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When Rep. Jim Leach steps down from his post as chairman of the U.S. House Committee on Banking and Financial Services at the end of this year, he will do so knowing that his name will be forever linked with one of the most important pieces of banking legislation enacted during the preceding century.
The Financial Services Modernization Act (or Gramm-Leach-Bliley), signed into law at the close of last year, not only overturned Depression-era legislation that had so shaped the industry throughout the century, but also established rules that will greatly affect the future of the financial services industry.
The Iowa congressman first began pushing for a financial modernization
bill in 1995, when he assumed the chairmanship of the House Banking
Committee, and as he notes in the following interview, his intentions
were more than to revamp old laws: He wanted the bill to establish
certain ground rules for banking's evolution. From defining which
financial institution can sell what type of financial product,
to answering questions surrounding privacy and community reinvestment,
the Act has changed the rules for years to come.
Rep. Leach recently discussed those new rules, and many other issues, in a conversation with Gary Stern, Minneapolis Fed president. The following discussion reveals, among other things, that Leach does not see the need for immediate follow-up legislation to address a "corrections agenda," that privacy issues have been well addressed in the bill, and the notion of merging commerce and banking is easy to advocate "until the public finds out about it."
STERN: When you took the reins of the House Banking Committee in 1995, you introduced the initial modernization bill. What led to your interest in that legislation and what did you hope to accomplish?
LEACH: My sense was that the Congress in the 1930s introduced arbitrary and uncompetitive elements into the landscape of finance and that the American financial system could be made more competitive internally as well as externally. The original Glass-Steagall Act had been precipitated by conflicts of interest that were perceived to have existed at the time of the Great Depression, but subsequent analysis indicated that those conflicts were not as pervasive as was assumed at the time. Indeed, in retrospect, it would appear that Glass-Steagall was rooted more in resentment than need and that with each passing decade the barriers to competition it introduced into the delivery of financial services increasingly skewed and misserved the market.
As products that bankers were precluded from offering found favor, commercial banks inevitably lost market share. Particularly in the last three decades of the 20th century, American savers moved markedly away from making commercial bank deposits to preferring other types of savings and investment instruments. The question for bankers became one of whether they preferred staying in a market niche that was partially sheltered, but diminishing in size, or whether they could accept becoming less sheltered competitors in a broader financial services industry.
Aspects of the debate about the wall that was erected between commercial and investment banking began immediately on passage of Glass-Steagall; but nuances developed with a changing market environment. For instance, one of the changes that occurred over the decades was that Glass-Steagall reform, which had originally been considered principally an issue of competitive concern to large institutions such as Morgan Stanley and J.P. Morgan, came to have increased implications for smaller institutions and the customers they serve.
If you take the great Middle West, for example, arbitrary barriers in finance made modern financial products less accessible to consumers. The average Midwestern manufacturing company has excellent relationships with its commercial bank, but virtually no relationship with an investment bank. By allowing institutions to combine commercial and investment banking services, Midwestern businesses will have more access to more financial products.
STERN: What other issues did you hope to address through financial modernization?
LEACH: There are other kinds of issues that came into play in legislation of this nature. For instance, I've always believed in expanding the realm of competition within finance, but have not been one who favored merging banking and commerce. This issue involved differing judgments as the bill went forward, both with regard to putting constraints on new powers, as well as reconsidering existing charter arrangements. That is, loopholes in the current law existed which allowed the expansion of commerce and banking through the so-called unitary thrift provision. The final modernization legislation not only refrained from authorizing the expansion of commerce and banking, but closed the most significant existing aspect of law that allowed it. The Gramm-Leach-Bliley Act was designed to increase competition within finance and at the same time preclude an excessive expansion of bank powers outside of finance. While the Glass-Steagall wall was breached, a unitary thrift barrier was erected.
STERN: On the unitary thrift question, I can understand from the bankers' point of view, particularly the independent bankers' point of view, why that legislation was very important. On the other hand, how should consumers feel about it? I can see where consumers might have liked the idea of being able to bank at Wal-Mart.
