Year

1990

1991

1992

1993

1994

1995

1996

Table 2

Funding Cost Advantage for Lead Banks Relative to Bank Holding Companies

Funding Cost Advantage (in

basis points)

14.3

13.9

11.5

9.8

9.0

8.2

9.4

8.2

9.4

1997

1998

Notes: This table values the average 14 notch rating advantage for the lead bank relative to its holding company parent. The figures in this table result from multiplying 14 notches by the average difference in interest rates per rating notch, evaluated annually. This difference was calculated from Moody's indexes of interest rates for bonds rated Baa, A, Aa, and Aaa. Each of these broad rating categories (except for Aaa) contains three notches. Thus, a mid-level Baa rating is three notches below a mid-level A rating, which is itself three notches below a mid-level Aa rating. We assume that a mid-level Aa rating is three notches below the Aaa rating, even though there are no explicit gradations within the Aaa category. Because the Moody's interest rates for adjacent rating categories reflect difference of three notches, we divided the interest-rate spread between Baa-rated and A-rated bonds by three to obtain the difference per notch, and did the same to calculate the per-notch interest rate spread between the A and Aa ratings and the Aa and Aaa ratings. We then averaged the resulting per-notch interestrate spreads to generate the funding cost advantage shown in the table for each year.

Mr. OXLEY. Without objection, that will be made part of the record and we appreciate that. Let me just end with one question. As my memory serves me, throughout the 1980's, the Treasury consistently opposed expanded powers_for operating subs. What, in your estimation, is the reason that Treasury may have changed or I should say has obviously changed their minds in that regard?

Mr. GREENSPAN. Well, that is factually correct. Indeed, having been involved in many endeavors jointly with Treasury to create a financial modernization bill, we never differed on that question. So that Treasury in a certain sense had been even more strongly against operating subs than we.

I don't wish to make judgments as to why this Treasury has come to the position that it has. That is a question, I think, most appropriately put to the Secretary of the Treasury when you have him up here. I don't want to try to characterize his answer because he can do it better than I.

Mr. OXLEY. Thank you, Mr. Chairman. The gentleman from New York, Mr. Towns.

Mr. TOWNS. Thank you very much, Mr. Chairman. The Treasury has criticized Japan for having extensive subsidies and conflicts of interest in their financial system and has encouraged the Japanese to adopt a holding company structure for their banking system. Why isn't this good advice for the United States?

Mr. GREENSPAN. Well, again, Congressman, I think that ought to be directed to the Secretary of the Treasury.

Mr. Towns. But I just want to draw from all of this knowledge that you have and I don't want to pass up this opportunity.

Mr. GREENSPAN. Well, having heard me for the last 20 minutes or so, I don't want to bore you with repeating a lot of what I have said previously, sir.

Mr. TOWNS. Moving on, then, let me ask you this. Is it really possible that an operating subsidiary could lose more than the capital of the parent bank before regulators could close the operating subsidiary?

Mr. GREENSPAN. No, it wouldn't lose more capital than the parent bank. That would be a Herculean task. But it surely could lose more than the capital of the subsidiary itself, meaning more than the capital that the parent bank would invest in the sub. And I think that is the crucial issue. That is, there is a presumption that it is easy to insulate the parent bank from losses in the sub. Our experience specifically in the case which I indicated in 1987, and in a lot of other related issues, is that is wishful thinking. When we are in a financial crisis, depository institutions, whether they are subs or anything else, have relatively low capital. They are highly leveraged institutions. And you can run through that capital in a rapidly changing market faster than a hot knife goes through butter, and the notion that we regulators have the capacity to fend that off I think is misplaced.

Mr. TOWNS. Could you explain the wholesale financial institution provision, how it works?

Mr. GREENSPAN. There has been, as I am sure you are aware, Congressman, a fairly major expansion in wholesale banking and a demand for a lot of sophisticated services that occurs as a consequence of the really quite dramatic change in technology that has occurred over the years. So there is essentially some form of increased demand for an institution which would be a wholesale bank. It will be regulated and has the characteristics under H.R. 10 of a regular commercial bank with the sole exception that it is not insured by the FDIC and cannot accept deposits below $100,000. So it is essentially a wholesale institution which is essentially a bank.

Mr. Towns. Thank you. In the last Congress, this committee reported legislation that included provisions allowing the SEC to be a holding company, regulatory, or a broker that owned a relatively small bank. Do you have any objection to this provision?

Mr. GREENSPAN. None whatsoever. Indeed, as I recall, we testified I think exactly in that regard to this committee a year ago. In any event, should a large securities firm purchase a small bank, the presumption that somehow the Bank Holding Company Act should be applicable in the sense that it currently is envisaged sort of makes no sense. I mean, our view basically is that the oversight of the financial services holding company in that type of situation almost surely should be the securities firm, not the bank.

