Volume 11; No. 2; September 1999
The Great Debate - What will become of financial modernization?
By Winthrop P. Hambley, Deputy Congressional Liaison, Federal Reserve
Board of Governors
It appears that the financial services, insurance, and securities industries
may finally see some resolution on the myriad of issues that comprise
what has come to be known as "financial modernization." There
are a number of issues yet to be resolved, including possible ramifications
for the CRA. In the article that follows, we'll explore some of those
issues and explain some of the key legislative provisions. We'd like to
thank Win Hambley for his insight, and for taking the time to provide
the Fed's perspective on financial modernization.
What is financial modernization about?
The central idea behind financial modernization is to permit broad affiliations
between banks, securities firms, insurance companies, and other "financial"
businesses. Such legislation would facilitate the creation of "financial
supermarkets" offering "one-stop financial shopping" to consumers. Modernization
involves significant changes to the Glass-Steagall and Bank Holding Company
Acts, two laws that currently prevent such broad affiliations.
Allowing and encouraging the formation of financial conglomerates raises
questions as to how they will be supervised and regulated in the public
interest. Thus, modernization also calls for a blend of "functional regulation"
of the individual businesses - for example, banks regulated by banking
regulators and securities firms by the SEC and "umbrella supervision"
of the consolidated entities by the Federal Reserve.
Why is modernization important?
The public would benefit from the greater convenience of the one-stop
shopping concept. In addition, the legislation would promote competition,
economic efficiency, and innovation. This would lower the cost, and improve
the variety and availability of financial products. For financial institutions,
modernization would eliminate artificial and outdated restraints on product
offerings, allowing them to compete more effectively in response to changing
Where does modernization stand now?
The Senate and House have each passed separate modernization bills -
S.900 and H.R.10, respectively. The Senate approved S.900, a purely Republican
bill that the President has threatened to veto, on a party line vote of
54-44 on May 6, 1999. In contrast, the House approved H.R. 10, a bipartisan
bill supported by the President, by a vote of 343-86 on July 1.
What issues remain to be resolved?
The two bills differ sharply on CRA, operating subsidiaries, privacy
issues, and the transferability of existing unitary thrifts to commercial
CRA continues to be highly controversial, and there are major CRA differences
between the House- and Senate-passed bills.
The House bill (H.R. 10) requires all depository institution subsidiaries
of financial holding companies to both have and maintain at least "satisfactory"
CRA ratings in order to engage in the new financial activities authorized
by the bill. Comparable provisions apply to national banks with subsidiaries
engaging in new financial activities. In addition, CRA would apply to
newly-authorized "wholesale financial institutions. " CRA provisions would
not, however, apply to insurance or securities firms that become subsidiaries
of either banks or financial holding companies.
The Senate bill (S.900) contains none of these provisions. It would:
a) exempt small and rural banks entirely from CRA, b) create a "rebuttable
presumption" that banks with at least a "satisfactory" CRA rating have
complied with CRA, and therefore could not have applications turned down
on CRA grounds, and c) require full disclosure of all CRA agreements between
banks and community groups.
A second issue to be resolved concerns the permissible new activities
of national bank subsidiaries, or "op subs." The House bill would allow
certain principal activities, notably securities underwriting and merchant
banking, to be conducted in an op sub structure. In contrast, the Senate
bill would permit small banks not in holding companies to engage in most
new principal activities through direct subsidiaries. Larger banks and
banks in holding companies would have to conduct new principal activities
exclusively through a holding-company affiliate.
In addition, differing provisions on unitary thrift holding companies
leave unresolved the contentious "banking and commerce" issue. H.R.10
leaves the "unitary thrift loophole" open: it would stop the creation
of new unitary thrifts with "commercial" connections, but would also permit
more than 500 existing unitary thrifts to be transferred to commercial
owners. The Senate bill, in contrast, would both stop the creation of
new "commercial" unitaries and prevent the transfer of existing unitaries
to commercial firms.
The House provisions on financial and medical privacy, disclosure, and
the sharing of customer financial information with non-affiliates and
third parties go well beyond anything in the Senate bill. Notably, the
House bill requires disclosure of financial institutions' privacy policies,
allows consumers to opt out of having their personal financial information
shared by their bank with non-affiliates, prohibits financial institutions
from transferring customer account or credit card numbers to third parties
for marketing purposes, and generally prevents disclosure of medical records
without customer consent. There are no such provisions in the Senate bill.
Although still contentious, most believe these issues will not derail
How might these issues be resolved?
The end result will depend on negotiations not yet conducted among conferees.
Still, because of the strong House vote, House conferees appear to have
an edge in the negotiations, and the final bill probably will look more
like H.R. 10.
A deal on CRA might be possible. Last year, Senator Gramm said he wanted
a modernization bill that was "neutral" or "silent" on CRA. He is now
in a position to negotiate to get there. The bill approved by the Senate
contains all of Gramm's bargaining chips-the small bank CRA exemption,
the so-called safe-harbor, and no requirement that all depository institutions
in holding companies (or banks with op subs) have or maintain a "satisfactory"
or better CRA rating.
Similarly, a deal on CRA may be possible for the Administration and Congressional
Democrats. Perhaps, in order to get Gramm to give up on the small bank
exemption and safe harbor provisions, they could trade away the House
provisions requiring banks to maintain satisfactory ratings, thereby reaffirming
the CRA "status quo" and still declaring victory.