LEACH: Well, first of all, let me stress that the issue isn't whether you can bank at Wal-Mart; the question is whether or not Wal-Mart is your bank. Those are separable questions.
STERN: Fair enough.
LEACH: I don't see any case for merging banking and commerce in this country. I am for a healthy, vibrant, competitive model within finance, but not a system which would inevitably lead to an uncalled-for concentration of asset ownership in America.
If you believe in allowing anyone to do anything, you have to look at the models in finance and commerce that have existed around the world. The places that have allowed it have experienced great losses to the public treasury as well as great conflicts of interest within their own financial systems. I see no economies of scale and no consumerist case to be made, for example, for Citigroup to merge with General Motors and Wal-Mart, whereas there are economies of scale that can be put on the table when a commercial bank is allowed to offer investment banking and insurance services, and vice versa.
Gramm-Leach-Bliley is a three-way street for competition within finance, but a closing of the barriers to the Keiretsu model of Japan, and the banking and commerce model that has developed on parts of the Continent, which has stultified aspects of the German economy and cost the Spanish and French taxpayers billions of dollars to rescue banks which imprudently thought they could invest in and manage well commercial enterprises.
While the public did not follow the commerce and banking issue, I cannot overstate its importance to me and how close the Congress came to making what I believe would have been one of the gravest legislative errors of the century. After all, the modernization approach I introduced five years ago was opposed by the Treasury, powerful parts of the banking system and key congressional leaders of both parties because it didn't sanction the integration of commerce and banking. Secretary Rubin and the Treasury pushed strongly for the merging of commerce and banking and the Fed initially acquiesced to a so-called basket approach, which represented a partial merging which inevitably would have been extended further. But, as time evolved, the Treasury reversed its position and the Federal Reserve modified its stance and both eventually came out against any modernization approach that would allow the merging of commerce and banking. Of all the things I am proud of in my tenure as House Banking Committee chairman it is that in the end the world's two greatest governmental institutions of finance revised their initial positions and not only ended up concurring with my position on this issue, but established unequivocal positions in favor of an independent financial sector.
My concerns on this subject relate far more than to past experiences in other societies where taxpayer resources were jeopardized when explicit and implicit deposit safety nets expanded to activities beyond the banking system. My paramount concern is that modern finance has gotten so sophisticated in its ability to leverage ownership relationships that asset concentrations could be precipitated in short order throughout society if the financial industry becomes a handmaiden to commercial interest.
The first modernization bill that I passed out of committee five years ago did not have a commerce and banking provision, but the Republican leadership objected because it wasn't perceived to be sensitive enough, in their view, to a combination of small insurance agent, large bank and unitary thrift interests. In the next Congress, the committee moved in the direction of banking and commerce. I considered this a fatal legislative error and prevailed on the House floor in knocking the banking and commerce "basket" provision out of the bill at the time, but unfortunately the final product couldn't muster Senate support to become law.
But, fortunately, just as the House, the executive branch and the Fed shifted on the commerce and banking issue, so did many of our large banks. You are correct to note that small banks have been against the commerce and banking model for a long time while many large banks embraced and argued for it. But two years ago I put out a statistical analysis, which indicated, based upon market capitalizations of various kinds of companies, that pointed to the near certitude that if the banking and commerce model were adopted, banks would become the acquired, not the acquirers. And by "banks," I mean all banks. Even, or perhaps particularly, the independence of Chase Manhattan and Citigroup would have been immediately in doubt.
Within weeks of adoption of a commerce and banking principle, companies such as Microsoft, AOL-Time Warner, BP-Amoco or GE would knock off every major bank in the country. Although they naturally don't prefer to advertise their vulnerability, the top leadership in the major banks now fully recognize this circumstance and their advocacy of mixing banking and commerce is, for the time at least, quieted.
