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In addition, I must say that if you look at the Asian crisis, you will see that government interference in the financial institutions there brought about the Asian crisis. I am not talking as a Republican or as a Democrat. But if you have elected officials through the Treasury Department setting up arbitrary and discretionary requirements for financial institutions in the future, you are inviting political manipulation rather than objective standards for those purposes.

Finally, I would like to say that by all means I believe we need a bill this year. If we in the Congress do not get a bill this year, we are essentially saying that the regulators and the Court-we can't do our business and the regulators and the courts will fill in and redesign financial institutions and modernization without statutory authority because we would have abrogated our responsibility.

Again, Mr. Chairman, I believe that you will see that the testimony reflects completely from my own experience and my position as the chairwoman of what Chairman Greenspan has laid out to you and what you, Mr. Chairman, and Mr. Tauzin, vice chairman, have enunciateed in your opening statements.

[The prepared statement of Hon. Marge Roukema follows:] PREPARED STATEMENT OF HON. MARGE ROUKEMA, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF NEW JERSEY “We cannot escape history. We of this Congress and this administration will be remembered in spite of ourselves.” Those words remain as true today as they were the day Abraham Lincoln uttered them in 1862 and they have special significance for Congress as we consider legislation that would comprehensively modernize our financial laws.

Financial modernization may not have the headline-grabbing power of air strikes in Serbia or school violence, or the potential to affect our daily lives like a proposed tax increase. But this legislation is critically important. If not “done right” it has the potential to drain hundreds of billions from America's financial system and from federal budget priorities such as preserving Social Security and improving education. This is not about winners and losers. By all means, we need a bill this year.

The pending financial modernization legislation is designed to replace outmoded laws—many of which were drafted during the Great Depression. The bill would tear down the out-of-date barriers that prohibit banks, securities firms, insurance companies and other financial service providers from affiliating with each other and entering each other's businesses. It would foster competition for financial services, permit financial organizations to offer consumers wider array of products and services, and enhance the ability of U.S. banking and financial companies to compete more efficiently in the global market.

Congress has a special responsibility, however, to ensure that the newly authorized affiliations and activities occur within a framework that protects the safety and soundness of this nation's insured banks, the Federal deposit insurance funds and the American taxpayer. In fact, this decision regarding the how we construct an appropriate framework for authorizing new financial activities is likely the most important decision associated with financial modernization, and a misstep will have profound consequences for our financial system and the taxpayer.

We have been down this road before. The savings and loan debacle of the 1980s cost the Federal deposit insurance funds and, ultimately, the American taxpayer hundreds of billions of dollars. Indeed, the price tag grows every day as lingering lawsuits are settled.

These losses were caused in part because S&Ls were permitted to engage in risky activities directly or through subsidiaries incurring substantial losses. In some cases, these losses had a direct impact on the financial solvency of the parent thrift. Hundreds of federally insured thrifts had to be bailed out by the federal government, and ultimately, by us, the taxpayers.

Following the thrift taxpayer-financed bailout, Congress restricted the ability of insured state banks to engage through subsidiaries in such risky activities, such as underwriting property and casualty insurance or making equity investments in nonbanking entities. We also required the accounting practices of Federal banking agencies to “be uniform and consistent with generally accepted accounting principles."

Now we have to apply the standards of safety and soundness to financial modernization. Unfortunately, the painful lessons of the thrift debacle have faded with time and our enduring economic boom has tempered memories of what can happen, particularly to insured depository institutions, when the economy turns sour.

I believe the Treasury Department's own modernization proposal has the potential to repeat the costly mistakes of the thrift crisis. In particular, the Treasury Department has championed a proposal that would allow so-called “operating subsidiaries” of national banks to engage in some of the potentially risky activities that Congress has not allowed national banks to conduct directly. These activitiesinclude merchant banking activities, which would allow subsidiaries of national banks to acquire up to 100 percent of the equity of companies engaged in any type of financial or commercial activity,

Here we go again. Treasury's proposal would place the American taxpayer at risk. Losses at an operating subsidiary can occur quickly and can significantly exceed the bank's total capital and investment in the subsidiary. These losses must be fully and immediately reflected in the financial statements of the parent insured bank under generally accepted accounting principles and, thus, can have an immediate impact on the bank's solvency. The direct ownership and management link between an operating subsidiary and its parent bank also gives the bank a strong incentive to support a financially distressed operating subsidiary. These economic realities have not changed since the thrift crisis of the 1980s.

Treasury would address the risks inherent in the operating subsidiary structure through the creation of so-called regulatory "firewalls.” But these firewalls would not fully protect an insured national bank, the Federal deposit insurance funds or the American taxpayer from losses incurred by an operating subsidiary. Experience with the thrift crisis proves that such artificial regulatory accounting devices are not effective because they cannot alter economic realities—losses at a subsidiary reduce the economic resources of the parent.

