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For R e l e a s e on D e l i v e r y
November 2 , 1988
9:15A.M. E.S.T.



H. R o b e r t H e l l e r
Member, Board o f

Governors of



Reserve System

CATO C o n f e r e n c e on B a n k i n g R e g u l a t i o n
W a s h i n g t o n , D. C.
November 2, 1988


Lessons From History

No one who studies the history of American banking
can fail to be struck by the ever-present tension
between market forces and regulatory presence in
the American banking system.

In view of the vast

changes now impacting our banking system,
I believe that the topic of your conference is
highly appropriate and timely.

In the early years of the Republic, the First and
Second 'Bank of the United States provided an
anchor to America's emerging banking system —


much of the American populace saw these institutions not as an anchor that provided stability,
but as an anchor that impeded progress.

Thus, it came as no great surprise that when the
charter of the Second Bank of the United States
expired in 1836, the nation let the market place
determine the shape of banking, and a quartercentury of free-wheeling banking by statechartered institutions ensued.

A measure of stability returned when Congress
passed the National Banking Act of 1863, although
it did so more with an eye toward the needs of
Civil War finance than the need to reform the
chaotic banking system.

Nevertheless, the

legislation provided for the establishment of the
Office of the Comptroller of the Currency, who had
the power to charter National Banks that would be
subject to stringent capital requirements, and
mandated that circulating bank notes be backed by
U.S. government securities.

The Federal Reserve Act of 1913 provided again a
central bank for the nation, and also defined the
regulatory functions of the Fed.


legislation further expanded and elaborated on the
role of the nation's central bank.

Markets and Regulation

But while I am a supporter of free markets, I am
also a central banker.

I also believe in the

Constitutional mandate that Congress shall have
the power to coin money and regulate the value

Thus, monetary affairs are the proper

realm of government and the institutions set up by
Congress to execute these functions serve a

legitimate purpose.

But it is also clear that rules and laws should
have a certain flexibility so that the institutions do not impede the functioning of the
markets, but support their development.


rules allow the individual financial institutions
the leeway they need to adopt to a changing
environment so that the financial needs of
individuals and corporations can be accommodated.

The rules and regulations also should be
equitable, so that fair competition is fostered.
This applies to domestic as well as foreign institutions that compete in the same market place —
an important point to which I would like to return
later on.

You will address two important issues at this

they pertain to our ability to

insulate banks from associated institutions in
order to protect the federal safety net and
questions regarding the international coordination
of regulation.


Let me address them in turn.

Insulating the Bank

Insulating a bank from the economic and financial
fortunes of associated activities or companies is
necessary because the federal safety net offers
special protection for the depositors in financial

The Federal Reserve's discount

window is a ready source of liquidity for banks
and helps them to avoid being caught short of cash
to pay off depositors.

FDIC insurance offers

explicit protection to depositors and is largely
responsible for the absence of runs on banks —


event that otherwise might not be unheard of in
these financially troubled times.

The insulating properties of firewalls between the
bank and associated companies are not only needed
to protect the safety of depositors, but also to
avoid giving companies associated with banks
access to low-cost funds that might otherwise give
them a competitive advantage vis-a-vis competitors
without such a privilege.

Thus, insulation is a

two-way barrier.

I believe that current laws, especially as
embodied in Articles 23 A and B of the Bank
Holding Company Act, provides the necessary

insulation of the bank from its sister companies.
But just to be on the safe side, and to further
protect the banking system and the depositors, the
Federal Reserve has long adhered to the policy
that a holding company should serve as a source of
strength to its subsidiary banks and stand ready
to provide additional capital funds in times of
financial stress.

Source of Strength Policy

The source of strength policy acts as a most
important safeguard to the banking system.

In its

absence, holding companies might well be tempted
to ask the bank to remit excessive dividends,
charge unwarranted management fees, or otherwise
loot the bank.

As we have found out, especially

in times of financial stress, there is literally
no limit to the inventiveness of the human mind
when it comes to devising new methods to get hold
of money —

legal or illegal.

Furthermore, if a holding company would have the
option of cutting subsidiary banks off if they
failed to perform up to expectations, true chaos
would descend upon our financial system.


such circumstances, branch-banking institutions

might be tempted to reorganize as a bank holding
company with many subsidiaries.

Then, as one or

the other subsidiary would encounter difficulties,
it would be allowed to fail and the FDIC would be
left to pay off the depositors —

while the

holding company shareholders would be left whole,
and maybe even be in a position to walk away with
handsome profits from the healthy subsidiaries.
That would be the implication of corporate
separateness carried to the extreme.

A Double Umbrella of Protection

Instead, I have advocated the "Double Umbrella"
concept for bank holding company structure.


this concept, banks could be owned by financial
service holding companies —

along with securities

firms, insurance companies, and other financial

The financial service holding

company would have to make a commitment to serve
as a source of strength to the bank subsidiary in
return for the privilege of being allowed to own
the bank with access to the federal safety net and
the payments system.


I would also permit commercial firms to own
financial services holding companies, but again
with the proviso that they have to serve as a
source of strength to the financial services
holding company.

Thus, there would be a double

umbrella of protection over the banking system —
something that may well be helpful in these
troubled times.

Recently, the Federal Reserve Bank of St. Louis,
published a staff study that evaluates a broad
range of financial restructuring proposals with
respect to the likely losses to be borne by the
FDIC, the rate of return to shareholders obtained
due to additional diversification, and other

I was gratified to see that according

to this evaluation the "Double Umbrella" concept
results in the lowest cost to the FDIC (neglecting
the complete merger case of banks and non-bank
institutions) while allowing shareholders to
achieve returns that are only insignificantly
different from the returns obtainable under the
other alternatives studied.

