Gentlemen, you have been very, very patient. We apologize for the late hour.

Mr. Litan, go right ahead. As you know, you have 10 minutes each.

STATEMENT OF ROBERT E. LITAN, SENIOR FELLOW, BROOKINGS INSTITUTION

Mr. LITAN. Thank you very much, Mr. Chairman. Nice to see you again.

I will briefly attempt to summarize my testimony, but before I turn to the specific legislative proposals that are before you, I have two broad comments.

First, I would like to congratulate you and other members of the committee for bringing this debate to center stage. There is now a clear consensus within the academic community and within the regulatory community, that a responsible dismantling of the barriers between banks and other financial enterprises is both desirable and necessary.

And Mr. Chairman, your own statement introducing S. 1886, presents a clearly stated, succinct and powerful case for removing the barriers between banking and the securities industry.

Second, restructuring is inevitable over the long run, even if Congress fails to act. This is a very important point, because the States are already doing the job by gradually expanding the activity authority of the banks they charter. If Congress does not act, that process will only continue. Nevertheless, in my opinion, the Nation would be far better served by comprehensive reform now at the Federal level, not because I dislike the dual banking system, but rather because the sooner restructuring is accomplished for all financial institutions, wherever they do business, the more quickly consumers will benefit and banking and securities lawyers and lobbyists, as well as members of this committee, can go on to other more productive activities.

FEDERAL LEVEL OF REFORM PREFERABLE

Indeed, for these and other reasons, I believe that federally driven comprehensive reform is preferable to the interesting proposal recently offered by Representative Tom Carper, who would delegate the entire job back to the States.

Now, let me turn to the two specific bills before you. I didn't have a chance to look at the D'Amato-Cranston bill, but it certainly looks like it's going in the right direction.

First, the threshold issue is how far should you go? Should you stop with banking and securities, or should you go all the way to more comprehensive reform?

From solely an economic point of view, and I am not going to get into the politics, unless we do so in Q and A, the answer is simple. Go as far as possible.

While the removal of Glass-Steagall will clearly provide benefits, such as lower underwriting costs and lower advisory fees, these will only be indirectly seen by consumers. But if you allow bank holding companies to enter insurance agency and real estate brokerage, among other areas, consumers will see the direct benefits. It is no

accident that in Massachusetts and New York, banks provide insurance at very low cost, and I find it hard to believe that real estate commissions would stay stuck at 6 percent, if bank entry into that line of business would be permitted.

Indeed, I think you would see a lot more discount real estate brokers, just as you see a lot more discount securities brokers, when banks are allowed to enter that business.

Second, where should you put the new powers? In holding companies, deregulated banks or subs of the bank? I side with the holding company approach that is reflected in each of the bills before you.

There are several problems with expanding powers of banks directly.

First, if you do that, banks could then take advantage of the incentives for risk-taking created by deposit insurance to expose themselves and the FDIC to greater risk.

Second, if nonbank activities located inside or beneath the bank were to fail, the bank's capital would then be directly impaired, and, in fact, the FDIC could be called upon to ensure not only the banking industry but the securities, insurance, real estate and other businesses as well.

Now, the FDIC has recently recognized these problems and they've proposed that bank investments in subsidiaries not be counted toward bank capital. While this may work for activities directly in bank subsidiaries, it probably can't work if the expanded powers are carried out by banks directly, because then the capital for the various activities would be blended together.

More important, even under the FDIC proposal, banks would be able to use federally insured funds to invest in other enterprises, an advantage nonbank individuals and firms do not enjoy.

Critics of the holding company requirements say it is too expensive, even under the expedited procedures of Proxmire-Garn. If you believe this is a problem-that is, a political problem-then.

One way around it would simply be to exempt small banks from the holding company requirements, on the grounds that smaller institutions do not pose the kind of systemic danger that large banks do. Alternatively, you can keep the holding company requirement but exempt very small bank holding companies from Fed supervision. The third issue is: Which agency should be responsible for supervising new financial conglomerates?

