"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.
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.
One of the reasons why Fed chairman Alan Greenspan was so tenacious in attempting to get this authority, argues Wallison, was that the local Federal Reserve banks had nothing to do. "The local bankers who sit on the boards of the Federal Reserve banks have a good deal of local political power," he says. "That's extremely important to the Fed's political support in Congress."
Still, the Fed didn't get everything it wanted. "We would have preferred to have all the new activities reside in affiliates," says the Federal Reserve Board's Meyer, referring to the Fed's jurisdiction in that area. But the agreement with the treasury removed an important obstacle blocking passage of the legislation. "We are much better off with the compromise than we would have been without it," he continues. "The bill includes important safeguards for new activities in bank operating subsidiaries."
Wallison likes the way the bill's language directs the Fed to regulate the FHCs, but points out that: "The difference between what the law says and what the Fed actually does is frequently very great."
The Fed's expanded authority, however, could be a plus for US institutions overseas. Some foreign regulators and supervisors have apparently been reluctant to allow US securities and insurance companies to enter their markets because they were not subject to safety and soundness regulation by a recognized US supervisor.
The Securities & Exchange Commission is not a safety and soundness regulator. It's largely a disclosure regulator. And insurance companies in the US are regulated by the states. "The fact that these organizations can now reconstitute themselves as financial holding companies," observes Wallison, "and say that they are at least nominally supervised as to their safety and soundness by the Federal Reserve might help them."
Other clear winners include the Federal Home Loan banks (FHLBs) - regional institutions modelled on the local Federal Reserve banks - set up to lend to federally chartered thrift institutions. The bill enables them to lend outside the housing sector to new "community financial institutions" set up to channel credit to small businesses, small farms and small agri-businesses. That is a dramatic departure from their traditional role of simply and always providing housing finance.
Emory University's Benston is among the critics. "Congress has just expanded the federal safety net enormously," he says, "because taxpayers have contingent guarantees for the obligations of the FHLBs".
The reason: Congress is hemmed in by its own budget procedures. "Every time somebody proposes a new programme," explains the American Enterprise Institute's Wallison, "they need to find either a new tax or a spending cut to offset it. That is a big pain." But politicians can get all kinds of things done without spending cuts or new taxes or without even bothering to oversee what is going on, if they use federally guaranteed credit programmes. So Congress will get kudos for helping constituents by allowing small local banks to borrow from the FHLBs. The FHLBs, in turn, borrow at favourable rates because the market thinks they have federal guarantees.
"That is really very dangerous. Congress is giving up its control of the public purse," says Wallison. "The FHLBs have been very effective in preserving themselves, when they've lost any reason for being. I predict that Congress will do this with all kinds of activities - rural electrification, rural telephones and many others."
Benston thinks that there's room for small banks to underwrite stock issues for companies that want to distribute them locally. They could be winners. And mutual insurance companies located in states where it's costly to convert to private stock companies also show up in the winners' column. Some states require these outfits to split their reserves with policyholders before converting. The bill gives them the right to move to another state where those deals are cheaper.
Who - taxpayers aside - are the losers? Most people think that OCC lost ground in a more immediate sense. Some of the important new activities - insurance underwriting, for example - can only be carried out in the affiliates or subsidiaries of the FHCs. And those are squarely on Fed turf. Wallison, Kaufman and many others would have preferred it if the OCC had the authority to permit banks to engage in a much broader range of activities through subsidiaries.
Ceding regulatory turf
Another loser could be the Office of Thrift Supervision (OTS) which has cultivated new constituents with a special loophole in the Bank Holding Company Act. OTS had been passing out charters for unitary thrift holding companies (UTHCs) that could operate across a broad range of activities, much like the new FHCs regulated by the Fed. Most insurance companies had applied for them.
Killing off new UTHCs suddenly became urgent in late May when retail chain Wal-Mart filed an application with the OTS. Small community banks were incensed. So Congress closed the loophole retroactively starting a few weeks before the Wal-Mart filing. The OTS won't be riding quite as high without this source of new business.
What's going to happen when one of these US financial services monsters runs into trouble? "I suspect that the bill will make some companies that are already too big to fail, much bigger still," says Karen Shaw Petrou, a banking consultant who previously ran the Bank of America's Washington office. "It's vital for Congress to address this issue or we'll end up with more LTCM situations. That was poor public policy."
Petrou points out that there are no limits on the Fed's ability to support a financial holding company that is too big to fail. And she thinks that deposit insurance would probably not be used to bail out the very largest institutions. The Fed, instead, would advance loans to the troubled institution through the discount window and other facilities.
"Too big to fail is a reality of the industrialized world," says Bert Ely, a Washington-based banking expert. "Regulators don't know how to deal with this issue," he says. "I think you'll continue to see ad hoc responses, whenever big institutions get into trouble."
The view from the Fed is different. "Absolutely no bank is too big to fail," says Meyer, "if the measure is whether shareholders take a loss and management gets replaced." Meyer acknowledges that very large banks involved in complex activities could be difficult to liquidate immediately. "But that's a very important distinction," he points out.
