rower. For example, the weakened credit standing of the Japanese banks has engendered a risk premium that these entities have paid-and today would have to payto fund their U.S. affiliates; this has required them to sharply reduce their business loan volume in the United States. Japanese bank branches and agencies in the United States have reduced their share of business loans from over 16 percent of the market in 1995 to less than 11 percent today.

In short, the subsidy is a critical competitive issue in competitive markets. Allowing the bank to inject federal subsidies into the proposed new activities could distort capital markets and the efficient allocation of both financial and real resources. New affiliations, if allowed through banks, would accord them an unfair competitive advantage over comparable nonbank firms. The holding company structure, on the other hand, fosters a level playing field within the financial services industry, contributing to a more competitive environment.

Safety and Soundness. In addition to our concern about the extension of the safety net that would accompany the widening of bank activities through operating subsidiaries, the Federal Reserve Board is also sensitive to the implications of operating subsidiaries for the safety and soundness of the parent bank. Most of the new activities contemplated by H.R. 10 would not be accompanied by unusually high risk, but they could imply more risk. The Board believes these activities add the potential for new profitable opportunities for banking organizations, but it is almost always the case that the more potentially profitable the activity, the riskier it is. Although, to be sure, diversification can reduce that risk, the losses that would accompany riskier activities from time to time would fall on the insured bank's capital if the new activities were authorized in bank subsidiaries. Such losses at holding company affiliates would, of course, fall on the uninsured holding company. This is an important distinction for the deposit insurance funds and potentially the taxpayer. This potential for loss and bank capital depletion is another reason for urging that the new activities be conducted in a holding company affiliate rather than in a banking subsidiary.

H.R. 10 is supposed to virtually eliminate this concern. As I earlier noted, the bank's equity investment in the bank subsidiary under H.R. 10 would be deducted from the bank's regulatory capital, with the requirement that the remaining regulatory capital still meet the well-capitalized standard. At the same time, the OCC has asserted that it would order an operating sub immediately to be sold or declared bankrupt and closed before its cumulative losses exceeded the bank's equity investment in the failing sub. Combined with the provision of H.R. 10 adjusting regulatory capital for investment in subs, this provision is intended to cap the effect on the bank of subsidiary losses to the amount of the bank's original investment. Since that amount would have already been deducted from the bank's regulatory capital, the failure of the subsidiary, it is maintained, could not affect the regulatory capital of the bank.

The Board is concerned that this regulatory accounting approach, that does not address the actual capital of a bank, could provide a false sense of security. We had extensive experience with attempts to redefine reality by redefining regulatory capital in the thrift industry in the 1980's. This approach was widely viewed as a major mistake whose echoes we are still dealing with today. Regulatory capital at the time soon began to mean nothing to the market, and, as a consequence, Congress in FDICIA ordered the banking agencies to follow Generally Accepted Accounting Principles (GAAP) whenever possible. In the current context, there is-as in the 1980'sno reason to believe the new regulatory definitions will change the reality of the market place. Economic, as opposed to regulatory, capital of the bank would not, as I have noted, be changed by this special regulatory capital accounting and such deductions from equity capital would not be reflected under GAAP. It is the economically more relevant GAAP statements to which uninsured creditors of banks look when deciding to deal with a bank, and they will continue to do so after financial modernization. Bank creditors will, in any event, continue to view the investment in the bank subsidiary as part of the capital protecting their position—for the simple reason that it does. If they see the economic and GAAP capital at the bank declining as operating sub losses occur, they will react as any prudential creditor should-regardless of artificial regulatory accounting adjustments or regulatory measures of capital adequacy.

Perhaps more to the point, it seems to me particularly relevant to underline that losses in financial markets-large losses—can occur so quickly that regulators would be unable to close the failing operating sub as contemplated by H.R. 10 before the subsidiaries capital ran out. Indeed, losses might even continue to build, producing negative net worth in the subsidiary. At the time of closure of a subsidiary, there is nothing to prevent the total charges for losses against the parent bank's regu

latory capital from exceeding the prior deduction required by H.R. 10. Our experience following the stock market crash of 1987-when a subsidiary of a major bank not only lost more than the bank's investment in its sub, but the bank was unable to dispose of the subsidiary for several years-underscores the seriousness of such

concerns.

