Of course, some non-banking firms would find that their non-financial activities would exceed a small basket exemption. Such excess nonconforming assets might be addressed on a case-by-case basis with a scheduled longer term divestiture to avoid the worst short term inequities. A basket clause plus case-by-case review of individual situations might also provide a way to make available a common bank and thrift charter to those unitary thrifts that are affiliated with non-financial businesses.

Madam Chairwoman, the Board has no firm opinion on just exactly how such tradeoffs might be made, constrained only by the general concerns I summarized earlier.

Thank you very much.

Chairwoman ŘOUKEMA. Thank you, Mr. Chairman. As always, you have given a conceptually comprehensive exposition of the values of the services of the Fed. Of course, you have given us the benefit of your experience. A lot in your testimony.

[The prepared statement of Hon. Alan Greenspan can be found on page 433 in the appendix.]

Chairwoman ROUKEMA. Let me present just two short, well, two questions. I don't know how short they are. And then I will let my colleagues have a go at it.

Now, you address this question of the safety net subsidy, but let me ask the question my way, recognizing that some of your answer will be redundant, but I think it is important to go over this again. You warn in your testimony that we must not inadvertently extend what you reference as the "Federal safety net, without a thorough understanding of its implications, and such an extension would be a risk to the competitive balance and the systemic risk of our system."

To what degree would you think the systemic risk would be increased by permitting banks, and I know you address this, but I want you to go over it again, by permitting banks' operating subsidiaries to engage in these non-bank activities? Go over it again in relationship to the safety net subsidy, because I have another question on the definition of that subsidy.

Mr. GREENSPAN. OK. The first thing that I think is important to recognize is that the subsidy exists. There is concern amongst a number of analysts and commentators about whether, in fact, we do actually have a subsidy in the sense that a number of bankers argue that the cost of regulation, deposit insurance, when it is other than zero and a number of other elements that are involved in banking, exceed the benefits to whatever extent they are of such a subsidy.

The answer to that is twofold: first, that the subsidy exists is very clearly demonstrated by comparing finance companies or other types of intermediaries of a comparable credit rating with banks, in other words, getting the same credit rating of the finance company and the bank with essentially the same sort of assets.

What you find is that, in today's market, that finance companies require 6 or 7 percentage points higher capital/asset ratios than do banks; and the reason for that is the market requires that they have more capital because the bank, through its availability of the discount window and deposit insurance, is able to have a far more flexible system and an insured system than are nonsubsidized fi

nance companies. So that the subsidy exists and that it has a significant effect on earnings of the banks strikes me as not an open question.

The key question with respect to the subsidiary of the bank is whether that subsidy which exists in the bank itself more easily can be transferred as equity from the bank to the sub of the bank than from the bank to the holding company.

I don't want to get into the details because we will be here all today.

Chairwoman ROUKEMA. Why is that important to us in terms of our statutory definition? Why is that important?

Mr. GREENSPAN. It is very important because if you create a sub of the bank and allow it full powers that exist in the type of expansion of powers that we are contemplating in a number of the legislations, I am reasonably certain that the affiliates of the bank with the subsidized equity credit will have lower costs of capital than competitors in other areas of the economy and that what you will do is create an unlevel playing field in which the banking organization, because it concentrates its competitive activities within the bank sub, has competitive advantages because of the government subsidy not available to other players in our economy.

Chairwoman ROUKEMA. I said I had two questions. I think you have answered the second question, but let me make reference to it in any case.

Later, one of our panelists, Mr. Ludwig, will take issue with that by saying that there is no "net" subsidy. I think you have addressed that from your perspective. He will have the opportunity to refute it. But is there anything more that you want to say, with respect to that no "net" subsidy, in the context of observations? I don't know whether or not you have seen that testimony.

Mr. GREENSPAN. Yes, I did, and I hesitate to argue with Gene Ludwig, who is one of my regular golf partners and I am worried

Chairwoman ROUKEMA. Well, this is the time to get back.

