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nomic policy for which it is held accountable is banking policy. For an administration to have an effective role in banking policy, it must have a strong nexus with the banking system. That in turn requires the maintenance of the effectiveness of a national bank charter. In this instance, I am talking about bank policy, not regulation. By law, the Secretary of the Treasury cannot get involved in case-specific regulatory matters.

We also believe that it is very important that the Federal Reserve Board maintain its strong connection with the banking system. Therefore, we have taken steps to help ensure that the Federal Reserve's jurisdiction is not weakened. Under H.R. 10, the Federal Reserve would continue to be the sole regulator of bank holding companies and their affiliates, and the largest banks would be required to operate through a bank holding company.

We strongly support H.R. 10, though in certain respects we believe it could be improved. Let me briefly touch on four of those.

We are concerned about the Federal Home Loan Bank System provisions of H.R. 10. A great deal of the subsidized debt raised by the system is used not to expand home ownership, but rather to fund arbitrage activities and short-term lending to benefit the system and its bank and thrift members.

As currently drafted, H.R. 10 takes no steps to ensure that the funds that the system raises will be used for the public purpose for which the system was established. Rather H.R. 10 would allow the system's regulator to cut the capital requirements of the system in half. We believe such a step to be very unwise.

We are also concerned about a provision of H.R. 10 that would allow greater affiliations between commercial firms and savings associations. We have serious concerns about mixing banking and commercial activities. Thus we are concerned that H.R. 10 would allow commercial firms to acquire any of the 600 thrifts currently owned by unitary thrift holding companies.

Finally, we continue to believe that any financial modernization bill must have adequate protection for consumers, and that there are improvements that could be made by this committee and approved by the full House, including provisions addressing securities sales regulation issues.

Let me conclude, Mr. Chairman, by saying that the financial modernization legislation can produce significant benefits, but the job must be done right. H.R. 10 has received broad industry and bipartisan Congressional support, and we believe its critical provisions should be preserved. We look forward to working with this committee and with Congress to move a bill forward that best serves the interests of the American people.

Thank you, Mr. Chairman.
[The prepared statement of Hon. Robert E. Rubin follows:)

PREPARED STATEMENT OF HON. ROBERT E. RUBIN, SECRETARY OF TREASURY Mr. Chairman, Members of the Subcommittee, I appreciate this opportunity to discuss the Administration's views on financial modernization, including H.R. 10, the Financial Services Act of 1999.

Mr. Chairman, as we approach financial modernization legislation, the Administration's overall objective has been to do what best serves the interests of consumers, businesses and communities, while protecting the safety and soundness of our financial system. We will support legislation that achieves those aims.

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Let me begin by noting that the U.S. financial services industry is stronger and more competitive in the global market than at any time in many decades. The United States is dominant in global investment banking and highly competitive in other segments of financial services. U.S. commercial banks are today more competitive abroad than at any time I can remember. The problem our financial services firms face abroad is lack of access rather than lack of competitiveness.

Financial modernization is occurring already in the marketplace through innovation, technological advances, and the lowering of regulatory barriers. Banks and securities firms have been merging; banks are selling insurance products; and insurance companies are offering products that serve many of the same purposes as banking products—all of which increases competition and thus benefits consumers.

Financial modernization will continue in the absence of legislation, but it can, with good legislation, occur in a more orderly fashion. Treasury has long believed in the benefits of such legislation, but we have also been clear that if this is going to be done, it needs to be done right.

Let me turn now to H.R. 10. The Administration strongly supports H.R. 10, which was reported by the Banking Committee by a bipartisan 51-8 vote. H.R. 10 takes the fundamental actions necessary to modernize our financial system by repealing the Glass-Steagall Act's prohibitions on banks affiliating with securities firms and repealing the Bank Holding Company Act prohibitions on insurance underwriting. 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 services firms to organize themselves in whatever way best serves their customers and their businesses.

Today, I would like to focus primarily on how H.R. 10 gets these two issues right. I will then discuss four ways that we believe that H.R. 10 could be improved.

The first issue is preserving the relevance of the Community Reinvestment Act (CRA). CRA encourages a bank to serve creditworthy borrowers throughout communities in which it operates. Since 1993, a greatly invigorated CRA has been a key tool in the effort to expand access to capital in economically distressed areas and to make loans to rebuild low and moderate-income communities.

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 record. If we wish to preserve the relevance of CRA at a time when the relative importance of bank mergers may decline and the establishment of non-bank financial activities will become increasingly important, the authority to engage in newly authorized activities must be connected to a satisfactory CRA performance. We strongly urge the Committee to retain this important provision and otherwise leave CRA intact.

The second Administration priority is to allow banking organizations to choose the structure that best serves their customers. Before getting into specifics, I would like to make two general points.

