Regional President Speech

CHANGING GLASS-STEAGALL: OPPORTUNITIES AND RISKS FOR THE FINANCIAL SYSTEM BY THOMAS M. HOENIG PRESIDENT FEDERAL RESERVE BANK OF KANSAS CITY BEFORE THE FED CORRESPONDENTS ASSOCIATION APRIL 20, 1995 I.Introduction This year, Congress is considering several bills that, if passed, could dramatically alter the structure of our financial system. The foremost objective of these bills is to repeal provisions of the Glass-Steagall Act, which have long separated commercial banking from investment banking activities. In addition, several legislative proposals would go much further and allow nonfinancial companies to own and operate banks. The bills to repeal the Glass-Steagall Act, in particular, have drawn widespread support within Congress, the Clinton Administration, larger banks, and the regulatory agencies and thus deserve careful consideration from all of us. Today, I will provide a brief overview of the various proposals for breaking down the barriers between banking, securities, and commercial activities. Next we will discuss the basic reasons supporting this transformation of our financial system. Then I wish to direct your attention to what I consider the key issue in this process -- what must be done to ensure the stability of our financial system as we create an entirely new structure for it. II.Proposals for reforming the Glass-Steagall Act -- Three different ways for revising or repealing the Glass-Steagall Act have been proposed. •Leach Bill -- A bill introduced by House Banking Committee Chairman Jim Leach would allow a financial services holding company to own both banks and securities firms, with their activities to be conducted in separate subsidiaries of the holding company. The Leach bill would impose specific restrictions or firewalls between the two different activities. The Federal Reserve would be responsible for overseeing the holding company, while banking agencies and the SEC would supervise the appropriate subsidiary activities. •Treasury Department Proposal -- Under the Treasury Department's proposal, banks, securities firms, and insurance companies would be allowed to affiliate with each other. In contrast to the Leach bill, the nonbanking activities could be placed in either a subsidiary of the holding company or an operating subsidiary of a bank. A council headed by the Treasury Secretary would determine the activities that could be conducted by affiliates. 2 •D'Amato and Baker Bills -- Under bills introduced by Sen. Alfonse D'Amato and Rep. Richard Baker, banks and other depository institutions would be allowed to affiliate with both financial and commercial firms under a financial services holding company structure. As a result, either a holding company or its subsidiaries could engage in any type of business. While regulation of the subsidiaries would be divided along functional grounds, umbrella or consolidated supervision of an organization would be largely eliminated. Instead, these bills would rely almost entirely on strong firewalls, costly penalties, and enforcement procedures to prevent holding company and nonbank affiliate problems from jeopardizing insured banks. III.Why Should We Change the Glass-Steagall Act? •Technological change and innovations within our financial markets are creating a financial system that is far different from that of the 1930s, when the Glass-Steagall provisions were passed. •Pathbreaking developments in the processing of data and in our communications networks, for instance, have greatly improved access to financial information throughout all segments of the marketplace, lowered the costs of many financial transactions, and increased the complexity and variety of financial instruments that can be offered. •Several examples of the changes resulting from such developments are the growth of the mutual fund industry; the rapid expansion of the commercial paper market; the creation of many new financial instruments, contracts, and methods of managing market risk; and the securitization of mortgages, car loans, and other obligations. •Overall, these changes have allowed securities firms and banks to expand the types of services they offer and to compete more closely with each other. Securities firms now offer cash management accounts and lending and credit placement services that are close substitutes for bank products. Similarly, banks have become active in the mutual fund business in order to provide their customers a range of investment alternatives, and many banking organizations have found a variety of means for securitizing credits, offering investment advice and stock brokerage services, 3 conducting private placements, and engaging to a limited extent in debt and equity underwriting. •As a consequence, it is no longer possible to define a limited set of deposit and lending activities that constitutes banking and a different set of financial activities that represents investment banking. Such barriers would clearly keep banks and securities firms from adapting and serving customers in the most efficient and competitive manner. Thus, changing our banking and securities laws is no longer a question of whether or not to do so, but one of how to proceed. IV.What Must Be Done to Ensure the Stability of our Financial System? •Having cited the reasons for reforming the Glass-Steagall Act, I must now turn to what I consider the key issue -- How can we ensure the stability of our financial system as we change its basic structure, and, I might add, without significantly expanding the federal safety net? •Through our supervision of bank holding companies at the