Reflections on the Ongoing Effort to Modernize Financial Services Regulation - John D. Hawke, Jr.

• Citation: Vol. 49 No. 3
• Publication year: 1998

Reflections on the Ongoing Effort to Modernize Financial Services Regulationby John D. Hawke, Jr.^*

The subject today is financial modernization, and I will address in particular the proposal that we in the Treasury Department of the Clinton administration put forth last year, in 1997, relating to the modernization of rules governing financial services. .' especially wish to share with you the thinking that underlies our legislative proposal. I will not try to get embroiled in the details, because I think the broad principles are, in many ways, more interesting.

The first objective was to try to get rid of the rules that serve—and in fact were intended to serve—to limit competition between different providers of financial services. Such laws as the Glass-Steagall Act of 1933 and the Bank Holding Company Act of 1956, especially as amended in 1970, have served principally to divide markets among politically influential segments of the financial services industry. To the extent that those laws prevent affiliation among firms engaged in the securities, insurance, and depository businesses, while limiting providers of certain of those products from offering a full line of financial products and services in the format that best meets their business needs, we think they should be repealed.

At the same time, we think it is essential that the expansion of the financial activities and affiliations of organizations owning banks not present additional threats to the safety and soundness of federally insured institutions. For several reasons, we are confident that our proposal will not pose such risks.

First, the existing regime for bank capital, which requires the maintenance of high levels of capital, together with prompt corrective action if capital levels should slide, provides a very strong first line of defense. Hypothetically, if one could measure the true market value of bank capital on a real-time basis, one would have very little concern about what activities banks engage in other than the taking of deposits. Obvious problems exist with that hypothesis because a person cannot measure the true value of bank capital on a real-time basis, and bank capital requirements have to be constructed with that reality in mind. Nevertheless, if regulators attempted to measure bank capital on a real market-value basis and move quickly to restore bank capital when it began to fall below various threshold levels, this oversight would provide significant protection for the kinds of federal interests that are involved.

Second, we also have a very strong system of fire walls, particularly those in sections 23A and 23B of the Federal Reserve Act. Under our proposal these safeguards would be made even stronger. We would have provided that in order for a banking organization to take advantage of new expanded powers to engage in other financial activities, either through subsidiaries of the bank or through holding company affiliates, the bank's capital would have to be maintained at the highest level required by law, the so-called well-capitalized level. Moreover, the bank would have to be and stay well managed. If the new financial activity were to be conducted through a subsidiary of the bank, as opposed to a holding company of the bank, the bank's satisfaction of that well-capitalized requirement would have to be measured after deducting the bank's equity investment in the subsidiaries. The bank would have to be in essence overly well-capitalized before it could invest equity in a subsidiary to take advantage of expanded financial activity. To put it in other terms, even if the bank's investment in the subsidiary were wiped out by a failure of the subsidiary, the bank's ability to satisfy its capital requirements should not be diminished.

Furthermore, we would also make the 23A and 23B fire walls applicable to dealings with the subsidiaries; they are not so applicable now. We thought that would provide an effective subsidiary framework for expanded financial activity.

I should say that this second main feature of the proposal is not without its detractors. Our position was that there should be full parity between holding company affiliates and bank operating subsidiaries in the scope of permissible financial activities. The Federal Reserve has strongly argued to the contrary that all new financial activities should be permitted only in holding companies subsidiaries and not in bank subsidiaries. Interestingly, the Federal Reserve's position was not based on safety and soundness concerns, because I think the Fed recognized that safety and soundness considerations were probably not affected by that choice of format. The Fed's argument was based instead on the notion that banks enjoy a safety-net subsidy that is somehow more easily spread to subsidiaries than it is to affiliates, and that is a matter of public policy. According to this logic, the format for new activity should be limited to the holding company affiliate in order to dampen...