Mr. GREENSPAN.-That if I am too unfriendly he won't give me five-foot putts like he tends to do.

But I have read his arguments, and I must say I do not agree with them. He raises questions, as I recall, as to whether there is a subsidy; and then, like a good lawyer, he says, if there is not, then such and such.

But if the subsidy weren't there and it wasn't more valuable to have deposit insurance and access to the discount window, it strikes me that there would be an awful lot of banks who, burdened with all of the excess stuff we put on them, and we do, would abandon their bank charters and go do their own thing without that.

Most importantly, this is visible when you take a look at deposit insurance. Deposit insurance is very clearly a much higher value than the price that is paid. I refer to Federal deposit insurance. If that were not the case, we would have a lot of private deposit insurance competitors and what is very evidently the case, that you will look far and wide for people who are willing to abandon the Federal deposit insurance for private insurance. So that clearly is

evidence that the benefits far exceed the costs as perceived by the banks.

I don't want to get into a number of the details that Gene Ludwig raises, but he does raise the question with respect to the question that the holding company debentures, as I mentioned in my prepared remarks, have a lower credit rating than the parent. And he argues the parent bank-I am sorry. They have a lower credit rating than the bank, and he argues that that is evidence that subsidy, that since the gap is very small between the interest rates on the debentures of the holding company and the bank, that the subsidy is small.

What that reflects at this particular time is the relative degree to which the subsidy spills over from the bank into the holding company. It says nothing about the level of the total subsidy that exists within the holding company itself. Even there, I might say that he quotes, as I recall, 4 to 7 basis points difference. Usually, it is a much higher number, and the reason it is different today is that all yield spreads have converged very sharply. This is unusual and won't exist very long.

He raises a number of other issues that perhaps I better insert my remarks for the record rather than take up the time.

Chairwoman ROUKEMA. Please. I would appreciate that, and I can assure you that Members of this subcommittee will be going over in detail the testimony, both yours and Mr. Ludwig's. I think this is a very educational indication of how complex the issues are that this subcommittee is going to have to deal with this year, but we must confront them head on. I appreciate your testimony.

Mr. Vento.

Mr. VENTO. Thank you. Thank you, Madam Chairwoman.

I think the sovereign credit, that is to say, the issue of deposit insurance Fed window and wire issues, there is obviously this debate about the magnitude to which and how they carry through in terms of corporate structure; and, of course, the question is how do you limit, you know, this risk.

I mean, I don't think any of us, I mean, everyone talks a lot about free enterprise. It is just they only like one side of it. That is where they make money. They don't like the side about losing money. So they want to get as many of their assets under the protection that they can.

I guess that is human nature. And I guess the question for us is, you know, your conclusion is that the bank holding company structure somehow gives an advantage in terms of limiting this particular structure. But that, as I mentioned earlier in our informal conversation, has only been around for 26 years or so; and I think the challenge for us is to, obviously in modernization, to try to prevent risk.

I mean, I think there has been an expansion of the deposit insurance in terms of the fact that some of the instruments and the convergence of financial activities inside banks begins to take on many aspects. After all, it is during this same 26 years that we had the problems with the thrifts and the problems with the banks. So it isn't obviously something that is completely-we have had some serious problems in spite of the fact that we have had this type of structure in terms of the expansion.

So our question is, is this type of holding company structure_the only way? Do we have to, or does the marketplace have to, reflect some specific type of legislated corporate structure in order to actually provide regulation? In other words, can we effectively deal with preventing that basic subsidy insofar as it does exist? I will leave that between you and others. I have read this, but isn't there other ways that we can do it?

Mr. GREENSPAN. I don't think you can fully prevent some leakages, because it is a very powerful force which moves around a bit. But what you can do is significantly limit its expansion so as not to corrode the overall incentive structure in the financial system. Having looked at this issue in some detail, and it is a very complex question, we have concluded at the Federal Reserve Board that the holding company structure is by far the superior means by which you can contain the effect of the sovereign credit subsidy moving out of the bank where it is located into any other series of entities.