Federal Reserve, we have already encountered some of the problems that are likely to arise in combining banking and securities activities. In particular, my experience in the farm, energy, and real estate downturns in the 1980s taught me that nonbanking activities cannot be easily separated from banking activities within the same organization. A number of organizations in our District, for instance, could not adequately address problems in their subsidiary banks, because they were also having to deal with serious difficulties in nonbanking operations. Moreover, while some of these nonbanking activities appeared to offer good opportunities for diversification, we found, instead, that they often responded to downturns in much the same manner as banking operations. Another key lesson learned from this experience is that supervision may be limited in its ability to anticipate and counteract widespread problems. •As a result, I cannot emphasize too strongly the importance of developing appropriate and prospective "rules of the road" now that can be applied on a consolidated basis to "financial services holding companies." 4 I would note that some of the proponents of Glass-Steagall reform have suggested that we can de-emphasize this rule making and place major reliance on supervisory oversight of the underlying activities and on marketplace discipline. I must admit that I am sympathetic to these views, and I would be the first to recognize the dedicated work of our supervisory agencies and the importance and strength of market forces. However, the stability of our financial system should not be based on the premise that examiners and supervisors can unerringly anticipate and respond to market changes and uncertainties -- neither can we count on others to perform this difficult task without an appropriate framework. We must therefore design rules which will help prevent serious problems from occurring, while ensuring the tools and resources for taking corrective steps when needed. •In designing these rules, there are three factors that we should stress -- (1) reform of the deposit insurance system, (2) adoption of firewalls and other means for containing risk and limiting conflicts of interest, and (3) the development of a system of consolidated supervision. •Deposit insurance reform -- Reform of deposit insurance must be the first and foremost objective if we are to limit taxpayer risk and prevent further expansion of the federal safety net. •The fundamental problem with deposit insurance is that it gives depositors little incentive to distinguish between sound and weak institutions, thus giving an insured institution a funding base beyond the control of the normal market process. With Glass-Steagall reform, moreover, a broader range of organizations with possibly greater conflicts of interest and different risk characteristics would be gaining access to this funding base. • I realize that there are no easy solutions to the shortcomings in our deposit insurance system, but we must begin to work toward assuring market discipline in this system. One alternative that may be worth considering is the use of narrow banks or similar forms of depositor protection for organizations that choose to pursue a broad range of financial activities. This option, in 5 fact, would closely mirror the cash management accounts and money market sweeps already used by many securities firms. •Firewalls -- A second factor in the rules of conduct must be firewalls. An appropriate set of firewalls can play an important role in minimizing the risk of contagion within our financial system. One thing that should emphasize the need for firewalls between insured institutions and nonbank affiliates is the losses that several investment banks, derivatives traders, and insurance companies have recently experienced -- the British investment bank Barings and its $1.2 billion in losses is just one example. These cases further point out the importance of confining such activities to separate and distinct corporate entities. I would thus strongly argue for an approach that uses subsidiaries of a holding company as opposed to operating subsidiaries of a bank. However, we must also acknowledge that firewalls may fail during periods of severe stress, and thus we cannot place exclusive reliance on them as some proponents of Glass-Steagall reform have suggested. •Firewalls are of additional benefit in controlling conflicts of interest -- conflicts that are likely to multiply as organizations take on broader activities. In this regard, I would stress that banks have traditionally played the role of impartial lenders and participants in the payments system, and most banks have not had a strong vested interest in favoring one group of borrowers or depositors. This has clearly helped to limit the conflicts that banks have faced, while also ensuring greater diversification within individual banks. These characteristics have further served to prevent widespread abuses of our deposit insurance system. While Glass-Steagall reform may allow many organizations to achieve an even greater level of diversification, we would be remiss not to expect some problems and greater conflicts of interest within these organizations. It is also likely that a number of organizations will develop around a narrow and less diversified customer base. Several examples should illustrate these concerns and emphasize the need for 6 developing strong firewalls and a clear corporate separation between activities. •First, I think it is not unreasonable to expect that organizations with substantial investment banking operations will