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FOR RELEASE ON DELIVERY
1:30 p.m., E.D.T.
APRIL 19, 1988
Manuel H. Johnson
Board of Governors of the Federal Reserve System
Restructuring America's Financial Services Industry
Morin Center for Banking Law Studies
School of Law
April 19, 1988
RESTRUCTURING AMERICA'S FINANCIAL SERVICES INDUSTRY
It is a pleasure to join you today to discuss the
restructuring of America's financial services industry.
Boston University School of Law is to be congratulated for
the timeliness of this conference as well as the impressive
All of the speakers are playing a significant part
in the statutory and regulatory reforms now in process to
modernize the U.S. banking industry.
It has often been noted that lawmakers frequently adopt
important legislative changes only after market forces have
succeeded in circumventing existing outdated statutes.
certainly pertains to both interest rate ceilings on
deposits as well as geographic restrictions on bank
expansion. By this standard, the House should surely join
the Senate in authorizing securities powers for bank holding
Such an action is necessary to confirm what is
already occurring in the market place.
It is worth reviewing once again the reasons why
securities powers for banking organizations are in the
Banks—like all intermediaries—evolved as
a kind-of information processor able to collect, store, and
evaluate the pertinent facts on actual and potential
With their information base, banks were in a
better position to evaluate and choose among creditors than
any other market participant.
This knowledge permitted
banks to choose the most successful and balanced portfolios
and left many other prudential lenders with little choice
but to hold significant portions of their own portfolios as
claims on banks.
Three major developments have undermined the
traditional returns to bank intermediation.
the growth of the institutional investor.
The first was
investment management brings to bear bank-like expertise to
choose among potential borrowers, undermining one of the
specialties previously reserved mainly for banks.
professional investment manager—as well as the
simultaneously evolving cash.manager—was but a sleepy giant
prior to the occurrence of the second major development—the
Information processing, as I noted,
was the real basis for banks' value-added.
revolution permitted a growing number of investors to
cheaply tap and use a quantity of previously undreamed of
up-to-date facts and knowledge about firms, instruments, and
markets in order to make their own informed decisions and
With the institutional investor and the information
revolution has come the third major development for b a n k s —
increased competition by those able to exploit expertise and
knowledge without the constraints placed on banks.
competition has taken many forms with which you are all
the money market fund offering liquid, safe,
transactions balances; the corporation by-passing banks to
borrow funds directly in the money market; the development
and rapid growth of consumer and business direct lenders,
often affiliated with nonfinancial businesses; the
internationalization of financial markets, which opened up
for both lenders and borrowers a seemingly endless range of
instruments and markets; the creativity of the investment
bankers not only to innovate and design new instruments, but
also to act world-wide as true merchant b a n k e r s underwriting and lending on their own account; and, finally,
the creation of new financial instruments—such as financial
futures and options, and interest rate and currency swaps-as well as a wide range of pricing algorithms and formulas,
all of which provide low cost means of managing risk when
coupled with rapid information processing.
It is no wonder that banking organizations in such
circumstances have talked about level playing fields and
sought increased powers.
And it should also not surprise
anyone that their successful non-bank competitors have
marshalled their considerable resources to seek to sustain
present limitations on banks' ability to compete.
questions relevant for good public policy are:
if one is
neither a banker nor a banks' competitor, is there any
reason to care about these current and prospective
That is, will the public be affected one way
or another by an evolving delivery system for financial
services that increasingly bypasses banks?
If the public is
adversely affected, how can we change the rules consistent
with safe and sound baulking and financial market stability?
If the public is not adversely affected, why not let the
bank market share shrink?
These questions—which I think are the right o n e s —
unfortunately have no easy answers.
Indeed, the evidence is
consistent with answers on both sides of the issue, but I
believe that, on balance, it supports the position that we
should care because the more limited powers for banking
organizations are both unreasonable and inconsistent with
the public interest.
Bank holding companies have not been sitting idle
while markets have changed, but have tried to respond to the
new competition, using the tools of their rivals.
example, they have increased their private placement
activity in the U.S.; developed investment banking expertise
abroad; provided investment advise and management;
participated importantly in interest rate swaps; levied fees
for old and new services that used to be part of the banking
package; and have sought to obtain at least half-a-loaf by
participating with their customers in the use of new
techniques by guaranteeing credit market instruments for a
fee and originating and selling loans to others.
responses have generated revenues that have tended to offset
some of the lost business and have also, I think
irreversibly, led commercial and investment banks into each
other's business. But, despite these activities, banks have,
in fact, lost share in the short-term business credit
markets, and those losses have been among the highest
As a result, the overall quality of many
banks' portfolios have suffered a decline.
Bank organizations need securities powers to compete in
evolving markets and if they are unable to do so they will
be unable to attract capital, a necessary prerequisite to a
safe and sound banking system.
As financial evolution
continues, existing regulation will restrict the ability of
banks to deploy their existing capital in the most
Of course, not all of banks' capital is
financial or physical; its most important real capital in
fact is the expertise of its personnel.
