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US bank regulation - Winners and losers of new finance law

The US could be in for more than a few surprises this holiday season as it unwraps the Financial Modernization Act of 1999 - its latest gift from Congress. It's a big bill with lots of attachments. Principally, it allows banks to conduct securities and insurance business under the umbrella of new financial holding companies and boosts the power of the Federal Reserve as regulator of these. Another outcome may be to extend federal safetynet protection to lending for pork-barrel projects. James Smalhout reports.

Regulator calls for deregulation

Recent regulation

Wallison: concerned at the Fed's control

The purpose of the new law was, ostensibly, to repeal the Glass-Steagall Act, which in 1933 forced commercial banks to spin off investment banking operations. That was a big mistake, by almost all accounts. "There is no economic basis for separating commercial and investment banking," says George Benston of Emory University's Goizueta Business School. Countries that restrict securities and non-credit activities of banks are more prone to banking crises, say researchers at the World Bank and elsewhere. And there is already evidence that banks that have been permitted to set up securities operations in the US, on a case-by-case basis, have benefited from diversification. The performance of the two businesses has not been strongly correlated, although profits from securities tend to be more volatile than from banking.

"Part of the motivation for the [new] bill was to put US banking organization in a more competitive position," says governor Laurence H Meyer of the Federal Reserve Board. "To the extent that securities and banking are increasingly interconnected activities with power synergies, US banking organizations are better able to play in the global arena than they were before."

The law enables banks to go into securities and insurance business through affiliates in new organizations known as financial holding companies (FHCs). Banks can also run more limited activities through their operating subsidiaries. But will the cure be worse than the disease? This year's 400-page bill became a veritable Christmas tree, festooned with just and unjust deserts for those who Capitol Hill Santas decided have been naughty and those who have been nice.

"Any bill written by lobbyists at midnight has a lot of bad in it," says George Kaufman, a professor at Loyola University in Chicago, co-chairman of the shadow financial regulatory committee, an influential group of eminent bankers, academics. lawyers and regulators. "This is a horse-trading bill," he continued. "A lot of little things were done under the cover of darkness. I think it's going to take people years to find out what's really in it."

Glass-Steagall was, for all practical purposes, already dead before Congress acted. Regulators had been chipping away at it for years, reinterpreting the language of the bill to permit more underwriting. But the bill is a landmark, despite all that.

Meyer: absolutely no bank is too big to fail

Edward Kane of Boston College compares the strategy behind US financial regulation since 1933 to planning a city with ethnically pure neighbourhoods. The city fathers built walls and put sentries on the walls. "You can look at this history as trying to keep natural competitors from competing," Kane observes.

But technology broke down the neighbourhood walls. People from banking jumped into securities and securities people jumped into banking. Insurance didn't attract much attention from across the walls until the Citigroup deal.

Kane sees the new law as the outcome of a struggle between two groups. Some people were willing to pay Congress to leave the restrictions in place, others were willing to pay it to take them down. Prying loopholes and exceptions out of Washington has been costly for the insurgents. But it also cut down the value of the walls to the people who wanted to keep them.

"We finally reached a tip-over point," says Kane, "where the people who want to do things in cheaper, non-circumventive ways were ready to pay more for that freedom than the previous beneficiaries were willing to pay to keep the walls standing."

The tip-over point came at a convenient time - when many banks and insurance companies in Europe were combining. "A really serious trade problem was developing between the US and Europe arising out of the way our laws were structured," says Peter Wallison, a Washington attorney who is co-director of the American Enterprise Institute's programme on financial market deregulation.

It wasn't possible for the same organization to control both a bank and an insurance company that were operating in the US. Foreign banks either had to divest insurance activities or banking activities. Now those organizations can become financial holding companies with both insurance and banking operations in the US.

Robert Litan of the Brookings Institution, puts it this way: "The bill is basically an open door, an invitation for foreign firms to come into our market." But he cautions that firms on their home turf generally have an advantage. "There are cultural differences and one of the challenges facing any foreign institution coming into our market is keeping talent," he says.

Kaufman suspects that there are hundreds of winners and hundreds of losers from the new set-up. "The bill gives somebody a power here and takes a power away from somebody else there," he notes.

Citigroup is perhaps the most conspicuous winner because it only had a few more years to carry on in insurance business without spinning off its Traveler's unit. The merger last year was predicated on the assumption that there would be a change in legislation or in its interpretation by regulators.

Another clear winner is the Federal Reserve, which emerged as the "umbrella" regulator for the new financial conglomerates. "I am very much concerned about the new control that the Fed has acquired over the industry," says Wallison. He argues that the Fed has a history of suppressing innovation, very conservative management and a readiness to take on board requests from Congress for restricting new activities.

Three federal agencies regulate banks in the US. The Fed supervises bank holding companies and state-chartered banks that belong to the Federal Reserve. The Office of the Comptroller of the Currency (OCC) covers national banks as well as their subsidiaries. And the Federal Deposit Insurance Corporation supervises state-chartered banks that do not belong to the Federal Reserve. Numerous authorities at the state level also get in on the act.

But the Fed, with its new powers, no longer has as much competition. "I think it's going to have even less incentive to open up financial services activities," reckons Wallison.
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