H.R. 10 would exclude from permissible bank subsidiaries only insurance underwriting and real estate development. One of the permissible activities is merchant banking, which does not have a long or significant 20th century history in this country. Merchant banking currently means the negotiated private purchase of equity investments by financial institutions, with the objective of selling these positions at the end of some interval, usually measured in years Merchant banking has become so important an element of full service investment banking in this country, so much so that to prohibit bank-related investment banks from participating in these activities would put them at a competitive disadvantage. The Board has consequently supported merchant banking as an activity of a holding company subsidiary, but believes it is potentially the most risky activity that would be authorized by H.R. 10, and would be especially risky if permitted to be conducted in bank subsidiaries.

Existing law permits some limited exceptions to the otherwise prohibited outright ownership of equity by banks and their subsidiaries, but these are quite limited both in the aggregate and in the kinds of businesses in which equity can be purchased, as well as in the scale of each investment. True merchant banking, as envisioned by H.R. 10, would place no such limits either per firm or in total. The potential rewards for such equity investments are substantial, but such potential gains are the mirror image of the potential for substantial loss. In addition, poor equity performance generally occurs during periods of weak nationwide economic performance, the same intervals over which bank loan portfolios are usually under pressure, raising concerns about the compounding of bank problems during such periods. Functional Regulation

The holding company structure especially for the new activities also has the significant benefit of promoting effective supervision and the functional regulation of different activities. The holding company structure, along with the so-called "Fedlite" provisions in H.R. 10, focuses on and enhances the functional regulation of securities firms, insurance companies, insured depository institutions and their affiliates by relying on the expertise and supervisory strengths of different functional regulators, reducing the potential burdensome overlap of regulation, and providing for increased coordination and reduced potential for conflict among functional regulators.

Executive Branch Prerogatives

There is a final point I want to make since it appears to have driven Treasury's recent opposition to financial modernization legislation that has not adopted the universal bank model. It is not necessary to adopt the universal bank model in order to preserve the executive branch's supervisory authority for national banks or federal savings associations; nor is it necessary in order to preserve the share of this nation's banking assets controlled by national banks and federal savings associations. In fact, the share of assets controlled by national banks is predominant and growing, in part the result of the enactment of interstate branching authorities, an initiative the Federal Reserve fully supported. As shown in the tables in the appendix to my statement, national bank assets have increased in each of the last three years while state bank assets have declined over the past two years. As of year-end 1998, 58.5 percent of all banking assets were under the supervision of the Comptroller of the Currency, up from a little over 55 percent at the end of 1996. As the second table clearly suggests, the largest banks, especially those with large branching systems, tend to be national banks, providing a distinct advantage to national banks in an environment of interstate branching.

Furthermore, Congress for sound public policy reasons has purposefully apportioned responsibility for this nation's financial institutions among the elected executive branch and independent regulatory agencies. Action to alter these responsibilities would be contrary to the deliberate steps that Congress has taken to ensure a proper balance in the regulation of this nation's dual banking system.

'Moreover, should creditors of the subsidiary choose to attempt to recover their funds from the bank parent, the removal of the loss charged against the bank's capital could occur only when a court has affirmed both the bankruptcy and the rejection of the claims on the bank made by the subsidiary's creditors. This process could and would take some time, during which, even if the court eventually found for the bank and/or the regulator, further losses by the subsidiary could continue to impinge on the bank's capital. And, again, the point is that the bank would have been at risk during that interval.

Summing Up

The Board is a strong advocate of financial modernization in order both to eliminate the inefficiencies of the current Great Depression regulatory structure and to create a system more in keeping with the technology and markets of the 21st century. We strongly support the thrust of H.R. 10 to accomplish these objectives. Equally as strongly, however, we also believe that the new activities should not be authorized for banks through operating subsidiaries. We believe that the holding company structure is the most appropriate and effective one for limiting transfer of the Federal subsidy to new activities and fostering a level playing field both for financial firms affiliated with banks and independent firms. It will also, in our judgement, foster the protection of the safety and soundness of our insured banking system and the taxpayers, enhance functional regulation, and achieve all of the benefits of financial modernization for the consumer and the financial services industry.

Table 1-Net Change in Commercial Bank Assets from De Novos, Mergers, and Charter

Mr. OXLEY. Without objection, so ordered. We thank you for your testimony, Mr. Chairman, and the Chair will begin the questioning, even though it appears that we have both the red and the green light on.

