Federal Reserve Board Chairman Alan Greenspan weighed in on financial modernization reform last week for the first time this year. Edited excerpts of his Feb. 13 testimony before the House Banking Committee's financial institutions subcommittee follow:


We strongly urge an extensive increase in the activities permitted to banking organizations and other financial institutions, provided these activities are financed at nonsubsidized market rates and do not pose unacceptable risks to our financial system.

In this century the Congress has delegated the use of the sovereign credit-the power to create money and borrow unlimited funds at the lowest possible rate-to support the banking system. It has done so indirectly as a consequence of deposit insurance, Federal Reserve discount window access, and final riskless settlement of payment system transactions.

The public policy purpose was to protect depositors, stem bank runs, and lower the level of risk to the financial system from the insolvency of individual institutions. Sovereign credit guarantees have significantly reduced the amount of capital that banks and other depositories need to hold, since creditors demand less of a buffer to protect themselves from the failure of institutions that are the beneficiaries of such guarantees.

But all good things have their price. The use of the sovereign credit in banking creates a moral hazard that distorts the incentives for banks: The banks determine the level of risk-taking and receive the gains therefrom but do not bear the full costs of that risk. The remainder of the risk is transferred to the government. This then creates the necessity for the government to limit the degree of risk it absorbs by writing rules under which banks operate.

The United States government has been remarkably successful in containing the value of most of the subsidy within depository institutions. The bank holding company organizational structure has, on balance, provided an effective means of limiting the use of the sovereign credit subsidy by other parts of the banking organization.

It has been suggested that the bank holding company structure imposes inefficiencies on banking organizations and that these organizations should thus be given the option of conducting expanded financial activities in a direct subsidiary of the bank.

The bank subsidiary may be a marginally more efficient way of delivering such services, but it cannot avoid being a funnel for transferring the sovereign credit subsidy directly from the bank to finance the new powers, thereby imparting a subsidized competitive advantage to the subsidiary of the bank.

I am aware that these are often viewed as only highly technical issues and, hence, ones that are in the end of little significance. I do not think so.

The issue of the use of the sovereign credit is central to how our financial system will allocate credit, and hence real resources, the kinds of risk it takes, and the degree of supervision it requires. If the Congress wants to extend the use of the sovereign credit further, to achieve a wider range over which the benefits of doing so can accrue, it ought to make that decision explicitly and accept the consequences of the subsidy on the financial system that come with it.

Whether new activities are authorized in bank subsidiaries, bank holding companies, or both, Congress, in its review of financial modernization, must consider legal entity supervision versus umbrella supervision. The Board believes that umbrella supervision is a realistic necessity for the protection of our financial system and to limit any misuse of the sovereign credit.

To understand the risk controls of the bank, we have first to come to grips with the fact that the organization is interested in risk and its control, not by instrument or legal entity, but for the entire business.

Regulatory policies and operating procedures have had to respond to these realities, to focus on the process of decision-making for the total organization. Thus, the Federal Reserve-the historical umbrella supervisor- also has found it necessary to concentrate more on the process that banking organizations use to manage market, credit, operating, and exchange rate risk and less on the traditional after-the-fact evaluation of balance sheets that can and often do change dramatically the day after they have been reviewed by the supervisors.

In such a world, process, if not everything, is critical, and that process is determined increasingly at the parent holding company for all of the units of the organization on a consolidated basis.

Finally, let me turn to an issue that has bedeviled supervisory and regulatory discussions for years: the potential separation of commerce and banking.

New technologies will make it highly unlikely that the walling off of any ownership of financial institutions by nonfinancial businesses and vice versa can be continued very far into the 21st century.

Modifications of such a fundamental structural rule as the separation of banking and commerce should proceed at a deliberate pace.

Excessive delay, however, would doubtless produce some inequities. Expanded financial activities for banking organizations requires that those firms operating in markets that banks can enter should, in turn, be authorized to engage in banking.

However, some of these nonbanking financial firms already own-or are owned by-nonfinancial entities. A complete commerce-and-banking prohibition would thus require the divestiture of all nonfinancial activities by those organizations that wanted to acquire or establish banks.

Perhaps those organizations that either have or establish well- capitalized and well-managed bank subsidiaries should be permitted a small basket of nonfinancial assets-a certain percentage of either consolidated assets or capital. A small permissible basket would establish, in effect, a pilot program to evaluate the efficacy of further breaching of the banking- and-commerce wall.

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