Vol. 1999-5

Whether banks and other financial institutions face a bright or a bleak future depends ultimately on just two things: first, on the business powers authorized by law and, second, on who in government will write, and enforce, the defining rules for the exercise of these powers. At one time, banks, alone among major financial institutions, had a third factor with which to contend -- the locations at which business could be conducted – but this disappeared several years ago with repeal of the McFadden Act. Today, as has been true for the past decade or so, legislation with the stated objective of "modernizing" laws relating to banks and other financial institutions is once again working its way slowly through the congressional labyrinth. The prospect for final passage by the Congress and acceptance by the President, while by no means certain, seems to be marginally better than has been the case heretofore.

As has also been true on prior occasions, slow progress is attributable largely to the continuous jostling and deal making among the contending parties – which include federal government agencies as well as financial institutions – each of which seeks to preserve or improve its present position at the expense of competitor organizations. The legislation now taking form (familiarly known as H.R.10 for the past several years) encompasses about 400 pages. It has often been suggested that true modernization should require just one page, with two simple provisions: complete repeal of the Glass Steagall Act (which not even now is provided for in the current legislation) and complete repeal of the Bank Holding Company Act. These two Acts account for almost all of the overlapping, duplicative, and burdensome regulation plaguing banks, while serving at the same time as a drag on the ability of banks and other financial organizations to expand competitively. Each Act is a product of a bygone era; there is no place for either in today’s world. Unfortunately, when it comes to legislation affecting the powers of competing financial services firms, and government agencies, Congress seems incapable of acting logically.

One of the driving forces behind H.R.10 has been the intention to expand the scope of permissible business activities available to firms in each of the major industries – banking, insurance, and securities. In fact the "preamble" to H.R.10, in the version adopted by the House of Represent-atives on July 1, states that the bill’s purpose is to provide a "prudential framework" for an expansion of business powers through affiliations of various kinds. And if and when the bill is enacted, the financial press will declare it to be, finally, repeal of the Glass-Steagall Act -- an almost totally incorrect description.

So far as the scope of permissible business activities is concerned, passage will be immediately beneficial to a handful of major institutions. How important it will be over the long run for most firms will depend on the extent to which the 400 pages of statutory promises and understandings – an inevitable bonanza for litigators and lobbyists, incidentally – will accomplish the intended objectives of the authors. As readers know, I have some serious reservations.

This is not, however, the subject of the present report. There is another driving force behind the legislation now being fashioned. If enacted, it would be the first important step in creating a new government regulatory structure intended to deal with the fact that the financial services industry has long since outgrown the structure that has existed in the U.S. ever since 1933. An intense battle over the shape, form, and management of this new regulatory structure is already underway, but it is a battle that is being waged out of sight. To be sure, it surfaces at times because it pits the executive branch of government against the central bank – almost an eerie re-play of the Andrew Jackson-Nicholas Biddle "bank war" more than a century and a half ago. Moreover, it involves completely different theories of appropriate prudential regulation of financial institutions. Nonetheless, the battle becomes virtually invisible because it is being dismissed merely as evidence of a "turf war" between Treasury and the Federal Reserve. That it is something much more important is only gradually becoming apparent.

Unfortunately the large majority of those following the fortunes of H.R.10 continue to accept the "turf war" description and look no further. Even so sophisticated a publication as The Economist seems to have been seduced by this argument. In a recent article on American financial regulation, titled "Turf Love" (June 26, 1999), the editors reported that "Wall Street" regards the wrangling that has occasionally surfaced between Federal Reserve Chairman Greenspan and former Treasury Secretary Rubin as just an "irritating turf war." This was demonstrated, at least to the satisfaction of The Economist, by a remarkable observation by a lobbyist for a large New York bank, to the effect that: "for financial firms, how this issue is resolved matters much less than that it is quickly resolved." It is hard to believe that this represents the depth of understanding of the stakes involved, since no statement could be more wildly out of touch with reality. It is not often that a mere "turf war" can generate threats of a veto from the nation’s chief executive (reminiscent of Jackson’s veto of the charter of the Second Bank of the United States), matched by imperious threats from the head of the central bank that no legislation would be preferable to an Act that met the Administration’s objectives.

I have written frequently on this subject but readers may be assured that I will not do so again here (see, in particular, Vol. 1997-2, "the Battle for Bank Regulatory Supremacy" and Vol. 1997-10, "The Battle for Financial Modernization"). Moreover, as I indicated earlier, calling attention to the importance of the battle over the future of bank regulation is no longer a lonely effort, being waged by a few isolated individuals. There is now growing attention being paid to the changes in the regulatory structure subsumed in the present legislation. From such diverse and prestigious places as the Shadow Financial Regulatory Committee, noted professors of law, leading academicians, and "think tanks," as well as from government agencies primarily concerned with bank supervision and regulation (the Comptroller of the Currency and the Federal Deposit Insurance Corporation), there is increasing evidence of serious concern over the regulatory direction that appears to be intended by the congressional managers of the modernization legislation.

There is, however, a surprising omission from the debate. The same factors that face the U.S. banking and financial system are working their effects in other countries. Within the past several years, in nation after nation, serious study and thought has been given to devising new regulatory arrangements to deal with the new financial world. There are differences of course among the various nations but two each are clear. First, there is an obvious desire to bring together, under one roof, financial supervision and regulation of most or all financial services firms. The business entities themselves are making it increasingly impossible to justify a fragmented regulatory system. Second, there is a growing realization that central banking may be dangerously incompatible with bank supervision and regulation, to such an extent that the two must be kept separate. The problem is how to assure effective coordination between the agency charged with prudential supervision and the central bank. I find it utterly fascinating, but also quite strange, that so little is known about this in the United States, where a powerful effort is underway to place prudential regulation of banking and of other financial institutions largely, if not entirely, in the central bank.

In earlier reports, I described the decision by the British government in 1997 to separate the Bank of England from direct responsibility for bank supervision. Since those pieces were written, interesting additional information has become available. In fact, the volume of work being done and its evident quality make it almost impossible to understand why so little attention is being paid to it in this country. One would have assumed, at the very least, the House or Senate Banking Committee (or one of the subcommittees) would have looked quite carefully at what is happening, particularly since much of it directly bears on the "turf war" underway in this country. But so far as I am aware there has been little or no interest displayed by Congress, by any bank or banking industry association, or by any of the "think tanks" that usually display a close interest in banking developments. The report that follows cannot, even remotely, fill this strange void. Possibly it may pique some interest and stimulate examination of what is going on, particularly in nations as once viewed as models for this country.

Section I deals briefly with the reasons why the existing arrangements for prudential regulation had to be reformed, and describes the approaches being taken in England and Australia which, incidentally, differ in some important ways. Section II focuses on the reasons why regulatory reform is proceeding in most countries without reference to the central bank -- in some cases actually taking responsibility for prudential supervision away from the central banks. But Section II also focuses on the importance attached to achieving effective cooperation between the regulatory agencies and the central banks. Finally, Section III offers a few conclusions and observations.