Meyer feels that consolidation across financial activities might not create the same problems that might occur as a result of boosting the size of a bank. The Fed's approach would be to wall off the depositary institution and to prevent the problems of the non-bank affiliate from spreading to the deposit institution. "We hope to insulate the deposit institution without undermining potential synergies," he says, "by placing the new activities in affiliates."
But many outside experts think that will be very difficult to enforce. "The stakes with taxpayer guarantees are less central than they ought to be," says Boston College's Kane. "Too big either to fail or to discipline adequately puts a blessing of government guarantees over the liabilities and operations of any very large firm."
Kane says the approval process for mergers and acquisitions needs to be revised. Financial mega mergers tap into an implicit taxpayer back-up when they are aggressive and perhaps cut corners in risk management. "Regulators have got to develop estimates of the benefits and protocols for reducing them," he urges. "They've been telling merged institutions to sell off some branches. That doesn't address the breadth of this problem."
There's clearly a major debate brewing about whether federal banking regulators are up to the job. A string of costly failures earlier this year involving relatively small institutions in California, West Virginia and Colorado are raising troubling questions.
"Frankly, there's a real sleaze element that's developing in banking, particularly with some of the sub-prime lenders," says Ely. "I think that's going to be emerging as an issue, although there has been a desire, particularly on the part of the House Banking Committee, to avoid it."
Another major issue Congress will face over the coming decade is modernization of financial regulation. The new banking bill solidifies the old product-based approach that many outside government consider hopelessly obsolete. However, banking products can perform like insurance products or securities products, and vice versa, with only slight changes to standard contracts.
Consolidated supervision, along the lines of the UK's and Australia's, tends to apply more uniform regulation and supervision across all financial activities, institutions and organizations. But the presence of deposit insurance, the discount window and the Fed's payment system are big obstacles to progress in that direction for the US.
"We want a differentiated approach for the framework that applies to deposit institutions and to the non-bank activities taking place in affiliates," says the Fed's Meyer. "There should be greater reliance on market discipline in the case of affiliates and a less intrusive form of supervision and regulation."
Meyer acknowledges the calls for greater consistency. But he thinks that banks are different. "A system with an umbrella supervisor but not a consolidated supervisor may be the most efficient one to promote a dynamic, innovative and competitive financial services sector," he says.
And within banking, it's not the norm to have multiple, competing regulators. But Meyer points to some advantages. "Just as we believe that competition is good in other dimensions of our economic life, it has a payoff in the regulatory sphere," he says. "It reduces the likelihood that a single authority will be rigid and arbitrary and will interfere with the ability of the financial sector to innovate."
He concedes, though, "that it's an incredibly complex system of multiple federal regulators and a dual banking system. This is not an ideal system, by any respect."
Banks are still the predominant source of systemic financial risk, as the Fed sees it. And it still seems inevitable that governments will turn over to their central banks primary responsibility for maintaining financial stability and responding to crises. So Meyer firmly believes that central banks should keep their fingers on the pulse of the banking system. And they can't be expected to do that by simply reading somebody else's reports. So the Fed should remain one of those regulators.
The shadow financial regulatory committee, strongly disagrees with this view. The committee - on which Benston, Kane, Kaufman, Litan and Wallison have served - has called for a transfer of responsibility for national banks and their holding companies to the OCC. Similar responsibility for state chartered banks and their holding companies should be transferred to the FDIC. The shadow committee thinks that a conflict of interest prevents the Fed from being effective as a bank supervisor and simultaneously promoting financial-market stability.
So where does the US go from here with financial deregulation? "Larger size in banking organizations, more complex activities and a wider range of activities mean that these organizations are more difficult to supervise than before," says Meyer. "It's incumbent upon regulators and supervisors to adapt as the industry changes rapidly, but we should be very careful to improve our practices on an evolutionary basis, particularly with very large and complex banking organizations."
There will be no tougher issue than the separation of banking and commerce. "I, for one, am not persuaded that the synergies between banking and commerce are sufficient to compensate for any additional risks to the financial system," says Meyer. He points to the demise of the unitary thrift holding company loophole as evidence that Congress wants to hold the line.
But that could be an exercise in futility. "People in Congress still think that they have separated banking and commerce, but this bill eliminated that," says Wallison. He contends that there's no substantial difference between auto manufacturing, at least concerning its use of bank credit, and securities underwriting. Investment banks are huge users of bank credit. They borrow from banks, just as automobile companies borrow from banks.
"Once Congress authorized banks to be affiliated with securities firms," he suggests, "they essentially said there's no real distinction any more between banking and commerce." Wallison predicts that the Fed will eventually be forced to permit a non-financial company to enter the banking business.
Today, information and communications companies could become financial institutions quite easily. They have been performing many of the key functions under contract for years. "All they have to do is add a deal-making arm," Professor Kane points out.The Federal Reserve may have to fight a rearguard action to slow down this process. There will be a tendency," says Kane, "to continue doing what they did in the past, ceding ground very grudgingly and acting more or less in favor of the banks." The key question for regulators should be how this new group of competitors is to be accommodated into the natural extension of their activities. "The Fed may learn," he says, "that the most important thing, in the long run, is to promote efficiency."