Mr. TOWNS. Thank you very much Mr. Chairman.

Mr. OXLEY. The gentleman's time has expired. The gentleman from Ohio, Mr. Gillmor.

Mr. GILLMOR. Thank you very much, Mr. Chairman. I would like to pursue, Mr. Chairman, a couple of questions on the concept of "too big to fail" as it functions as a practical matter. The bigger the institution, it gets special treatment, and I think it basically amounts to a subsidy by smaller and medium institutions. To what extent in looking at mergers do you consider that, if at all?

Mr. GREENSPAN. Congressman, you are raising one of the really more difficult supervisory problems that we at Federal Reserve have.

We are acutely aware that almost by definition a merger creates larger institutions and should the larger institution fail at some point, it clearly could have significant contagion effects in the fi

nancial system and those systemic concerns obviously are crucial to

us.

The answer is yes, we do look at the issues and we try to envisage how, should that institution run into difficulty, we would create a responsible liquidation, one that would not undercut the safety and soundness of the overall system. It is a very difficult issue.

The presumption, however, that we will just automatically bail out large institutions is false. Were we actually to make that an issue of policy, I think we would find that the efficiency of the American banking system, which is really quite impressive, would deteriorate. Our issues face not on the question of how to keep the organization in place, but how you create a degree of structured liquidation so that the pieces are taken apart in a manner which does not create difficulties for the rest of the system.

In any event, we don't look at it as an issue of too big to fail. We look at it as an issue of very difficult to liquidate. If the markets presumed that we really did have a too big to fail policy in this country, the ratings on bank debentures, even though they are higher than bank holding company debentures, are nowhere near the rating you would give to a U.S. Treasury issue or an organization essentially guaranteed directly or indirectly by the U.S. Government. There is still a pretty big gap there which implies, fortunately, that the markets realize that an institution cannot be too big to fail.

But the question you raise makes it more difficult for us and we have spent a considerable amount of additional time looking at those larger institutions in the context of the type of principle that I just enunciated.

Mr. GILLMOR. One of the things that I have been working on has been an amendment which would require that that be one of the factors that would be considered. And I am just wondering if you would have I would like to get that language to you when we get it finalized but I am wondering if you would have any strenuous objection to that concept since, as you indicate, you are already looking at that to a degree.

Mr. GREENSPAN. Congressman, I really don't think that it is legislatively necessary. We have all the legislative powers that are required to implement that particular issue. And as far as I can judge, not only the Federal Reserve but all of the other supervisory organizations, both banking and otherwise, are acutely aware of the issue that you raise, and it is hard for me to imagine that that is not an issue that is continuously on the table.

Mr. OXLEY. The gentleman's time has expired.

Mr. GILLMOR. Thank you, Mr. Chairman.

Mr. OXLEY. The gentleman from Michigan, Mr. Dingell.

Mr. DINGELL. Mr. Chairman. I thank you. I have here before me something that I am very interested in because it tells me that the Japanese have chosen the route of holding companies rather than operating subs. Is that because the banks in Japan are very weak and the Japanese found that not only the banking system but the financial system is weak and they are choosing the stronger of the two courses which would give them a better chance of a strong system and a better chance to an earlier recovery?

Mr. GREENSPAN. I would say yes to both questions, yes.

Mr. DINGELL. Mr. Chairman, I ask unanimous consent that this be inserted in the record at the appropriate place.

Mr. OXLEY. Without objection.

[The information referred to follows:]

[Tuesday, April 27,1999-The Wall Street Journal]

DAIWA SECURITIES BECOMES HOLDING FIRM

By Jathon Sapsford, Staff Reporter of The Wall Street Journal

TOKYO-Daiwa Securities Co. Monday became the first globally recognized Japanese corporation to restructure under a holding-company format, reviving a business custom once banned by U.S. occupiers after World War II.

It is a strategy the world will be hearing more of from Japan. Businesses in nearly every industry-banking, telecommunications, technology and manufacturinghave said they are looking at remaking themselves as holding companies and then turning their divisions into subsidiaries as a way of cutting costs.

Daiwa is the first big company to take the plunge. "I believe that the conventional [Japanese] style... is not sufficient for meeting future challenges," said Daiwa President Yoshinari Hara, in a full-page add in Japan's newspapers on Monday. "This is why we have chosen the holding company structure."

Daiwa's move, on the surface at least, will turn it into the Japanese equivalent of a U.S. holding company. Daiwa said It will change its name to Daiwa Securities Group Inc. and that this will be the entity its current stakeholders own. It will split its divisions off into a series of 10 subsidiaries owned by the holding company. Those subsidiaries will pay dividends to the parent, which in turn will pay dividends to shareholders.