If that experienced
staff cannot be used efficiently, because the services
demanded by the market are not consistent with bank
regulation, not only are banks disadvantaged, but financial
markets too are made worse off, with society's resources not
allocated in the most productive way.
If there is a strong analytical case that such an
expensive reallocation of resources is in the public
interest, the interaction of changing market demands, new
competition, the information revolution, and unchanged law
and regulation should cause bank personnel and other capital
to leave banking and migrate to another institutional
structure to deliver financial services.
banks have not been free to allocate their assets as they
Rather, regulatory restrictions and the extension
of a federal safety net have been applied in reflection of
the important place banks have held as the basic suppliers
of monetary assets, the safekeepers of deposit funds, and
the central role they have played in the payments mechanism.
But both history and recent experience--including the
stock market crash and its after-effects—suggest that the
risk of securities powers can be managed effectively by
bank holding companies.
The history of the 1920s and early
1930s record no major bank failure caused by securities
underwriting and dealing.
Moreover, recent discussion of
such powers often ignores the fact that the issue of abuse
of securities underwriting by both banks and nonbanks-especially fraud and double-dealing—was addressed by the
Securities Acts of the 1930s.
Indeed, I believe it is very
difficult to make the case that it's an acceptable risk for
a bank to lend to a corporation long-term at a fixed rate,
to guarantee its commercial paper, to provide it a long-term
letter of credit, to engage in interest rate swaps with it,
and to.underwrite its securities in London or Tokyo, but not
to permit that same bank organization to underwrite the same
corporation's stocks and bonds in the United States.
quite frankly, an absurd position and as that absurdity
becomes more obvious the law will ultimately be changed.
Securities underwriting and dealing probably is more
risky than the average bank portfolio, although, as I noted
earlier, I believe that risk is manageable.
additional risk is well suited to the bank holding company
structure, which is designed to minimize the transfer of
risk to the affiliate bank and to minimize the risk that the
safety net will be extended beyond banking.
Garn bill passed overwhelmingly by the Senate, and the St
Germain bill now before the House, both go beyond the
typical affiliate-bank insulation that is now part of the
Bank Holding Company Act, to build so-called firewalls
between the bank and its securities affiliate (as both
borrower and lender).
The objective is to prevent the
securities affiliate from obtaining any benefits from the
safety net and to assure that the bank will not draw on the
safety net because of its dealings with its securities
The arrangements spelled out in these bills are
designed both to underline and to build into our
institutional infra-structure a corporate s u b s e t — b a n k s —
that has access to the safety net, permits those banks to be
associated with firms engaged in certain nonbank activities,
but likewise limits the ability of the affiliates to benefit
from the banks' access to the safety net.
I personally believe that these arrangements will work
well and that we will, in fact, be able to use the proposed
structure in the future for wider bank holding company
But there are other well informed observers who are
concerned that firewalls will burn through just when they
are needed the. most.
The issue is too important to leave to
assertion or attempts to write rules which overcompensate
for real or imagined risks.
Securities powers lend
themselves well to a test because the additional risks
suggest that even if firewalls do not work, the risks to the
bank affiliate are manageable; if it does seem to work,
further experiments can perhaps be conducted, assuming that,
as is true with securities powers, a case can be made that
they are in the public interest.
Whatever new powers are
granted to Bank Holding Companies, the current Board of
Governors is resolved to do what it can to assure that banks
and their nonbank affiliates are, in fact, maintained as
Indeed, it is, I suggest, of extreme importance for the
future of our financial system that, as
we reform it to
recognize evolving developments, we do not at the same time
knowingly or unknowingly extend the safety net over a wider
and wider range of institutions.
To do so would increase
the moral hazard associated with institutions increasingly
less constrained by effective market discipline.
importantly, perhaps, it would also invariably lead to more
detailed government supervision and regulation of an
expanding number and variety of our institutions.
why I favor such high and wide firewalls and it is why I
will do what I can as a member of the Board to assure that
firewalls are maintained both conceptually and in fact.
There is a related concern that I would like to call to
It is axiomatic today that our financial
institutions compete world wide, and that the world's
financial markets are increasingly interrelated.
was that clear in last October's stock market developments,
but also it is no longer noteworthy that developments in the
foreign exchange or Euro markets today promptly affect U.S.
In such an environment, our non-bank
institutions—including affiliates of bank holding
companies—might find themselves in the years ahead directly
competing with entities that are, in effect, departments of
a bank domiciled abroad. Since the bank and all of its
customers will presume direct central bank support for the
bank as a whole, the nonbank function and its customers will
also presume at least indirect central bank support.
"Universal baulking, " as I understand the term, puts less
emphasis on the value of firewalls of the type evolving in
the United States.
This implies a broader degree of
governmental support in world wide financial markets than is
necessary or desirable.
It would be a grim joke indeed if
after so carefully restructuring our financial services
industry, it was successfully argued that international
competitive pressures were such as to require extension of
the banking safety net to all U.S. financial firms in order
to obtain an international level playing field.
As was the case with the bank capital convergence
discussions, this issue is one that, with the globalization
of financial markets, may benefit from international
consultation and cooperation.