The Washington Turf Battle of the Year

The turf battles in Washington are renowned for their unrestrained character. The current fight between the Department of the Treasury and the Federal Reserve is setting new records in this field. At the center of the controversy is H.R.10, the banking modernization bill, which will allow the consolidation of banking, insurance, investment banking, mutual fund industries, and all other financial operations into one entity. The dispute is over how this new, all-purpose financial operation should be structured and who should regulate it.

Secretary Rubin and the Treasury’s position is that the banks should be allowed to engage in these new nonbanking activities (insurance, investment banking, money management, real estate development, etc.) by carrying on these businesses in their ownsubsidiaries or in subsidiaries of the bank holding company, as the bank chooses.

Chairman Greenspan and the Federal Reserve’s position is that these new activities must be operated only by subsidiaries of the financial institution holding company.

H.R.10 decides the issue in favor of the Fed’s view, and it recently passed the House of Representatives with a less-than-landslide margin of one vote. Round one goes to the Fed. Treasury Secretary Rubin has stated that unless the administration’s view prevails, he will recommend that the president veto the bill.

In Washington there is an old saying, “Where you sit is where you stand.” In this case, the views of the parties are clearly influenced by their current regulatory powersu00e2u20ac”the Treasury (through the Office of Comptroller of the Currency) regulates banks and the Federal Reserve regulates bank holding companies.

Before a House committee hearing Chairman Greenspan said, “It appears to be a very small issue, but it will determine the financial regulatory structure of the United States for the next generation.” No one questions that statement.

Not only is the structure of the banking system at stakeu00e2u20ac”but also who is going to regulate this new world of finance.

Both sides argue that their structure provides a safer and sounder system. My own view is that both structures will provide a reasonably safe system with little advantage going to either one. The same people and assets are involved; thus, how you arrange them should not make much difference as long as there is appropriate supervision.

Both sides argue that their structure is necessary to allow them influence over the banking systemu00e2u20ac”the Fed needs influence to maintain sound monetary policy and a sound economyu00e2u20ac”the Treasury requires influence to enhance the administration’s economic policy.

Both views assume that the financial system regulation should be “influenced” by other objectives of the regulatory agency. My thought is that regulators ought to have one objective: the safety, soundness, and efficiency of the financial system. Otherwise, conflicts can easily occur (e.g., whoever regulates the bank could easily tell the bank what type of loans, good or bad, to make).

The Fed argues that the federal subsidies of the banking system (the deposit insurance, the Fed window, etc.) should not be extended to nonbank operations through their subsidiaries.

If there is such a subsidy (and there is considerable debate on this point), it seems to me it can be extended up to the holding company as easily as it can be extended down to the subsidiaries of the bank.

It should be noted that bank holding companies are a U.S. inventionu00e2u20ac”no other major country uses this format, and it has inherent problems. For example, the FDIC is still fighting a lawsuit with the bond holders of the failed Bank of New England over the issue of whether the holding company directors violated their duty by putting holding company cash in the Bank of New England’s subsidiary when the bank got into trouble. There is always a basic conflict of interest between the bank and its holding company when both entities need resources.

Further, when problems occur and these big financial monsters need a rescue, because they are too big too fail, the bank subsidiary model is much easier for the FDIC to handle. When you take over the bank, you can take over all the resources of the financial conglomerate.

Perhaps the bottom line is that most banks would prefer the simpler bank subsidiary format because it is more efficient and eliminates layers of regulators. But if they move in this direction, the Fed will be out of the regulatory business.

This battle is likely to keep the banking modernization bill from becoming the new law of the land anytime soon. Perhaps a compromise can be worked out, but its outline is not apparent at this time. Round two will take place in the Senate this year. My vote (if I had one) would be for the Treasury viewu00e2u20ac”let the banks decide which structure is most efficient for the New World of finance.