Federal Reserve Board Chairman Alan Greenspan testified recently in favor of repealing the provisions of the Glass-Steagall Act that prohibit affiliations between investment banking firms and member banks. If he had stopped at that point, his testimony would have been on sound footing.
Regrettably, his testimony went on to reopen an old debate about bank holding company subsidiaries versus bank subsidiaries. Chairman Greenspan argued that the activities of securities affiliates should be required to be conducted in bank holding company subsidiaries instead of bank subsidiaries.
Early in the Reagan administration, the Treasury prepared legislation to deregulate banking rather substantially. Among other things, the Glass- Steagall Act was targeted for meaningful revision.
The Federal Deposit Insurance Corp. was asked its view of the proposal. It responded that it was wholeheartedly in favor of repealing the provisions of Glass-Steagall that prohibited banks from affiliating with investment banks.
The act was undermining the soundness of the banking industry by preventing banks from counteracting the loss of their best customers. These customers were bypassing the banking system by going directly into the securities markets to invest their excess cash and to arrange their funding.
Far from protecting the banking industry from high-risk transactions, the Glass-Steagall Act was increasing the industry's risk profile. As banks lost their best customers, the remaining business on their books was composed of a relatively higher proportion of marginal borrowers.
Despite its strong support for the thrust of the Treasury proposal, the FDIC expressed one serious reservation. The Treasury, in order to get the Federal Reserve's support for the proposal, had agreed that securities activities would be required to be conducted in a holding company affiliate, as opposed to a bank subsidiary.
The Federal Reserve argues that holding company affiliates are a safer way to conduct investment banking activities. The theory is that a bank would thus be better insulated from any disasters that might occur in the securities affiliate.
The theory is simply wrong. If investment banking activities were conducted in a separately capitalized and funded bank subsidiary, subject to the same firewalls applicable to holding company affiliates, there would be no basis to assert that the bank would have any more legal, business, or moral responsibility for the losses in the bank subsidiary than it would have for a holding company affiliate.
An affiliate is an affiliate. The bank will either have or not have responsibility for the affiliate's problems. The outcome will not be affected by where the affiliate is located in the corporate structure of the banking company.
One thing that will be affected is the degree to which the bank will benefit from the successful operations of the affiliate. If the affiliate is a subsidiary of the bank, the bank will own 100% of the affiliate's profits. If the affiliate is a holding company subsidiary, the bank will own none of its profits.
That's why the FDIC has felt strongly about allowing nonbanking activities to be conducted in bank subsidiaries. It would be the height of folly to expose the bank to whatever risk those activities entail and not allow it to reap whatever rewards those activities generate.
Another thing that might change, depending on where the activity is housed, is the agency that regulates the subsidiary. If the activity is conducted in a bank holding company subsidiary, it will be regulated by the Federal Reserve. If it's conducted in a bank subsidiary, it will be regulated by the relevant bank regulator.
The Federal Reserve's attempt to grab more turf might be justifiable if it were a clearly superior regulator compared to the other banking agencies. The Federal Reserve is a good supervisor, but not demonstrably better than the Comptroller or the FDIC.
The Federal Reserve typically makes a big to-do in its turf wars about its role as the lender of last resort. The truth is that the FDIC has become the real lender of last resort for the banking industry. When a Continental Illinois teeters on the brink of insolvency, the Federal Reserve provides liquidity loans 200% secured by marketable securities, while the FDIC steps in to absorb all the losses.
Bankers should have an abiding interest in the outcome of the Fed's turf war. If banks place most of their nonbanking activities in bank subsidiaries, the earnings of banks will be greatly enhanced, making it far less likely the industry will experience the kind of debacle that overtook the S&L industry in the past decade.
With the new interstate branch banking legislation, holding companies are no longer needed for geographic expansion. If nonbanking activities are organized in bank subsidiaries, holding companies could well become an anachronism.
Bankers should be allowed the freedom to choose the most efficient form of organization to best serve their customers. If the form they choose does not sit well with the Federal Reserve or some other government agency, then so be it. Mr. Isaac, a former chairman of the Federal Deposit Insurance Corp., is chairman and chief executive officer of Secura Group, a financial services consulting firm based in Washington.