As you know, the Banking Committee made some changes in the operating subsidiary language from the bill that passed the House last session. It is my understanding that the product that came out of the Banking Committee preserved in the operating subsidiary the securities underwriting and merchant banking segments and indeed eliminated insurance underwriting from within the op sub. Your view on their efforts is what? Is that a good start toward removing the operating subsidiary language totally? What is your opinion of what the Banking Committee did?

Mr. GREENSPAN. Mr. Chairman, I think that having both securities and merchant banking in operating subsidiaries as the structure is envisaged in H.R. 10 creates a very serious problem for the structure of American banking as we enter the 21st century. A number of people have looked at this question of the operating sub versus affiliate issue either as a matter of turf between the Treasury and ourselves or strictly as a marginal question of an option that a banking organization should be allowed to make judgments on for business reasons. It is not a turf issue, it is a fundamental issue with respect to how the United States wishes to restructure its regulatory apparatus, given the extraordinary changes that are now currently under way in the technology of finance which is going to have a very dominant effect on how financial services are created and delivered to consumers and to business.

If there were no subsidy involved in this issue, Congress, indeed no one, should question the freedom of individual business organizations to make business judgments as to where they put particular organizations. This is not a choice. If given the opportunity, any sensible banker confronted with a lower cost of capital in an operating subsidiary than in a nonsubsidized organization would not consider that a choice. There is only one possibility. You put it in the sub of the bank. And that, in my judgment, will create significant corrosion to what has been a superb financial system that has developed in this country.

Mr. OXLEY. You stated in your testimony that you felt that the subsidy amounted to about a 10 to 12 basis points advantage. Was that based on a study that the Fed conducted? And if you could perhaps give us a little better detail as to how that study was conducted.

Mr. GREENSPAN. Mr. Chairman, why don't I include for the record what we did is we really tabulated for 35 bank holding companies the credit rating given to the debentures of the holding company and the credit rating given to the major bank of that holding company. What we found is that in no cases did the bank holding company have as good a rating as the bank, and in some cases the difference was more than just marginal. But I will include those data for the record.

[The information referred to follows:]

As part of our ongoing research into the size of the safety-net subsidy, the attached tables summarize work by Federal Reserve staff to measure the difference in borrowing costs between the lead bank in large banking organizations and the holding company parent. Since 1990, the interest rate on long-term debt issued by the lead bank has averaged about 10 basis points less than the interest rate on comparable debt issued by the bank holding company; on an annual basis, this funding cost advantage for the bank has ranged from about 8 to 9 basis points in recent years up to 14 basis points in 1990 and 1991.

The calculation of this difference in borrowing costs is done in two steps. The first step compares Moody's rating on long-term debt issued by the lead bank and by the parent holding company for all of the top 50 banking organizations that have ratings on comparable debt for both entities. This comparison can be done for 35 of the top 50 organizations. As shown in table 1, the bank debt carries a higher rating than the holding company debt in every case. The difference averages about 14 rating "notches", where one notch represents the difference between, for example, debt rated A1 and A2. The second step translates the 14 notch difference into the implied borrowing cost advantage for the lead banks. We do this using annual Moody's indexes of interest rates on bonds at various ratings within the investment-grade range. Table 2 displays this borrowing cost advantage in each year since 1990. The notes to tables 1 and 2 provide further information about the calculations.

Table 1

Debt Ratings of Top 50 Bank Holding Companies and Their Lead Banks
(Number of institutions in each category)

Notes: This table compares the debt rating of each of the top 50 U.S. bank holding companies with the debt rating of its lead bank, based on data from Moody's Investors Service, Banking Statistical Supplement, United States, August 1998. Whenever possible, we compare the ratings of long-term senior debt issued by the bank and the holding company; if such ratings are not available, we compare the ratings of long-term subordinated debt issued by both entities. This comparison could not be done for 15 of the top 50 banking organizations because the holding company and the lead bank did not have ratings on comparable debt. For all of the other 35 banking organizations, the bank's debt was rated more highly than the debt of its holding company parent. For 27 of these organizations, the bank's debt was rated one "notch" above the holding company's, while for eight organizations, it was rated two notches above the holding company's. One notch represents the finest gradation in Moody's rating scale; for example, one notch separate debt rated A1 and A2, while two notches separate debt rated Al and A3. On average, the lead bank was rated 14 notches above its holding company parent.