In sum, on this seminal issue, an evolution in judgment in the Treasury, a partial reconsideration at the Fed and an enormous reversal of thought in the larger banks has occurred, and I am extremely thankful. I stress this commerce and banking issue because I believe it alone to be more significant than the entirety of change wrought by the Gramm-Leach-Bliley Act. If Congress would have reached another judgment on commerce and banking, I would have done everything in my power to pull the plug on the bill.
STERN: Let's talk about the financial services business per se for a minute. Do you think that we're going to see most of the action on new delivery of financial services, or on a new range of products and services that are delivered? And then, which institutions are going to wind up as the major players in the financial arena when all is said and done?
LEACH: The answer to the first question is going to be both. You're going to have new arrangements as well as new products, and the only certitude in finance is that there's going to be continual change. In terms of winners and losers, I think a counterintuitive circumstance could develop. Those most on top of technology will have advantages, also those most in touch with their customers. The delivery of financial services is, in many ways, no different than that of soap. A company must have a good product, but also market strategies that reach people to make a sales approach work.
The circumstance in American banking that has been missed by many is that the big have gotten bigger from the top down through mergers, but at the local level, market share has been eroded for the large and increased for the small. Community banks and credit unions are doing quite nicely. I believe that community banks, including de novo institutions, have a very strong future for a number of reasons. One is that in this world of brand names, there is no better brand name than the State Bank of Hometown. Community banks that are on top of technology and have good ties to customers and good market-mix strategies may be best positioned to do well in the new financial order. And, based upon the phenomenon that market capitalization for banks is well above book value, enormous incentives exist for de novo institutions to be formed. In theory, if an investor can put x capital into a new institution, and it becomes viable and valued as other banks at double or more of book, a lot of entrepreneurs will be incentivized to establish de novo institutions. In addition, the negligible cost of deposit insurance due to the fact that the insurance fund has reached its statutory 1.25 percent of assets reserve level means that new institutions will hold as an asset a claim on an insurance system that their older institution competitors paid for.
In terms of winners and losers in the financial landscape in the next generation, the primary reason one institution will do well or less well relative to another will relate to technology and customer service rather than changes in law. While the law has just been changed dramatically in relationship to prior law, the change in legal framework that has occurred is more modest in relationship to market practice. The markets got ahead of the law and Gramm-Leach-Bliley simply represents a partial catch-up. What it principally has added is legal certainty, competitive equality and a more flexible regulatory approach designed to adapt more pragmatically in the increasingly competitive global financial system.
STERN: Let me shift gears and get to a public policy issue that we at the Minneapolis Fed have been concerned about for probably 20 years or so, and that's the so-called moral hazard problem. The problem is that if you grant banks new powers before you provide the proper incentives—that is, curb the moral hazard that's inherent in deposit insurance—that's akin to putting the cart before the horse, and is likely to not work very well from the taxpayer's perspective. Do you share those concerns?
LEACH: Well, it would appear that there have been banking mistakes of some size about every generation, and some, but not all, have related to moral hazard issues. That's one reason attention must by necessity be placed on prudential regulation. In this regard, it's of importance to stress that deposit insurance is designed to protect depositors, not owners. Nobody wants any institution to be considered too-big-to-fail, but if government, for whatever reason, finds compelling rationale to intervene in a market economy, it must be with private sector as well as public accountability. The system may require stabilizing acts, but owners and managers must be held accountable for market misjudgments. I support deposit insurance because, as we learned in the '30s, an average family's savings should not be at risk due to a downturn in the economy or a bank manager's error. This is an issue of compassion for the family that in the aggregate can have enormous confidence implications for the banking system. That is why I remain a strong advocate for the maintenance of deposit insurance.