The issue is how one structures the system; and while you can theoretically impart similar barriers in the bank sub and in the affiliates for bank holding companies, in our judgment you never can make them equal. In other words, there is no way to avoid the fact, no matter what you do, that if you have expanded activities in a sub of a bank, that equity will flow into that sub at subsidized competitive rates. There is no way to avoid that.

The only thing that can be done is to find a structure for these expanded activities, which we all support, which delimits the expansion of the safety net and delimits the subsidies thereof. Because it is only under those conditions that you can get the true advantages of market incentive forces and the type of viable economic structure which we have developed in this country to function effectively, and it is that issue which I think is at the cutting edge of determining what type of structure we have.

Mr. VENTO. All that talks about is what firewalls. Obviously, if you have a holding company, it doesn't lend itself to the profitability or the ability of banks to respond to the marketplace and other financial entities. We end up with, in essence, no net gain. But I know that that is not the intent. That is why you are asking for streamlining of the holding company structure and activity in the statement that you made.

One of the questions, of course, that we should address is the acquisition merger and the shape of the financial marketplace tomorrow in terms of the size of entities. In some views, it is reported that if, in fact, modernization will lead to merger acquisition of larger entities made up of both commerce and banking type of entities. In fact, even international, there is some, you know, suggestion that if we, in fact, write this legislation, don't prevent it, we could be owned by other entities on a global basis.

It seems to me, Mr. Chairman, that much of this business is becoming more global; and it is quite likely that we are going to have significant ownership on a global basis of financial entities in any case. The question is: Are there some words of wisdom briefly that you could offer that would guide us in terms of this merger acquisition concentration, even something as terrible as, in some folks' minds, as foreign ownership?

Mr. GREENSPAN. I don't know whether I can offer words of wisdom, but I will try to tell you how what I know. I don't know how you would characterize that.

Let's first remember that we are moving increasingly into a global environment. This is characterized by the fact that total trade is expanding far faster than the domestic, gross domestic products of the individual countries in the world, which means of necessity that, on average, imports are rising as a share of domestic demand and inevitably so is finance.

I don't think this should be something we should be concerned about. It is the inevitable way in which standards of living rise, and so long as there is a level playing field constructed in the United States I don't think that we should in any way be concerned about foreign holdings of U.S. institutions.

With respect to the concentration question, I think that I am not terribly concerned about it; and I would be if I thought that it would somehow impact on our community banking structure, which I think is a very important and crucial element in our society and the dual banking system with which it is related. I think it has been a very effective mechanism for economic growth in this country and were I concerned that the issue of globalization would somehow impact on that, I would be a bit worried.

I don't believe so. My view of the way our small banking system functions, especially when you view it in the context of some of the larger banks trying to get into the markets of those community banks, is that you cannot substitute for the personal contact that community banks can offer, which larger banks can never compliment.

The consequence of this is that no matter how complex technology becomes, now matter how much the system increasingly gets structured with different types of various risk management systems, you will never get away from the issue of what I call "character banking."

And "character banking" is essentially what we mean by community banking. I think that has got a very strong, competitive edge in this country, and I do not believe it is subject to pressure.

Mr. VENTO. Thank you. I note your statement also has a special reference to provide some liberal treatment of community banks. Thank you, Madam Chairwoman.

Chairwoman ROUKEMA. Chairman Leach.

Mr. LEACH. Thank you, Madam Chairwoman.

Mr. Chairman, you have defined access to the discount window and the payment system as, effectively, government subsidies. Is it conceivable to you that it is prudential to allow parties access, particularly to the payment system, without any Fed oversight?

Mr. GREENSPAN. I would say one should be quite careful about that. Specifically it is most relevant in the issue of the payment system, and the reason I suggest you have to be careful is that as we run, for example, so-called "Fed wire," which is a major system which has got a fund of risk free final settlements associated with it, which means we have a competitive edge which we have to be careful of because of that, in that system when we get individual institutions which are poorly rated, we make certain that they do not have access to significant amounts, or any, for that matter, of