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 of U.S. banks currently engage overseas in securities underwriting,

merchant banking and other non-banking activities. These subsidiaries—which currently constitute $250 billion of assets would be allowed to continue under all recent versions of H.R. 10, including last year's bill. These subsidiaries, I might add, have been approved by the Federal Reserve and are supervised by

the Federal Reserve. Foreign banks are currently permitted to engage in securities underwriting

through subsidiaries in the United States. These subsidiaries—which currently constitute $450 billion of assets—would be allowed to continue under all recent versions of H.R. 10. These subsidiaries, too, have been approved by the Federal

Reserve and supervised by the Federal Reserve. Subsidiaries of state banks are currently authorized to engage in a broad range

of non-bank activities permitted by their state charter, provided that the FDIC does not find these activities to pose a risk to the deposit insurance funds. Such

non-bank activities would continue in some form under all recent bills. The second point is that the idea of allowing the choice of subsidiary or affiliate has received broad support. The subsidiary option is supported not just by Treasury but also by the current Chairman of the FDIC, the agency responsible for insuring bank deposits, and her four predecessors—two Republicans and two Democrats and by independent economists and other academics. The FDIC chair has testified that the subsidiary actually preferable to an affiliate 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. Of those authorizing links between banking and insurance underwriting, all but one allow the choice of a subsidiary or an affiliate. By allowing a choice of structure, H.R. 10 is clearly in the mainstream of economic and legal thinking in this area.

Now, for the specifics. In 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 a subsidiary engaging in securities activities would be exactly the same as over an affiliate engaging in those same activities, and customers of that subsidiary would bene

fit from the same customer investor protections as customers of an affiliate. • Every dollar a bank invests in a subsidiary would be deducted from the bank's

regulatory capital, just as is the case with every dollar a bank pays as a dividend to its parent holding company for investment in an affiliate. A bank would have to be well-managed and well-capitalized before and after such investment is deducted from its capital and on an ongoing basis. The capital investment would remain on the bank's books for purposes of Generally Accepted Accounting Principles (GAAP), since all of the assets and liabilities of the subsidiary are consolidated with the bank for GAAP purposes. But that accounting consolidation does not affect safety and soundness in any way: as I noted, the bank must maintain capital at the highest level set by the banking regulators—the well capitalized level—even assuming the investment is a total loss, and the bank cannot lose more than its investments in and loans to

the subsidiary, which are expressly limited by statute. • 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 a loan 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 its parent bank. While the idea that a bank receives a net subsidy is debatable, these funding restrictions ensure that banks are no more able to transfer any such 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 its funding costs would be lower. A bank may have such an incentive, but that incentive has nothing to 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 and three former FDIC Chairs to conclude that the subsidiary is preferable to the affiliate with respect to safety and soundness.

If a company has a valuable subsidiary, then the capital markets will reward that company with lower funding costs because it is a better credit risk. Creditors prefer to see valuable assets lodged in a place where creditors can reach them if the company defaults. The FDIC shares this preference, as it seizes the assets of a bank in the event it fails. A subsidiary meets this test, but an affiliate does not. Thus, market incentives in this area are rational and have nothing to do with any subsidy received by the bank. It is difficult to understand why Congress would wish to disrupt these sound market incentives—incentives that also promote safety and soundness.

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, it is not significant enough to make a practical difference. If banks received a net subsidy significant enough to make a competitive difference, then presumably they would dominate the low-margin government securities market. They do not. Presumably, mortgage banking subsidiaries of banks, which currently operate without any of the funding restrictions imposed by H.R. 10, would dominate their non-bank competitors. They do not. I cannot help but conclude from our real world experience that the net subsidy is not that significant and, more importantly, that under the funding limitations of H.R. 10, any subsidy that a subsidiary would manage to extract from its parent bank would be inconsequential.

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 the choice of structuring themselves in the way that makes the most business sense and this, in turn, should lead to better service and lower costs for their customers.

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Second, the relationship between a subsidiary and its parent bank provides a safety and soundness advantage. As I have noted, firms that choose to operate new financial activities through subsidiaries are, in effect, keeping those assets available to the bank rather than transferring them outside the bank's reach. The bank's interest in the subsidiary could be sold if it ever needed to replenish its capital. If the bank were ever to fail, the FDIC could sell the bank's interest in the subsidiary in order to protect the bank's depositors and the deposit insurance fund.

Third, one of an elected Administration's critical responsibilities is the formation of economic policy, and an important component of that policy is banking policy. In order for the elected Administration to have an effective role in banking policy, it must have a strong connection with the banking system. That connection would be weakened if new financial activities were off limits to OCC supervision.

We also believe it is very important that the Federal Reserve Board maintain its strong connection with the banking system, and therefore we have taken steps to help ensure that the Federal Reserve's jurisdiction is not weakened. Under H.R. 10, the Federal Reserve would continue to be the sole regulator of bank holding companies and their affiliates, and the largest banks would be required to operate

through a bank holding company. The Federal Reserve would also supervise subsidiaries of State member banks, and would continue to supervise overseas subsidiaries of national banks and U.S. subsidiaries of foreign banks. Insurance underwriting would be conducted solely in Federal Reserve-supervised bank holding company affiliates. And the Federal Reserve would have the authority to veto any new activity for a subsidiary–Fed-supervised or not just as the Treasury would have the authority to veto any new activity for an affiliate.