focus much of their bank lending and deposit activities on investors, corporate customers, and other participants in the securities market. This type of customer base could thus leave such organizations with a even greater vulnerability to fluctuations in securities markets and to strong pressures to compromise credit standards. To better illustrate this, we might stop and ask ourselves what would have happened if Drexel had been allowed to establish a bank and develop extensive deposit and lending relationships with many of its highly leveraged customers. •One other potential conflict of interest and supervisory concern is linked to the role banks play in providing back-up liquidity to much of the securities market through letters of credit, credit enhancements, bridge financing, loans to securities dealers, and many other means. With the merging of banking and investment banking, we could be left with a group of organizations providing liquidity to and supporting the very markets in which they are actively taking positions and assuming the inherent market risks. •Consolidated supervision -- The final factor I would emphasize in constructing rules of conduct and in creating a supervisory framework is consolidated supervision. The deposit insurance issues and potential conflicts of interest just mentioned will be difficult, if not impossible, to monitor and supervise unless an agency has oversight responsibility for the consolidated organization. •Consolidated capital -- An important aspect of consolidated supervision is the enforcement of consolidated capital requirements. Capital provides a cushion for absorbing the type of problems expected in a competitive marketplace, and it is extremely important in bringing stockholder discipline and oversight into an organization's operations. However, based on our experience from the 1980s, we cannot rely exclusively 7 on capital as an early warning system or for absorbing a sustained string of losses -- we must also focus on proper diversification within organizations, adequate control of financial risks, and appropriate internal controls. •Divestitures -- In developing consolidated supervision for financial services holding companies, we must also be wary of several commonly suggested rules and supervisory steps. Many have claimed, for example, that we could streamline much of our regulation if supervisors were to be more forceful in ordering the divestiture of banks or other activities at undercapitalized organizations. Such claims, however, are hardly supported by our Bank's experience in asking for divestitures during the 1980s. We found that divestitures were next to impossible in a declining economy, most notably because few potential buyers had the resources or the confidence to take such risks without federal assistance. •Easing requirements for well-capitalized institutions -- Another set of suggestions imbedded in several of the Glass-Steagall reform proposals is that we greatly ease regulatory standards, application requirements, and supervisory oversight for well-capitalized institutions. While I agree with providing incentives for holding capital, we should not rely on capital as our only barometer of financial soundness or good management. Nearly every bank in the U.S. is now adequately or well capitalized, but few of us would be willing to bet that all of these banks will be immune to future problems. Moreover, capital levels can and do experience cyclical fluctuations, and linking supervision and regulation too closely to an inflexible standard could inadvertently create a more cyclical financial system and economy. The "credit crunch" demonstrated what can happen when standards are tightened after the economy has already bottomed out. Currently, we might be facing the opposite problem of relaxing regulatory oversight at a time when banks should begin preparing for future uncertainties. 8 V.Summary •Overall, I want to reemphasize that we must establish an appropriate and comprehensive set of standards and supervisory procedures before banking and securities activities are brought together. I know that this will be a difficult, thought-consuming process, but if we fail to do so, we will be placing unreasonable demands on examiners and our supervisory process and will also be risking a major expansion in the federal safety net. •These concerns also lead me to believe that we should proceed with caution. Merging banking and securities activities will not be easy. As entry and competition are increased in each industry, new participants will likely find more imposing challenges than they had anticipated. This was clearly the lesson learned by U.S. and foreign banks when the "Big Bang" liberalized entry into the London Stock Exchange in 1986, and we should not expect anything different this time around. •I would further regard proposals for merging banking and commercial activities as premature. Until we have gained the necessary experience with financial services holding companies and done more to reform deposit insurance, I am afraid that opening banking to a broader audience would risk additional abuses of deposit insurance and could introduce more instability into our financial markets.

Thomas M. Hoenig (1995, April 19). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19950420_thomas_m_hoenig

@misc{wtfs_regional_speeche_19950420_thomas_m_hoenig,
  author = {Thomas M. Hoenig},
  title = {Regional President Speech},
  year = {1995},
  month = {Apr},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19950420_thomas_m_hoenig},
  note = {Retrieved via When the Fed Speaks corpus}
}