It's unclear how the op sub issue will be resolved. The Treasury and
the Fed each take incompatible positions. There is a strong temptation
to accept the Treasury position on op subs from the House bill, and to
reject that of the Fed's. After all, the President has veto power, and
the Fed doesn't. On the other hand, the Fed has won very important victories
on the op sub issue in the Senate and in the House Commerce Committee,
so the debate could go either way.
On unitary thrifts, the resolution is also unclear. As noted, the House-passed
bill allows (and the Senate-passed bill prohibits) the transfer of existing
unitary thrifts to commercial companies. The House approach may be slightly
more likely to prevail.
As noted, the bills differ sharply on privacy issues. Despite Chairman
Gramm's insistence that he will not accept privacy provisions beyond those
in the Senate bill, it seems likely that the final provisions will resemble
those in the House bill, which are bipartisan and were overwhelmingly
approved by the House.
What is the debate regarding operating subsidiaries (op subs) vs.
holding company subsidiaries?
The Federal Reserve opposes diversification through op subs, and supports
diversification through holding company arrangements, for several reasons.
First, banks are "subsidized," or have a funding advantage,
due to their connection to the federal "safety net" (deposit
insurance, discount window lending, and access to the payment system).
If banks diversify into new activities through direct subsidiaries, the
funding advantage will "spill over" to the subsidiary, putting other competitors
at a disadvantage. The funding advantage would be contained and the competitive
problems avoided by a holding company arrangement.
Second, op subs create a safety and soundness concern in that the op
sub approach to new activities is riskier for the bank. A subsidiary is
effectively part of the bank, and any problems in the subsidiary directly
hurt the bank. As a result, the bank and the taxpayer-backed deposit insurance
system are not effectively insulated from problems or losses in a direct
subsidiary. If new activities are conducted in a holding company, the
bank is more insulated, as any losses would not directly impair the bank.
Third, with the op sub approach, the Federal Reserve would tend to lose
hands-on supervisory control and understanding and information about the
workings of the financial system. It would also lose supervisory clout,
making it harder for the Fed to protect the stability of the financial
system through crisis avoidance, intervention, and management.
Finally, some in Congress feel that transferring supervisory authority
from the Fed to the OCC, the regulator of national banks, and thus, to
the Treasury and the Administration, would undesirably concentrate regulatory
authority and politicize bank regulation.
For their part, the Treasury and the OCC believe that banks should be
free to choose to diversify through either an op sub or through a holding
company as business considerations dictate. They doubt that there is any
subsidy from the safety net, and argue that there is no difference, in
any case, in subsidy between the op sub and holding company approaches.
This casts doubt on the competitive unfairness argument against op subs.
In their view, banks can be just as well protected from problems in subsidiaries
as from problems in affiliates, so there are no real safety and soundness
or insulation issues that differentiate the op sub from the holding company.
And finally, given free choice of organizational structure, some banking
organizations would continue as bank holding companies and some banks
would continue to have state charters. Thus, in their opinion, Fed concerns
about the loss of supervisory authority are exaggerated. Treasury also
fears that if certain types of new activities are restricted to a holding
company, the Fed would gain supervisory authority at the expense of the
Are major changes to CRA likely?
No. The Administration, with its veto and Democratic congressional support,
can prevent any weakening of CRA. Republican majorities in Congress, and
Chairman Gramm in particular, can prevent any major strengthening of CRA.
The biggest CRA change likely to be enacted is the bipartisan provision
from S.900 that would require full public disclosure of all CRA agreements
between banks and community groups.
How might modernization affect small banks?
Small banks should actually benefit. Both bills authorize small banks
to underwrite municipal revenue bonds directly, and engage through both
subsidiaries and affiliates in a broad array of new "agency" and "principal"
activities. This would allow small banks to compete more effectively.
Also, Federal Home Loan Bank reform included in modernization will expand
small bank access to cheap FHLB funding.
Nonetheless, small banks dislike financial giants and the mixing of banking
and commerce. Financial modernization promotes both. Small banks doubt
they will be exempted from CRA, and they fear that they will not be able
to compete with the new financial conglomerates or with "unfair" unitary
thrift competitors. Furthermore, they fret that privacy provisions that
let customers "opt out" of information-sharing with non-affiliates will
put them at a disadvantage. They also worry that modernization will let
states discriminate against banks, in their regulation of insurance activities.
What are the next steps for this legislation, and when might a bill
As of this writing, the House- and Senate-passed bills are ready for
negotiation in conference. Many speculate that conference negotiations
could be quite protracted and difficult, but there is a chance that final
legislation could be sent to the President by the end of October 1999.
If not, financial modernization will roll-over to the new session of Congress,
effectively postponing any further legislative action until next year
ABOUT THE AUTHOR
Winthrop P. Hambley serves as the deputy congressional liaison at the
Congressional Liaison Office of the Federal Reserve Board in Washington,
D.C. where he has worked since 1989. In his current role since 1998, Mr.
Hambley follows and reports on congressional proceedings, advises Board
and staff members on views of the Congress, and coordinates the drafting
of congressional testimony and correspondence. He works closely with all
operating units of the Board, with congressional liaison offices of other
regulatory agencies, and with representatives of trade associations and
other outside parties.
Prior to joining the Federal Reserve System, Mr. Hambley served as a
legislative assistant to U.S. Senator Paul S. Trible and as an economics
instructor at the University of Virginia. He holds an A.B. degree from
Columbia College and was a student in the doctoral program in economics
at the University of Virginia.