While we strongly support the House Banking Committee bill, there remain certain aspects of the bill that concern us.

We are concerned about the Federal Home Loan Bank System provisions of H.R. 10. The FHLBank System is currently the largest issuer of debt in the world. Last year, it issued approximately $2.2 trillion in debt, and it currently has $350 billion in debt outstanding. As a government sponsored enterprise directed to foster home ownership, the System receives tax benefits, an exemption from SEC registration for its securities, and benefits from a market perception that the government stands behind the System, even though there is no legal obligation to do so. Yet a great deal of the government subsidized debt raised by the System is used, not to advance its home ownership purpose, but rather to fund arbitrage activities and short-term lending that benefit the System and its bank and thrift members. For those who care about the market-distorting effects of government subsidies on U.S. markets, the Federal Home Loan Bank System should be a substantial concern.

The System's arbitrage is not only an abuse of its government subsidy but also injects risk into a System that was designed-by requiring all loans to be collateralized by stable, low-risk mortgages—to have very little.

As currently drafted, H.R. 10 effects no reform of the System's arbitrage and takes no steps to ensure that the funds it raises will be used for a public purpose. Rather, H.R. 10 would allow the System's regulator to cut the capital requirements of the System in half. We believe such a step is very unwise.

We are also concerned about a provision of H.R. 10 that would allow greater affiliations between commercial firms and savings associations. We have serious concerns about mixing banking and commercial activities under any circumstances, and these concerns are heightened as we reflect on the financial crisis that has affected so many countries around the world over the past two years. Thus, we are concerned that H.R. 10 would allow commercial firms to acquire any of the over 600 thrifts currently owned by unitary thrift holding companies. Currently, only a few unitary thrifts are owned by non-financial firms-many are owned by insurance companies and securities companies, for example but if H.R. 10 were to break down the barriers to affiliation among financial firms, then their need for owning thrifts would be substantially reduced. The logical buyers at that point would be non-financial firms.

We continue to believe that any financial modernization bill must have adequate protections for consumers. We believe that improvements should be made by this Committee and approved by the full House. Thus, we look forward to working with the Committee on provisions addressing sales of securities regulation issues.

Mr. Chairman, let me conclude by reiterating that financial modernization legislation can produce significant benefits, but the job must be done right. H.R. 10 has received broad industry and bipartisan Congressional support, and we believe its critical provisions should be preserved.

We in the Administration look forward to working with you and others in Congress to move the bill forward and improve it where necessary in order to produce legislation that truly benefits consumers, businesses and communities, while protecting the safety and soundness of our financial system. Thank you very much.

Mr. Oxley. Thank you, Mr. Secretary. We again appreciate your willingness to come here to testify and to answer some questions. Let the Chair begin with some questions.

This is perhaps inevitable because there was so much discussion about operating subsidiaries both by Chairman Greenspan last week and then you in your testimony today.

So let me begin with the obvious. You have indicated you believe that the provisions in the bill H.R. 10, as passed by the Banking Committee, effectively curtail the transfer of the subsidy that exists for banks to their operating subsidiaries. Would the provisions of H.R. 10 requiring deduction of investments and operating subsidiaries apply only to regulatory capital of the bank and not necessarily the operating capital?

Mr. RUBIN. Well, what the legislation would do is require a deduction from the regulatory capital. In terms of GAAP accounting, they would still be consolidated. But as you know, Mr. Chairman, if it turns out there were losses in the subsidiary, then the bank, when it sells the subsidiary or liquidates the subsidiary, whatever the case may be, for GAAP purposes it would recapture those losses. They would be in effect recaptured at the bank level. But for regulatory capital purposes, the deduction would be 100 percent.

Mr. OXLEY. Chairman Greenspan testified to this committee on two different occasions that the Fed had done an extensive study and indicated that banks using the operating subsidiaries concept would enjoy a 10 to 12 basis point advantage over other financial institutions.

You obviously disagree, but I am curious as to why such a wide disparity of opinion between two well-respected individuals such as yourself and Chairman Greenspan.

Mr. RUBIN. Could I correct one oversight. I apologize, Mr. Chairman, I have forgotten to introduce our Assistant Secretary, Rick Carnell, who is absolutely delighted to respond to questions as well.

Mr. OXLEY. Welcome, Mr. Carnell.
Mr. RUBIN. I apologize to Rick for that.

I lived in capital markets, as you know, Mr. Chairman, for 26 years before I entered the world of–I don't know how to describe the world that I am in now. I was going to say something, but I decided not to.

If there is a funding advantage, and I think, by the way, this may cut both ways. Let me give you a full answer, if I may, because it is a somewhat complicated question. It is one that I actually know something about.

If there is a funding advantage to a bank in setting up a subsidiary, it has nothing to do with transfer of subsidy. That is identical. But if you are a creditor of a bank and the bank takes a certain portion of its capital and puts it into the subsidiary to conduct securities business or whatever it may be, securities underwriting, those assets then remain subject to the creditors of the bank if the bank gets in trouble without having to get bank board approval or any such thing.

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