As long as we are on the topic of the optimal
corporate structure, let me also mention the
Federal Reserve's belief that any operating

subsidiaries should be subsidiaries of the holding
company and not of the bank itself.
several major reasons for this belief

There are
one, if the

subsidiary organization is a subsidiary of the
holding company —

rather than the bank —

it is

made abundantly clear that the federal safety net
can not be used to support the subsidiary if it
should run into difficulties itself.

Two, in those cases where the parent might want to
come to the assistance of the sub, it would be
clear that no funds obtained by the bank at
preferential rates could be used to bail out the
non-bank sub.

This charge might well be made if

the sub were a sub of a bank with access to
federally insured deposit funds.

Three, if a subsidiary of a bank were to encounter
difficulties, these problems would be reflected in
the consolidated balance sheet of the bank.
Hence, confidence in the bank itself might suffer
and depositors might fear for the safety of their

This dilemma would not arise if the

subsidiary were a sub of the holding company, as
the bank's balance sheet would not reflect the
problems of the associated institutions.


these reasons, the Federal Reserve believes that

it is important that ancillary non-banking
activities be carried on in subsidiaries of the
holding company, rather than in subs of the bank.

International Regulatory Cooperation

Let me now turn to the international regulatory

It goes without saying that the ever

increasing integration of our financial markets
has clear implications for the coordination of
international regulation,

in years past, there

was relatively little overlap between the various
regulatory provinces, but with the ever increasing
expansion of international banking, these issues
have come to the forefront of the supervisory and
regulatory agenda.

I will focus on two issues:

the new international

risk-based capital requirements and the policy of
national treatment versus reciprocity, which has
gotten much attention lately in the European

Risk-Based Capital

These days, no discussion of regulatory issues can
begin without mentioning the new risk-based

capital standards developed by the Basle Group of
bank supervisors and endorsed in July by the
central bank governors of the Group of Ten

While former international supervisory

agreements typically relied upon reciprocal
recognition of national supervisory standards, the
Basle Group's risk-based capital framework
represents the first truly global effort to
regulate an industry.

The framework provides for the same definition of
capital, the same risk classes, and the same
leverage ratio for all internationally active

The Basle agreement sets a 4 percent equity
standard and an overall 8 percent minimum capital
standard for the end of 1992.

It also sets an

interim target of 3.25 percent equity and 7.25
percent overall capital by the end of 1990.

In the meantime, the current 5.5 percent primary
capital standard is still applicable.


when considering capital adequacy of a banking
organization, the Board may also consider whether
the organization already meets the new risk-based

This ratio may be particularly

important in the case of foreign bank applications
that do not formally meet the current U.S. primary
capital standard.

As a matter of fact, the Board

has already approved several foreign applications,
where the applicant already meets the new
risk-based capital standards.

The proposed risk-based capital standard has been
out for public comment, and final rules should be
issued in the near future.

Reciprocity Versus National Treatment

I mentioned earlier the increasing importance of
international financial markets.

In 1992, the

European Community will pass a milestone with the
planned full economic and financial integration of
the member countries.

The shaping of EC policy

for 1992 toward banks from outside countries is of
critical importance to the United States banks.

There have been indications recently that the EC
might impose a policy of reciprocity on banks from
outside countries.

Specifically, banks from those

countries would not be granted the powers that are
available to EC banks unless those same powers
were permitted by the foreign bank's home country

for banks from all EC member countries.

As an

extreme example of how this policy might be
applied, a U.S. bank could be denied the right to
branch throughout the EC since no banks, domestic
or foreign, are allowed to branch throughout the

Also, the securities activities of the U.S.

banks in Europe could be restricted because of the
restrictions on banks' securities underwriting
activities in the U.S.

Clearly, a policy of reciprocity would be detrimental not only in that it would harm the ability
of U.S. banks to compete in the European market
for financial services, but it could lead to
further protectionist pressures that would be
harmful to all.

I strongly hope that the EC will

apply the international standard of national
treatment, rather than establish a new policy of

Needed Domestic Reforms

I also believe that we in the United States need
to move rapidly to remove the restrictions that
hamper the ability of U.S. banks to compete with
foreign financial firms that operate much more

Greater geographic diversification should enhance
the safety of the banking system.

This point is

illustrated forcefully by the problems encountered
by insufficiently diversified banks in the
agricultural and energy producing regions of our

This is in contrast to the situation

prevailing in other countries where nationwide
banking has increased the safety and soundness of
the financial structure through diversification.

While the states have taken the lead in this area,
interstate banking is clearly an area where a
national policy is called for.

Let's apply the

interstate commerce clause, which has brought us
prosperity and a competitive marketplace, to
banking as well. •

With respect to expanded powers, unfortunately,
Congress failed to enact appropriate legislation
and the Federal Reserve will therefore be faced
with applications by banks requesting new powers
within the context of the existing legislation.


As you can see, life will continue to be interesting for all of us.

The financial environment we

will face in the future is not likely to be much
less volatile than in the past.

Further inter-

national integration and structural change will
occur, and I trust that the innovators will be
busy as well.

That's the way it should be.

We as regulators and you as participants in the
market place should therefore continue to enhance
our capacity to cope with these developments.


creative forces in the markets need to be fostered
and we at the Fed remain dedicated to providing a
fair regulatory framework so that the private
sector can continue to prosper and flourish.

* R. Alton Gilbert, "A Comparison of Proposals to
Restructure the U.S. Financial System", Federal
Reserve Bank of St. Louis, REVIEW July/August