Proxmire-Garn takes an interesting approach to this question by setting up an 80-percent test for securities firms not heavily engaged in banking. I understand fully the reasons why you put in the 80-percent test-because you don't want to have intrusive Federal Reserve regulation of conglomerates primarily involved in the securities industry.

I would point out, however, that whatever percentage test that is used may create an incentive for financial organizations to adopt clever accounting techniques or to push their bank activities off balance sheets, in order to avoid Fed supervision. It is a problem. Maybe we can get to it in Q and A.

The Graham-Wirth bill, in my opinion, raises far more troublesome issues by suggesting the creation of a 15-member Financial Oversight Commission. I am skeptical. Why create another regula

tory body, when the United States already has the most complicated system of Federal regulation in the world? If the objective here is to expand powers of organizations that own banks, why not simply amend the "closely related to" test of the Bank Holding Company Act and replace it with the word "financial" or something like that instead, and specifically allow securities real estate and insurance powers, and then leave the regulatory responsibility, however broad it is, with the Fed, where it already is? I see no need for creating another agency with all those people on it.

The fourth and most important issue before your committee is how to insulate the bank from problems with its affiliates. In my opinion, Proxmire-Garn does reasonably well on this score by imposing a series of detailed restrictions on transactions between banks and their affiliates and between banks and the customers of their affiliates.

However, as some of you know, I think there is a better way to attack the insulation problem. That is to require that any conglomerate that desires to engage in activities beyond the Bank Holding Company Act, to restructure its bank into a narrow bank. Such a bank would only hold obligations issued by the Federal Government or a Federal agency, such as FNMA's or GNMA's.

As a result, narrow banks would essentially be run-proof, unlike conventional banks, under any of the proposals before you. Because all lending in such organizations would be conducted by commercial finance affiliates funded by uninsured debt and equity rather than by banks operating within insured funds, there would simply be no conflict of interest concerns. As I explain in my prepared testimony and in the attachment thereto, there would be transition rules to minimize strains on the securities markets and an exemption from the narrow bank requirement for small banks.

Narrow banking, in my view, removes the need for the kind of detailed restrictions of Proxmire-Garn and other similar proposals. Indeed, some of these restrictions may be more problematic than meets the eye.

PROPOSED RESTRICTIONS COULD BE A PROBLEM

For example, the law may say that a bank is not to lend to an individual for the "purpose of purchasing securities underwritten by the security's affiliate", or the law "may prevent banks from lending during the underwriting period."

But how can regulators really know what the money is used for, when the loan is made? After all, money is fungible. Now, I am not saying these problems are so insuperable that we ought not to proceed with reform. I am simply pointing out that in an ideal world, I would rather have narrow banking than any of the bills on the table.

But of course, this is the real world, and narrow banking is not on the table. So I would clearly support the Proxmire-Garn provisions having to do with insulation instead.

I have one caution, however, to add about a feature that is common to both Graham-Wirth and also Proxmire-Garn. Specifically, I refer to a provision that allows the supervisory authority to

force the divestiture of the bank, if its capital falls below a certain minimum.

While this feature might work, it also may not. Divestiture orders in the real world are likely to be vigorously contested in court, which could tie up the supervisory agency for years. Some banks may simply be too large to divest, especially if they have problems.

I should remind you that Continental Illinois was on the shopping list for several months. The regulators couldn't find anybody to buy it.

Finally, for these reasons regulators may simply be reluctant to order divestiture, especially when they are under political pressure, as they frequently are, to exercise forbearance.

One final point on the insulation issue.

If the political price for financial restructuring is a prohibition on cross-marketing, the effort in which you all have engaged will simply not have been worth it.

So I strongly advise against any restrictions on cross-marketing. The last issue relates to asset concentration issue, which I address briefly in my testimony.

My basic point is that I don't see the inherent evils of large organizations if they do not acquire excessive market power. This is what the antitrust laws are designed to prevent.

