services for low- and moderate income consumers and communities. Any financial modernization proposal must build on this success. The structural alternatives that financial modernization provides are extremely important in this regard. For example, allowing banks to conduct new activities in a subsidiary provides the opportunity to enhance the resources available for Community Reinvestment Act activities. Earnings from a bank's subsidiary flow up to the bank and, therefore, increase the bank's ability to undertake CRA activities. The earnings of a holding company subsidiary, on the other hand, flow to the parent holding company and are not available to directly support the bank's CRA obligations. Financial modernization must ensure, in addition, the protection of all consumers who use bank services. For example, proper disclosures must be made so that customers understand that some products are not FDIC insured and can appreciate the risks that uninsured products entail. The third principle is that financial modernization should promote competition and increase efficiency within the financial services industry. The increased competition provided by banks in new markets should both lower costs to consumers and increase, or perhaps create, access to the capital markets for businesses. Fourth, financial modernization must not impede community banks from competing in a changing financial services landscape. We are blessed, as Chairman Greenspan noted, with a fine community banking structure in the United States. Community banks profitably serve the financial needs of America's small businesses and farmers. Reform should not impose requirements that work for large institutions but are unnecessary and expensive when applied to small banks. I think the structural questions are very important to the viability of these smaller entities. The fifth and last principle I suggest today is that any reform must ensure that financial services providers have the flexibility to choose, consistent with safety and soundness, the organizational form that best suits their business plans. Today, banking companies have two structural options: the holding company affiliate approach and the bank subsidiary approach. Financial modernization should not dictate a particular organizational form just for the purpose of supervisory convenience. Instead, it must offer banks and other financial services providers the flexibility to adapt their organizational structures in any way that is consistent with safety and soundness so that they can best serve an evolving economy and changing consumer needs. Chairwoman ROUKEMA. Mr. Ludwig, I am sorry, but you have gone over the time. Could you summarize, please, and then we will get back? I am afraid the votes will start and I would like to have each member of the panel have their 5 minutes at least. Then we will come back and pick up during the questioning. I am afraid we Mr. LUDWIG. Let me summarize quickly. I want to address the subsidy question head-on. Some banking industry observers contend that allowing banks to participate in financial activities could lead to some expansion of the Federal safety net. Number one, whether or not there is a subsidy at all is a debatable question. It is not clear that, in fact, there is a subsidy. If there is a gross subsidy, it is probably in the 4 basis point area. But that is not the question. The question should be whether there is a net subsidy, a real subsidy, after you take into account the costs of bank supervision, reserve requirements, compliance costs and other costs imposed on the banking industry. We believe, based on empirical work on the subject, there may well not be a net subsidy. But, much more importantly, whether or not there is a net subsidy, there is a question of whether or not any subsidy is transferred from the bank to an affiliate. Our own view, very strongly, is that if the right mechanisms are in place, the same mechanisms for the affiliate and for the subsidiary, either a subsidy is transferred to both or no subsidy is transferred at all. I believe that the Sections 23(A) and 23(B) mechanism, with the capital deductions, results in essentially no transference of any subsidy, if a subsidy exists at all. Let me give you one bit of anecdotal but very important evidence. Banks are currently able to engage in a number of activities in either a bank subsidiary, the bank itself or a bank holding company subsidiary. Mortgage banking is a good example. If there was a subsidy, you would expect to see all mortgage banking conducted in the bank subsidiary or in the bank. That is not the case. You find really quite a varied pattern. Some banks, including some of the biggest banks, choose to engage in the activity in a holding company subsidiary; some choose to engage in mortgage banking in a bank subsidiary; and some choose to engage in it in a mix. If there were a subsidy, you would not expect to see this pattern. I hope the principles I have outlined are useful measures for evaluating proposals for financial modernization. I do have additional comments, Madam Chairwoman, on the subsidy and other questions. Hopefully, with additional time, I will be able to express those. But in any case, I will be happy to submit them for the record. I appreciate your indulgence in my going a bit over my time. [The prepared statement of Hon. Eugene A. Ludwig can be found on page 451 in the appendix.] Chairwoman ROUKEMA. Ricki Helfer, Chairman of the Federal Deposit Insurance Corporation, we welcome you today. STATEMENT OF HON. RICKI HELFER, CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION MS. HELFER. Thank you very much. Madam Chairwoman, Members of the subcommittee, I appreciate this opportunity to present the views of the Federal Deposit Insurance Corporation on financial modernization, on H.R. 268, the "Depository Institution Affiliation and Thrift Charter Conversion Act," and on related issues. I commend you, Madam Chairwoman and Congressman Vento, for placing a high priority on the need to modernize the Nation's banking and financial system. H.R. 268 represents a thoughtful approach toward meaningful reform that will serve us well in developing balanced, constructive legislation. Before turning to those topics, I want to express our gratitude to you and to other Members of the Congress for passing legislation providing immediate financial stability for the Savings Association Insurance Fund (SAIF). The legislation solved the immediate problems of the SAIF. The SAIF, however, has longer term structural problems because it insures the deposits of far fewer, and more geographically concentrated, institutions. A merger of the SAIF and the Bank Insurance Fund (BIF) would address these problems and create a single, highly diversified, well capitalized insurance fund. The FDIC strongly supports a merger of the two funds as soon as possible. The legislation capitalizing the SAIF made the merger of the BIF and the SAIF contingent upon the creation of a common bank charter that would include Federal savings associations, and I hope these issues can be addressed expeditiously. I have written testimony that examines in more detail financial modernization issues, and I would like to submit it for the record. This morning, I will discuss four important points: Point Number One: Experience has shown us that product and geographic constraints on insured institutions have resulted in inadequate diversification of sources of income and have prevented the institutions from responding to changing market conditions. In the 1970's and 1980's, such restrictions became increasingly harmful. Product restrictions on savings and loan associations created the inherently unstable situation of these