This is precisely why Congress must support the "holding company" framework. The holding company framework has an established track record of better insulating insured banks from the risks associated with new activities. An insured bank does not control a holding company affiliate. Instead, the bank is owned by the uninsured holding company. Losses incurred by a holding company affiliate are not directly reflected in the financial statements of an affiliated bank and are borne by the uninsured holding company-not the insured bank.

It is for these reasons that the financial modernization bills passed last year by the House and by the Senate Banking Committee rejected the operating subsidiary framework and required a holding company framework. Many who discount last year's action claim it is nothing but a turf battle. It is not. There are sound policy reasons to institute a prudent system of checks and balances.

There is one final risk that the operating subsidiary structure would present. It would invite the further politicization of banking and financial policy by greatly expanding the authority of the Treasury Department and, thus, the ability of any Administration-Democrat or Republican—to exert influence over banking organizations. For sound reasons, Congress has carefully divided responsibility for financial institution regulation and policy among the politically elected executive branch and independent regulatory agencies, such as the Federal Reserve Board.

We have the right regulatory structure now. Here I would point to Asia where the ongoing financial crisis was exacerbated by the outright corrupt relationship between the Asian governments and their respective financial industries.

The operating subsidiary structure would dangerously upset this careful balance and lead to the further politicization of financial policy. Banks play too important a role in our economy to allow banking policy to become further politicized.

The lessons of the financial collapse that led to Depression and the more recent Asian economic crisis should be “red flags” reminding Congress to do it job to protect the safety and soundness of the financial services sector. It does that by following the lead of Federal Chairman Alan Greenspan and by rejecting Treasury's dangerous “opsub” scheme.

Mr. OXLEY. Without objection, the full statement will be made part of the record as well as Mr. Baker's. We thank both of you for your testimony. The Chair would note that we do have a vote on the floor, and the committee will stand in recess for 15 minutes.

[Brief recess.]

Mr. OXLEY. The subcommittee will reconvene. We are honored to have as our lead witness this morning the Honorable Robert Rubin, Secretary of the Treasury. Secretary Rubin, thank you for appearing before the committee today. We appreciate you taking the time to be with us, and we apologize for the usual floor votes and other distractions, but we are eagerly anticipating your participation and your testimony. With that, let me recognize you for whatever time you wish to spend with us. STATEMENT OF HON. ROBERT E. RUBIN, SECRETARY OF THE

TREASURY, ACCOMPANIED BY RICHARD S. CARNELL, ASSISTANT SECRETARY OF THE TREASURY, DEPARTMENT OF THE TREASURY

Mr. RUBIN. Thank you, Mr. Chairman. Let me start by thanking you for the opportunity to be here with you.

Mr. OXLEY. Is that microphone on?

Mr. RUBIN. I do not know the answer to that, sir. Is it better now? Would you rather I have it on or off?

Mr. OXLEY. We will take a vote on that.
Mr. RUBIN. I think I will put it on. Let me start again, if I may.

Mr. Chairman, we are delighted to be here. I appreciate the opportunity to present our views on H.R. 10, and financial modernization more generally. Let me begin, if I can, with a general comment that the United States financial services industry is stronger and more competitive in the global economy than at any time in many, many decades, including dominance in investment banking and a stronger position abroad in commercial banking than certainly at any time in my memory.

Moreover, financial modernizations are occurring through the marketplace, products are being developed in one sector that serve another sector and mergers are taking place. This is because of the lowering of regulatory barriers.

Financial modernization, I have no doubt, will continue in the absence of legislation. But, in our view, it is important to get legislation—if we can get good legislation-because with good legislation it can be done in a more orderly fashion. However, if it is going to be done through legislation, it needs to be done right.

Let me now turn to H.R. 10. The administration strongly supports H.R. 10, which, as you know, is supported by the Banking Committee with a vote of 51 to 8 on bipartisan basis. H.R. 10 takes the necessary actions to modernize our financial system with respect to Glass-Steagell and the Bank Holding Company Act and it takes two other steps that are of critical importance to the administration. It preserves the relevance of the Community Reinvestment Act and it permits financial service organizations to organize themselves in whatever way they feel best serves their business purposes and their customers.

What I would like to do is focus primarily on how H.R. 10 deals with these two issues in what we view to be the right fashion. Then I will briefly mention four other ways that we think H.R. 10 could be improved.

The first is preserving the relevance of the Community Reinvestment Act, which is a key tool in providing capital to distressed areas. We strongly support H.R. 10's requirement that any bank

seeking to conduct new financial activities be required to achieve and maintain a satisfactory CRA rating.

In our view, to preserve the relevance of CRA at a time when the relative importance of bank mergers may decline and banks will focus to a greater degree on establishing new nonbank financial activities, the authority to engage in these new activities must be connected to satisfactory CRĂ performance.