STERN: We haven't advocated its removal or even its reduction, but we have tried to think of ways that would bring more market discipline to bear on insured institutions, to banks in particular. But the legislation does seem to at least acknowledge, maybe more than acknowledge, the issue. Explicitly, it ties the powers available to the subsidiaries of the 100 largest banks to their bond rating. There's a study mandated for the Treasury and the Federal Reserve to look at the use of subordinated debt to further enhance market discipline. It seems there is at least an implicit concern in the bill because institutions aren't given carte blanche, and because, as I'm sure you know, the subordinated debt proposal has some advocates at the Fed and elsewhere.
LEACH: Well, there is a technique of using subordinated debt as a measure of a company's ability to access the capital markets. There are other techniques that can be used, too. I'm for any reasonable approach to getting as much market accountability as possible, and certainly there are some techniques we use that other countries don't. We take some things for granted such as bookkeeping transparency that other societies don't. A country like New Zealand has largely diminished regulation of its financial system based upon new transparency rules for banks. That added transparency apparently has caused financial companies to seek prudential levels of capital because they found that good capital levels have been rewarded in the stock market. This emphasis on transparency instead of intrusive regulation fits New Zealand society. Whether it fits our society or any other as well is quite another matter.
Counterintuitive, for instance, to past models, a number of publicly traded banks have found that the less capital they have relative to assets, the more they are rewarded by investors who like leveraging. Hence stock market strength may, in some cases, be in inverse proportion to capital strength for particular institutions. There are, of course, limits to how stretched a bank can prudently become and this is a reason for responsible regulation. Regulators simply cannot assume that a bank's strength relates to its market capitalization rather than to its actual capitalization because if a bank errs or the economy turns sour, market value can quickly plummet. Hence, I've always been one who favors solid capital cushions, though I recognize that an increasing number of institutions have been rewarded in the market by diluting their capital.
STERN: That's counterintuitive?
LEACH: There are examples in all directions. J.P. Morgan has found that customers and credit providers appreciate its higher level of capital. Other banks are finding it more productive and beneficial to stockholders to increase dividends or buy back stock with what they perceive to be excess capital. And, the stock market in recent years rewarded these strategies. This is yet another reason why it is important for the taxpayer and the system as a whole to have reasonable regulatory rules as well as reasonable regulation.
STERN: I would certainly agree with that. Let me ask you to expand upon this: You recently said, "I doubt we will have combined oversight until there is some shakeout in the financial sector from the legislation." What shakeout might we expect?
LEACH: Well, I don't recall that quote [laughter], but I don't view a shakeout occurring related to legislation. The main changes that are occurring in finance relate to technology, but the main reason for consolidation in banking in most of the country, rural areas in particular, relates to one phenomenon alone: estate planning. When a community banker reaches an age at which he wants to retire, his options are to sell, usually over time with enormous tax liabilities, to a subordinate or exchange stock, at a premium with no tax consequence, to a regional bank. The president usually owns 10 percent to 50 percent of the stock and board members much of the rest. The only people happier than the banker to sell for stock are those on the board. Consolidation of financial institutions in the Midwest has been led, for the most part, by those who spent their lives committed to community banking arrangements. But the rural phenomenon that is growing is that when a community bank sells to a regional one, individuals in the town or banks in nearby communities look at the sale as a market opportunity and consider moving in or chartering a new bank. Community banks have found it easier to compete against the big than their brethren.
In any regard, the consolidation that has occurred to date in banking has thus related to prior, not new, law.
STERN: You mean through interstate banking?
LEACH: Yes, largely through the interstate banking provisions of the Bank Holding Company Act, but also through statutes that pertain to thrifts.
We will, of course, see further changes based upon the increased ease by which banks will be allowed to unite with securities companies and insurance companies. But this trend has evidenced itself without modernization legislation. After all, we have the Citigroup model which includes not only Citicorp and Travelers, but also Salomon. So you have that model in existence, and now we will see other examples of this model come into play with greater regulatory ease. But most importantly the modernization legislation puts in place a functionally regulated framework that provides a finely tuned balance with regulatory flexibility to adjust rules to changing circumstances.