institutions, borrowing short term deposits to fund long term mortgages, which helped lead to the collapse of the savings and loan industry. Commercial banks faced new competition, in the commercial paper market and elsewhere, that drove them into the riskier activities, such as commercial real estate lending, that led to increased bank failures in the 1980's and early 1990's. Point Number Two: Experience has also shown us that rapid expansion of insured institutions into unfamiliar activities, without adequate supervision and monitoring by the regulators, can have undesirable consequences. When many banks and thrifts aggressively expanded commercial real estate lending in the 1980's, insufficient attention was paid to safeguards against risky behavior. Point Number Three: Because the record earnings and favorable economic conditions that banks and thrifts now enjoy may not last forever, as no one has repealed the business cycle, any financial modernization proposal must be examined and evaluated for its effects when financial institutions are under stress. Our current experience is extraordinary. In terms of profits, annual earnings for commercial banks last year probably surpassed $50 billion for the first time. Moreover, the number and aggregate assets of problem institutions are only a fraction of what they were only 6 years ago. Nevertheless, we should be concerned about what would happen in times of stress. Point Number Four: Any financial modernization proposal should balance a number of public policy goals. These goals include: the safety and soundness of insured institutions; the integrity of the deposit insurance funds; and the need for depository institutions to generate returns sufficient to attract capital. Moreover, the proposal must be examined for its effect on small communities, isolated markets, the dual banking system, and the customers of depository institutions. We believe that the following principles are critical components for a financial modernization proposal that balances public policy goals and safety and soundness concerns: First, with limited exceptions discussed in my written testimony, financial organizations should be permitted to engage in any type of financial activity consistent with safety and soundness. Second, the financial institution should have flexibility to choose the corporate or organizational structure that best suits its needs, provided safeguards exist to protect the insurance funds and prevent expansion of the safety net. Third, safeguards should prohibit inappropriate transactions between insured institutions and their subsidiaries and affiliates, and should assure that capital levels remain strong after investments in non-banking activities. Fourth, regulation should be commensurate with risk-no less, no more-and should be along functional lines with no gaps between the functional lines. Fifth, easing the broad range of restrictions on activities of banking organizations beyond those that are financial in nature should proceed cautiously. In conclusion, it is imperative that we learn from the past as we contemplate a substantial expansion of powers available to banking organizations in the future. I applaud this subcommittee for its substantial attention to these issues, and we stand ready to work with the subcommittee on this very important effort. I look forward to answering your questions. Chairwoman ROUKEMA. Thank you. [The prepared statement of Hon. Ricki Helfer can be found on page 470 in the appendix.] Chairwoman ROUKEMA. Chairman Levitt of the Securities and Exchange Commission. STATEMENT OF ARTHUR LEVITT, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION Mr. LEVITT. Madam Chairwoman, Members of the subcommittee, I commend the Chairwoman and the Ranking Member for raising the important issue of financial services reform so early in this session. My colleagues on this panel have described how Glass-Steagall reform could permit greater competition and efficiency in the banking industry. As the Nation's chief securities regulator and someone who has spent the better part of a lifetime in the securities industry, I approach the issue with somewhat different concerns. Our markets are the envy of the world, and American securities firms are the unquestioned leaders of those markets. Last year alone, our firms raised more than $1 trillion. This capital was raised from investors, through the entrepreneurial and risk taking efforts of security firms without the benefit of Federal Deposit In surance. These markets are the engine of American capitalism. That engine is, and for many years has been, performing at a truly extraordinary level. From my vantage point, it is as if our engine gets 200 miles per gallon, while the rest of the world struggles to reach 50. While we should never be complacent and never assume we can't do better, we change the means by which we fuel this engine at our peril. The continuing success of our capital markets requires that we preserve the securities industry's ability to assume risks. It also requires that we maintain a strong system of investor protection that establishes, by both word and deed, that our markets are fair and honest and that public confidence in them is justified. If reform is to succeed, an appropriate balance must be struck between preserving bank safety and soundness and serving the needs of investors in the market as a whole. Although we agree with some aspects of H.R. 268, we feel it still has to go some distance to strike that balance. Most notably, it does not yet set forth a workable approach to functional regulation, and it seems to perpetuate inconsistencies in the so-called "two way street." I will describe each in turn. As we modernize financial services, we must also modernize their regulation. Investors should benefit if they can choose from a wider array of products and providers, but they should not be expected to give up basic safeguards in the process. The SEC continues to believe that the best way to ensure investor protection is through a system of functional regulation under which all securities activities are overseen by an expert securities regulator and all banking activities are overseen by an expert bank regulator. The unprecedented number of investors in our markets today deserve protections that apply without regard to whether they bought their investment from a bank or from a securities firm. Our second concern with H.R. 268 has to do with the so-called "two way street." To the extent banks are allowed to own securities firms, those firms should be allowed to own banks. Alternatively, if they choose, securities firms should have access to banking functions such as the payments system through limited purpose entities that are fully subject to banking regulation, but without also being forced to shoulder intrusive holding company regulation. Without such competitive equality, there is a roadblock on one side of the two way street. At the same time, the Commission believes that safety and soundness restrictions should not be applied to an entire organization made up of securities firms, insurance companies, and other financial services providers. Rather, these restrictions should focus solely on the discrete banking functions within that organization. Securities firms must be able to continue to engage in entrepreneurial risk taking activities. The Commission acknowledges the increased risks of a more concentrated financial system, but believes they can be managed through the use of segregated entities having solid capital requirements, strong firewalls, and a clear regulatory structure. For this reason, the Commission supports the thrust of the risk assessment provisions of H.R. 268. But we believe that more could be done to |