The second administration priority is to allow banking organizations to choose a structure that best serves their customers.

Before getting into specifics on this point, let me make two general observations. The first is that the subsidiary option is a proven success, not a risky experiment, and one that every current and recent financial modernization bill, including the bill reported by this committee last year, would continue to allow in some form. For example, subsidiaries—U.S. banks currently engaged overseas in securities underwriting, merchant banking, and other nonbanking activities—these subsidiaries have over $250 billion in assets, and they would be allowed to continue under all recent versions of H.R. 10 including last year's bill. These subsidiaries, as you know, have been approved by the Federal Reserve Board and are supervised by the Federal Reserve Board.

Second, foreign banks are permitted to engage in securities through subsidiaries in the United States. These subsidiaries, which currently have roughly $450 billion in assets, would be allowed to continue under all recent versions of H.R. 10. And here, too, the subsidiaries have been approved by the Federal Reserve Board and are supervised by the Federal Reserve Board.

The second point is that allowing the choice of subsidiary or affiliate has received broad support. The choice of a subsidiary option. This is supported by the current chairman of the FDIC, which, as you know is the agency responsible for securing bank deposits, and her four predecessors, in total three Republicans and two Democrats, and by independent economists and other academics.

The FDIC chair has testified that subsidiaries are actually preferable to affiliates for purposes of safety and soundness. Of the 18 other countries composing the European Union and the G-10, none requires the use of separate bank holding company affiliates for underwriting and dealing in securities.

Now for specifics. Under H.R. 10, subsidiaries and affiliates are subject to_safety and soundness safeguards that are absolutely identical. The bill contains the following rigorous safeguards. Subsidiaries of banks would be functionally regulated in exactly the same manner as affiliates of banks. The authority of the SEC, for example, over subsidiaries engaged in securities activities would be exactly the same as over affiliates engaged in those same activities.

Second, every dollar a bank invested in a subsidiary would be 100 percent deducted from the bank's regulatory capital, just as is the case for every dollar a bank pays as a dividend to its parent holding company for investment in an affiliate. The bank would have to be well-managed and well-capitalized before such an investment and on an ongoing basis with either a subsidiary or an affiliate. A bank could not invest any more in a subsidiary than it could pay as a dividend to its parent holding company for investment in an affiliate.

The rules governing loans from a bank to a subsidiary would be exactly the same as they are for loans from a bank to an affiliate. These safeguards are primarily addressed to safety and soundness; but they also resolve another potential concern, the possibility of a subsidiary gaining a competitive advantage by receiving subsidized funding from the parent bank.

While the idea of a bank having a net subsidy is debatable, these funding restrictions ensure that banks are no more able to transfer any subsidy to a subsidiary than to an affiliate. Now, it has been argued that even with these restrictions in place, the bank would still have an incentive to operate through a subsidiary because the bank's funding cost would be lower.

A bank may have such incentive, but that has nothing-zeroto do with the transfer of any subsidy that may exist. Rather, it is based on the interests of creditors, the same interests that have caused the current Chairman of the FDIC and the four former FDIC chairs, three Republicans and two Democrats, to state that the subsidiary is preferable to the affiliate with respect to safety and soundness. In other words, it is a better credit risk. It may be, I should say, it may be a better credit risk.

If a company has a valuable subsidiary, then the capital markets will reward that company with lower funding costs because, as I said a moment ago, the company is a better credit risk. Creditors prefer to see valuable assets lodged in a place where creditors can reach them if the company gets into financial trouble. The FDIC shares this preference, as it seizes the assets of a bank in the event it fails. A subsidiary meets this test; an affiliate does not. Thus market incentives in this area are rational and have nothingzero-to do with any subsidy received by the bank.

One last point on subsidy. As I have said, if there is a subsidy, it could be equally transferred to an affiliate and a subsidiary. And if there is one, the evidence is that it is not significant enough to make a truly significant difference. If banks received a net subsidy significant enough to make a competitive difference, then presumably they would dominate the low margin-the very low margingovernment securities market. They do not. The same is true with respect to mortgage banking subsidiaries of banks, which do not dominate that area either.

Thus we see no public policy reasons to deny the choice of a subsidiary. However, there are four important policy reasons to allow that choice.

First, financial services firms should, like other companies, have a choice of structuring themselves in the way that makes the most business sense and that, in turn, should lead to the lowest costs and best service to their customers.

Second, the relationship between a subsidiary and its parent bank provides a safety and soundness advantage as compared to an affiliate, the subject that I have just discussed. And to repeat this once again, it is for that reason that the Chairman of the FDIC and the four preceding chairpersons have said that an op-sub is preferable to an affiliate with respect to safety and soundness.

Third, one of the elected administration's, any administration's, critical responsibilities is the formation of economic policy, for which it is held accountable. An important component of that eco

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