriting and dealing are riskier than the total portfolio of other banking that the variability of returns functions in the sense to securities activities exceeds that of the returns to the combination of other banking functions. it is also important to note, however, that the average return to securities activities is also usually found to exceed the average return to the combination of other -14- banking functions. potential for In addition, limited risk reduction, for there diversification banks being is evidence of some gains, or overall allowed increased bank securities powers . The preliminary recent stock market evidence events on on the securities several conclusions drawn previously. activities are prudently. clearly Second, risky, to control the risk the securities companies should be monitored banks. dealing bank. be of bank managed holding in such a way as Third, the events an the degree could securities to have capital adequate to to maintain risk can and supervised legal structure which minimizes underwriting and risks of reinforces First, while to an affiliated shocks and effects firms activities of recent weeks highlight the need absorb unexpected limited institutional to which be passed to and securities affiliated As I have stressed, such a system can be established. I would now like to turn to what we see as the major elements of such a system. Fundamental to our recommendation the view that on Glass-Steagall that the safe and sound operation of banks securities conducted behind possible, the securities have argued activities walls bank designed from activities. involving the significant to separate, risks associated is requires risk in so be far with as the Let me note at this point, that some that insulating walls cannot completely protect a -15- bank from the risks of natural incentive its affiliates. Management has a in periods of stress to assist endangered components of what it sees as one entity, and depositors are free to withdraw their funds from the bank if they perceive -correctly or incorrectly — losses at affiliates. a threat to the bank"s safety from The task before you is to reduce the risk, taking into account public benefits relative to the risk, to acceptable levels. This effort will require clear rules and a firm expression of public policy that corporate conduct which passes on the risks of securities activities to insured depository institutions is unacceptable. We see two major elements to an approach to developing a practical insulating structure: the holding company structure should be used to institutionalize separation between a bank and a securities affiliate, and the resulting institutional firewalls should be strengthened by limiting transactions, particularly credit transactions, between the bank and a securities affiliate . First, we would take maximum advantage of the legal doctrine of corporate separateness. under this rule a separately incorporated company normally is not held liable for the actions of other companies even if they are commonly owned or there is a parent-subsidiary relationship. If effective separation can be achieved a bank would not be liable for the -16- actions of its securities federal safety net would affiliate and the benefits of the not be conferred on the securities affiliate. We believe that this goal is most effectively achieved if securities activities take place in a direct subsidiary of a holding bank. company rather The framework Board as the has than long most in a bank supported effective or a subsidiary of a the method holding of company accomplishing separation, and it was with these goals in mind that, in 1984, the Board joined the Department of the Treasury in supporting legislation to use the holding company framework to broaden the securities and other powers of affiliates of banks. The Board believes that the holding company approach, reinforced by the measures I will outline below, has several important advantages over other methods of expanding the powers of may banking organizations. First, any losses that be incurred by the securities affiliate would not be reflected the balance in sheets or income statements of the bank, as they would under normal accounting rules if the bank conducted the securities activities directly or through a subsidiary of the bank. A bank affiliated with a securities firm through a holding company structure thereby obtains the advantages of the holding company's diversification without the disadvantages conducting the securities subsidiary of the bank. into securities that necessarily activities activities flow from the bank directly or through a -17- Second, practical it is difficult, if not impossible standpoint, for a bank to avoid from a assuming responsibility and liability for the obligations of its direct subsidiaries. Experience has shown that the direct ownership link between a bank and its subsidiaries creates a powerful public perception that the condition of the bank is tied to the condition and financial success of its subsidiaries. Third, because of the direct ownership link between the bank and its subsidiary, any breach of insulating walls that may be constructed between the bank and its subsidiary would be more likely to result in the loss of protection from the legal doctrine of corporate separateness than would the same breach in the wall between a bank holding company and a securities affiliate. This is simply a function of the fact that there is no direct ownership link between the bank and the securities affiliate. Fourth, separation securities firm through competitive equity. of a a holding bank and company an affiliated helps promote Securities activities that are conducted directly within a depository institution or in a subsidiary of a depository institution are much more likely to benefit from association with the federal safety net through increased public confidence in securities offerings made by the insured banks and their subsidiaries than would be the case if these activities were conducted in a holding company affiliate. -18- Similarly, effective the holding company technique would be more in minimizing any competitive advantage banks would have in raising funds because of their association with the federal safety net and their ability to collect deposits. The second major element of the separateness structure is to assure that corporate separateness firewalls are not impaired and that the risks of securities activities are not passed on to an affiliated bank. We suggest a number of measures to accomplish this goal. bank lending to, and purchase of assets securities affiliate should be prohibited; from, a banks should not be able to enhance the creditworthiness of securities underwritten by a securities affiliate through guarantees or other techniques, banks should not lend to issuers of securities underwritten by a securities affiliate for the purpose of paying interest or principal on such securities; banks should not be able to lend to customers for the purpose of purchasing securities underwritten by a securities affiliate; appropriate rules should limit interlocks between the officers and directors of banks and those of affiliated securities firms; a securities affiliate should be required to prominently disclose that its obligations or the securities that it underwrites are not the obligations of any bank and are not insured by a federal agency; and a securities capitalized. affiliate should be adequately -19- Under this approach, rules should be put in place that will prevent use of the credit facilities of the bank for the benefit of constructing the securities these affiliate walls, a premium and to this end, in should be placed on arrangements that are simple, clear, and easy to apply, and that will not be subject to erosion by interpretation. It is with these principles in mind that we approach one of the most important issues in separating banks from their securities affiliates -- the question of whether a bank should be able to lend affiliates. to or purchase assets from its securities We considered that lending may be appropriate as a way of taking maximum advantage of