Once again, it appears that Congress will seriously consider reforming the banking law provisions, known as the Glass-Steagall Act, that have separated commercial banking and investment banking since 1933.
This has, of course, happened periodically throughout the 1980s and early 1990s without material progress. The most recent significant effort occurred early in the Reagan administration, when the Treasury study was completed and the Treasury prepared legislation to deregulate banking, including repeal of the Glass-Steagall Act.
In January, House Banking Committee Chairman Jim Leach, R-Iowa, introduced the Financial Services Competitiveness Act of 1995 (reintroduced later as H.R. 1062). The next month, Senate Banking Committee Chairman Alfonse D'Amato introduced the Depository Institutions Affiliation Act of 1995, and a companion bill was introduced in the House by Representative Richard Baker.
Throughout the history of this debate, a central issue has been the protection of the federal banking safety net from the risks of the securities business. This same concern manifests itself in the approvals given by the Federal Reserve to bank holding company subsidiaries - so- called section 20 subsidiaries - to engage in the securities business without being "principally engaged" in underwriting and dealing in securities that are not eligible to be underwritten or dealt in by banks.
All of the recently proposed reforms have taken the approach of creating "firewalls," that is prohibiting certain transactions and activities that are viewed as potentially visiting the risks of the securities business on insured affiliated banks.
Firewalls have another consequence, however, which threatens to undermine the very purpose of reforming Glass-Steagall. The main purpose of the Glass-Steagall reform is to strengthen the banking industry by providing greater and more diverse sources of revenue and profit. It also enhances the ability to meet customer needs. Deregulation of interest rates and efficiencies in the capital markets have resulted in commercial banks being disintermediated on both sides of their balance sheets.
Wholesale lending services are no longer as profitable because some traditional customers are able to fund themselves more efficiently in the capital markets. Indeed, certain traditional wholesale customers will no longer be customers of commercial banks in certain lines of business.
Glass-Steagall reform is designed to permit commercial banks to offer capital market products, such as commercial paper and debt underwriting, to customers. This will give commercial banks the opportunity to continue to serve customers who find these products more efficient than bank loans, thereby maintaining customer relationships, replacing lost revenue and diversifying revenue sources. To the extent that firewalls reduce natural synergies between commercial and investment banking, they run counter to this purpose.
Those fashioning the reform legislation must balance these considerations with the steps necessary to protect the federal safety net if reform is to achieve its purpose.
One way to help assure that the purpose is achieved is the mandate that firewalls be created only insofar as necessary to protect the federal safety net and to provide sufficient flexibility in the regulatory scheme so that any necessary firewalls can be adjusted from time to time. It is also necessary to achieve the desired balance as markets and products evolve.
Leaving aside substantial questions regarding regulatory consolidation, a fundamental reason why the bank regulatory regime is structured with regulators and regulations, rather than just statutory mandates, is to achieve this flexibility. It is a basic principle of administrative law that regulators are to be professional, experienced experts who are charged, among other things, with understanding the current market, the role of commercial banks in the market and achieving balance in regulation, in light of regulatory objectives established by statute.
If firewalls are embodied in statute, then the benefit of regulatory experience and expertise and regulatory flexibility will be lost, and over time, the fundamental purpose of the Glass-Steagall reform may be frustrated. The Leach bill provides a significant measure of regulatory flexibility in statutory firewalls, but even this bill contains specificity in the firewalls that is unnecessary and counterproductive.
Moreover, the standards for modification are not sufficiently focused on the federal safety net, but also include aspects that may be construed in a counterproductive manner. A better approach would be to state the objectives for regulation and allow regulators the flexibility to achieve these objectives in light of market conditions and experience as to those abuses that, in fact, endanger the federal safety net.
A cost-benefit analysis should be required in light of the experience garnered from supervision of the existing section 20 subsidiaries of bank holding companies before any firewall provisions are imposed. At the same time, the authority of regulators to impose restrictions that address abuses that are not now anticipated, but that arise in the future in connection with new markets, should be unambiguous.
Sharing of customer lists, joint marketing of services, and other synergies that do not threaten the federal safety net are the last things that should be inhibited by firewalls, if the statutory purpose of reform is to be achieved. In this context, the integrity of the federal safety net should be secured through appropriate disclosure to customers regarding the role and responsibility of insured banks in any transaction or service. Since it is impossible to predict in advance the nature of the products or services that will evolve, the examination process is the appropriate tool for achieving the result.
In fashioning the framework for firewalls, Congress should require that regulators take into account and not duplicate the existing banking laws. Many of the proposed firewalls are directed at assuring that any transactions between banks and securities affiliates are done on an arm's- length basis and do not disadvantage the bank.
Sections of the Federal Reserve Act regarding transactions with banks' affiliates already require this result as between an insured bank and any nonbank holding company affiliate. There should be a strong presumption against firewalls that merely duplicate the existing provisions. Similarly, firewalls should not duplicate anti-tying statutes and regulations already in place.
Inexplicably, some of the proposed firewalls appear to be directed toward assuring that no securities company affiliated with a bank achieves any competitive advantage from such affiliation even where there is no danger arising to the federal safety net.
This runs counter to the whole purpose of the reform effort, the success of which is dependent in part on the business success of securities affiliates. Lending limits and other provisions already exist to assure fair allocation of credit. No federal interest in protecting independent securities firms was suggested when major securities firms were purchased by insurance companies or retailers.
Provisions in the Leach bill, which would largely dispense with firewalls in the context of securities companies affiliated only with wholesale uninsured banks, are constructive, but are not the answer to the foregoing concerns because they can be expected to apply only to a narrow group of banking institutions.
A logical extension of this concept that would generalize its application would be to permit a single holding company to own both a retail bank, protected by appropriate firewalls, and a wholesale bank as well as a securities company.
One group that logically should benefit from these provisions is the foreign banks that conduct banking operations only through uninsured wholesale branches in the United States. Under the principles of national treatment - i.e. parity of treatment between foreign and domestic banks in like circumstances - international banks operating through uninsured wholesale branches in the United States should be treated the same as domestic wholesale banks regarding firewalls with affiliates in the securities business.
The Leach bill, as currently drafted, would appear to require an international bank to create a domestically chartered wholesale bank subsidiary or to restrict its deposit taking outside the United States to wholesale deposits in order to take advantage of these provisions. A Congressionally mandated joint Treasury and Federal Reserve study concluded in 1992 that international banks should not be required to operate through a domestic subsidiary bank as a condition to expanded powers.
This conclusion was implemented in the recent interstate banking legislation, and should be similarly followed in connection with the Glass- Steagall reform. The inefficiencies that would be imposed on financial services in the United States by any other approach are not warranted.
Further, United States banking organizations rely extensively on their ability to branch abroad and are typically able to engage in deposit taking and securities activities without the imposition of restrictive conditions that would affect their activities outside the host country.
If Glass-Steagall reform is to be effective, concern for the federal safety net must be balanced against the purposes of reform. This balance is dynamic and will change as markets and products change. It can best be achieved through legislation that articulates appropriate objectives and standards and relies on the expertise and experience of regulators to strike and maintain over time the necessary balance.