However, I also recognize that asset concentration limits could be procompetitive by forcing de novo entry and also by forcing the purchase of smaller firms by organizations with the intention of building them up later.

On balance, I see no overwhelming downside to putting concentration limits in. If they are viewed as politically necessary for getting a bill through, then fine, so be it.

That is the end of my comments, and I look forward to questions. [The complete prepared statement of Robert E. Litan follows:)

2

Thank you, Mr. Chairman, for inviting me to appear before the
Committee today.

I want to begin by congratulating you and the other members of the
Committee for considering the fundamental reforms of our financial system
that have been proposed both S. 1886 sponsored by Chairman Proxmire and
Senator Garn and S. 1891 sponsored by Senators Graham and Wirth. There is
a consensus within the academic and regulatory communities that the
restructuring of our financial laws is long overdue. In particular, the
evidence that I have examined over the past several years clearly suggests
that under the appropriate structural conditions consumers of financial
services households and corporations would clearly benefit if the
restrictions that now imperfectly segment banking from other activities
were removed. 2

-

Nevertheless, the debate about whether the financial system should be
restructured is fast becoming academic. While Congress has been
deliberating what course of action to take the states have been quietly
expanding the authorized powers of the banks they charter. In fact, most
states now grant their banks broader product-line freedom than the
Comptroller is permitted to allow for national banks.3

If Congress fails to act sometime in the near future, the states almost
certainly will settle the financial product-line debate just as they have
almost settled the once bitter contest over interstate banking.

The bills you have requested testimony about this morning can be
viewed as attempt by the Congress to wrest the initiative from the states.
I think such action is appropriate not because I oppose the dual
banking system, but because the sooner restructuring is accomplished for

The views expressed here are solely those of the author and should not
be ascribed to the institutions with he his affiliated, their
trustees, officers, partners or employees.

I set forth this view more fully in What Should Banks Do?, published by the Brookings Institution in September 1987.

See Financial Restructuring: Which Way for Congress?", Challenge. November-December 1987 (attached).

all financial institutions wherever they do business the better off we
will all be. Consumers will benefit more quickly. Closer to home, millions
of dollars (or over several years, even billions?) will be saved on
lawyers and lobbyists. And members of this Committee can allocate their
scarce time and political capital to other issues.

For these and other reasons, in purely economic terms the nation
would be better served by a comprehensive federal solution now than by the
legislation recently offered by Rep. Tom Carper, which would effectively
delegate the whole restructuring issue to the states (by equalizing the
powers of state chartered banks and national banks operating in the same
state).

I would now like to address a number of generic issues that are raised by both the Proxmire-Garn and Graham-Wirth proposals.

The threshhold question is how far should Congress reach in reforming
the financial laws? To be concrete, should only the banking-securities
issue be settled (by repealing Glass-Steagal1), or is the more
comprehensive approach embodied in the Graham-Wirth proposal (itself
modeled on the recent restructuring proposal offered by Gerald Corrigan)
more desirable?

Again, if economic considerations alone are to be considered, a more
comprehensive approach is preferable, especially for consumers. To be
sure, removing the Glass-Steagall barriers would provide benefits lower
underwriting costs and advisory fees paid by corporations. But consumers
won't directly observe these savings. Consumers would directly benefit,
however, if banking organizations were able to sell insurance and broker
real estate. It is no accident that in Massachusetts and New York, which
allow savings banks to sell life insurance, bank-provided insurance is
generally the lowest cost. Indeed, even the insurance industry has
aknowledged that the current system of delivering insurance is
inefficient."

I also find it hard to believe that with more competition in the real
estate brokerage industry -- especially from technologically sophisticated
banking organizations - real estate commissions would stay stuck at the
"customary 61. In fact, we are just beginning to see the development of
'discount real estate brokers. If banking organizations were permitted to
broker real estate, I suspect you would see a lot more such discounters"
-- just as banks have aggressively pushed discount securities brokerage.

4.

American Insurance Association, Expansion of Banks Into Insurance (New York, AIA, 1983), pp. 16-20.