the synergies that can be achieved between a bank and securities affiliates to the benefit of customers and that, as we have described here today, securities activities are the natural extension of the credit facilities provided by banks. We also considered that rules now exist limiting the amount of credit that a bank can provide to an affiliate and require that this lending be at arms-length and adequately collateralized . Nevertheless, our experience indicates that these limitations, embodied in sections 23A and 23B of the Federal Reserve Act, do not work as effectively as we would like and, because of their complexity, are subject to avoidance by creative interpretation, particularly in times of stress. On the other hand, a prohibition on an affiliated bank's loans to -20- and purchases of assets from its securities affiliate would sharply limit the transfer of the risk of securities activities to the federal safety net and would eliminate one of the key factors viewed by the courts as justifying "piercing the corporate veil" between the bank and its nonbank affiliates -that operations of the securities affiliate are financed and supported by the resources of the affiliated bank. For these reasons, and because of the desirability of having a clear rule that is not subject to avoidance, we decided to recommend you to that we have a simple rule that banks should not be permitted to lend to, or purchase assets from, their securities affiliates. under our A securities affiliate would, however, be free proposal, to borrow from its holding company parent -- an entity that is not protected by the safety net. A similar limitation was proposed in the recent study by the House Government Operations Committee. only one very limited exception allowing fully collateralized We would support to this rule. intraday We propose borrowing securities underwriter and dealer from an affiliated by a bank to support United States government and agency securities clearing operations. For very similar reasons, and as I have already outlined, we would recommend that a bank should not be able to guarantee or extend its letter of credit, or otherwise support securities issued by a securities affiliate. Allowing such -21- practices would not only raise the question of competitive fairness, but also would permit a transferring of the risks of securities activities to the federal safety net. reasons, loans to customers for the purpose securities underwritten by a securities For the same of affiliate buying or to a company whose securities have been underwritten by a securities affiliate for the purpose of repaying interest or principal due on such securities, should not be permitted. Prohibiting these transactions will establish a sound firewall. Another major purpose of firewalls is to prevent conflicts of interest that are competitively unfair and which can impair confidence in banking institutions. this problem is effectively dealt with As I mentioned, by the disclosure requirements and other provisions of the securities laws. already built-in protection of these strengthened by other provisions. securities affiliate must disclose laws should The be We would recommend that a its relationship to an affiliated bank and plainly state that the securities it sells are not deposits and are not insured by a federal agency. In addition, we should reinforce the requirements of existing law by providing that a securities affiliate cannot sell securities to an affiliated bank or its trust accounts during an underwriting period or 30 days thereafter or otherwise sell securities to the bank or its trust accounts unless the sale is at established market prices. -22- We would also recommend that neither banks nor their securities affiliates be able to share confidential customer information without the customer's consent and that a bank cannot express an opinion on securities being sold by its securities affiliate without disclosing that its affiliate is selling that security. As another step to prevent conflicts of interest, we would suggest that a securities affiliate could not sell securities backed by loans originated by its affiliate bank unless the securities are rated by an independent rating organization. We believe that the firewalls that are proposed will substantially augment the existing insulation of banks from affiliates that is now provided by the Bank Holding Company Act. In addition to these measures, perhaps the best insulator is adequate capital for both banks and securities affiliates. Adequate authority should be provided to assure that holding companies involving banks and securities activities should be adequately capitalized. In particular, investments by bank holding companies in securities firms should not be permitted if the investment would cause the holding company to fall below minimum capital requirements. With these safeguards in place we do not believe it is necessary to prevent a bank and a securities affiliate from jointly marketing banking and securities products or from using a similar corporate name. Here we believe that an analysis of -23- the tradeoff between corporate separateness on the one hand, and taking advantage of the efficiency and convenience to customers that can be achieved through coordinated marketing on the other, indicates that the g a m s to separateness would be small and would the losses to efficiency be high. The requirement of separate names would be artificial particularly because securities law disclosure would, in any event, require an affiliate to inform the users of association with a banking enterprise. out at the outset, the market for its services of its Similarly, as I pointed securities is only an extension of the market for other banking products and to deny a banking organization the ability to sell both products would lose much of the gains for the economy that we seek to achieve through the association between the two. be no competitive unfairness broad Moreover, there would in this arrangement since relaxation of the Glass-Steagall requirements the that we propose would enable securities firms to own banks as well as bank holding companies to own securities affiliates. The important point is whether these measures would cause the risks of securities activities to be passed on to banking institutions and to the federal safety net. As I indicated, the Board believes that the corporate separateness measures that we recommend should be put in place effectively deal with these problems. -24- The guidelines Congress has established for expansion of banking activities require a concern for whether expansion of securities powers will lead to a concentration of resources in the securities or banking industries. We believe that repeal of Glass-Steagall should have the opposite effect. have stressed today As I it will increase the number of viable competitors in both the banking enhancing competition in both. and securities industries, As a result, we doubt that the Congress need go beyond the requirements of the antitrust laws to anticipate a problem with concentration of resources in the emerging financial services industry. However, because we see as one of the major advantages to repeal to be an expected increase in competition, and because we could understand anxieties that this goal might be impaired by a combination of the largest banking and securities firms, the Board would not oppose a limited provision aimed at preventing the largest banking and securities organizations from consolidating. We commend this Committee for its active role in considering one of the most important issues that now faces our financial markets. We strongly recommend that you adopt legislation to repeal the Glass-Steagall Act and to put in its place a new framework allowing the affiliation of banking organizations and securities firms. We urge you to allow the moratorium on banking activities contained in Title II of CEBA -25- to expire on March 1, 1988 as the law now provides. We believe that these measures will ensure a more responsive, competitive and safe financial system.
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