The goal for Japanese companies considering holding-company transformations is to reduce bureaucracy and increase flexibility. Through the holding company, corporations could "exit" businesses that aren't making a profit by selling them off or folding them into a joint venture with another company that is stronger, in the given area. That is proving difficult for many big companies to do under the current structure, according to Japanese business officials.

A holding-company structure would allow corporations to pay some staff more than others, thus rewarding initiative and performance-a practice that runs counter to Japan's egalitarian pay structure. The goal is to dismantle a system under which employees are paid on the basis of their seniority, regardless of how much they contribute to the company's bottom line. By splitting divisions into separate companies, Daiwa, for example, could pay retail-stock salesmen a salary commensurate with the limited skills required to sit at a branch counter and sell shares.

Meantime, it could pay more to staff in its investment-banking division, which demands more experience and responsibility. "The key difference is that you can pay people different amounts," said Garry Evans, a strategist at HSBC Securities Japan Ltd.

Holding companies were at the center of this country's zaibatsu, the conglomerates of the pre-World War II era. The U.S. banned them during the Allied occupation of Japan for fueling the Japanese war effort. The individual units spun off at that time grew into huge empires with broad lines of businesses under the same roof.

Now, companies ranging from big banks such as Sanwa Bank Ltd. and Fuji Bank Ltd. to manufacturer's like Nissan Motor Corp. and telecommunications company Nippon Telegraph & Telephone Co. have expressed interest in the holding-company format.

Tax issues, however, remain a big hurdle. Transferring assets from a parent company to a subsidiary is a process subject to a "gift tax" under Japanese law. That can be expensive for banks, which would have to pay as much as half the value of the loan assets on their books. The government is studying a change in the tax code to make such transfers easier. Daiwa said part of its transfer taxes will be offset by its retained earnings.

Mr. DINGELL. Mr. Chairman, now I note here some years back NationsBank to its mostly elderly bank customers was selling risky funds with an understanding on the part of the buyers that their money was protected by the Federal Government. NationsBank peddled these securities in conjunction with an operating subsidiary, Nation's Securities. Now, question: By expanding the capabili

ties of operating subs, does H.R. 10 open the door for future, more varied fraudulent practices by banks and their subsidiaries?

Mr. GREENSPAN. Well, I certainly think that the issue is one that we have to be concerned about. It is very important that we put a Chinese wall or other safeguard, however we wish to describe it, between securities activities and banking activities and very especially not in any way indicate that the safety net which is under banking activities as authorized by the Congress not be somehow suggested as available to people buying securities. And I suspect that the greater the distance you have between the bank and the organization selling securities, the less that problem is likely to emerge. I should say that it is one of the more difficult issues that banking supervisors have confronted in recent years and I suspect that were we to authorize the structure of the operating sub, as indicated in H.R. 10, it would make our job more difficult.

Mr. DINGELL. Thank you. Now, Mr. Greenspan, you have referred to the possibility that H.R. 10 could galvanize a holding company to shift capital to a bank as opposed to a separate holding company affiliate in order to take advantage of the Federal subsidy. I note, however, the Department of Treasury reports empirical evidence which they indicate does not necessarily support this prediction. Parenthetically I will say I am on your side but I want to get your comments.

Treasury cites mortgage banking. Of the top 20 holding companies, six currently conduct mortgage banking activities in an affiliate, nine conduct such activities in the bank or a subsidiary of the bank, and five use a combination of bank and affiliate. What does this tell you? How do you explain this if you please?

Mr. GREENSPAN. We are aware of the criticism and we have looked at it in some detail and we don't agree with their factual analysis for a number of reasons. First, it is certainly true that there are a lot of activities that legally could be exercised within the bank and are actually exercised in an affiliate of the holding company. There are a number of reasons. In many cases in earlier years they were geographical, there were tax reasons. But the most interesting issue is that there has been a substantial move of powers currently authorized in the bank but having been exercised in holding company affiliates which have been moved to the bank. With respect to a number of these types of activities, if the capital required is very low, then the advantage of putting an activity in the bank where the cost of capital is less may not matter. And then if there is no capital, meaning there is no subsidy, then there is no reason why one would necessarily put it in either an affiliate of the holding company or in the bank itself.

With respect to those mortgage companies that are in both areas, I think you will find that in innumerable cases, especially in the very large cases, that although the activity starts within the holding company, it is essentially funded with moneys from the bank at subsidized rates. I would conclude that looking at the whole set of powers and how they proceed, as we went to interstate branching and as we changed a number of the tax laws and as we changed regulation, many of the reasons which induced banking organizations to keep powers in affiliates of holding companies, even though they were legally available to the bank have changed, and