STERN: You mentioned regulatory framework—do you think that there are going to be turf problems as that framework is developed? Or, on the other hand, do you think that maybe this regulation—or the supervision—will wind up being too specialized, and so if you have an institution that gets into trouble, you'll have a very serious coordination problem simply because of the number of agencies involved?
LEACH: The nature of regulatory bodies is surprisingly more competitive than people would surmise. While in the private sector issues often relate to the maximization of profit, in the pubic sector maximization of power concerns too often came to the fore. Indeed, at every point in the road this legislation traveled upon turf battles were underestimated, between the Fed, the Treasury, and the Securities and Exchange Commission (SEC), as well as with state banking, insurance and securities regulators. What the legislation established was the definitization of relationships. There will always be some tension. Unresolved issues, for example, exist now in the derivatives oversight area. Congress is going to have to take a hard look at this particular issue, as it relates to the proper locus of governmental oversight over product offerings, as contrasted with issues related to the right of parties to enter certain markets. The exact relationship of the CFTC [Commodities Futures Trading Commission], the SEC and banking regulators with regard to derivative products and exchange markets will necessitate further legislative action. But, for the first time, we have certain models for resolution in place on these issues, and the intent of the Gramm-Leach-Bliley Act was to press regulators toward a more cooperative and coordinative stance, as well as a recognition of functional roles.
STERN: Let's talk about consumers a little bit. Some people have expressed concern about what they think are the implications of the legislation for consumers on the privacy front and on CRA. How do you feel about those things?
LEACH: First, the privacy issue: This legislation has the strongest privacy provisions of any modern statute. A largely unnoted feature of the bill is that the privacy provisions come into play with all activities defined as financial in nature, both for those activities conducted by a bank as well as for those conducted by a nonbank. For instance, if a bank offers travel services, the privacy features apply not only for the bank's travel services function, but also for all travel agents in America. With regard to the "financial in nature" definition, which is a signature part of this bill, as it provides for expansion of future financial activities of banks and financial holding companies, the privacy features apply to each new activity that will come into being for the financial institution as well as for nonfinancial companies that offer similar services or products.
In theory, for instance, and this is not a credible example, if the Fed approved a bank getting into funeral services as a "financial in nature" activity, the privacy provisions would come into play for the funeral services of the bank as well as for the general funeral services industry. The privacy provisions of the bill are not only strong, but because of the new powers adaptations that will occur over time, they will inevitably get stronger even if no future legislation on this subject is adopted.
On CRA, the bill basically maintains the CRA obligation without dramatic change. However, several nuances were advanced: (1) CRA recipients will be subject to greater "sunshine" in how they use funds; (2) banks will be subject to CRA review if and when they seek to become a financial holding company; (3) community banks with satisfactory ratings will be reviewed every four, instead of three, years.
STERN: Do you think there will be further legislation addressing financial services coming forward in the next year or two? And if so, what type? What is out there that still needs to be addressed?
LEACH: First, I don't visualize a corrections agenda for this bill in the next year, and possibly longer, for several reasons. One is that this bill took a long time in development and most of the subtleties were dealt with during this lengthy review. Secondly, the hallmark of the bill is flexibility, particularly for the regulators, where nuances can be expected to be resolved. There is still some support among a few on Capitol Hill for the extraordinary issue of mixing commerce with banking. As I indicated, I believe a great strength of this bill is the number of causes such as this that it didn't include. But, I would note that mixing commerce and banking is an easy thing for any member to advocate until the public finds out about it. There is simply no support in the American public for concentration of ownership, and I am convinced it would be a liability for any political party or any individual to identify strenuously with that principle if it was ever thought that it might become a reality. Up to that point in time, it's kind of an esoteric "freebie" advocacy issue, but if the public ever thought it would pass, woe be to the advocate.
STERN: That doesn't sound like it has much of a future. Is there anything else you'd like to mention as we wrap this up?
LEACH: Well, I believe it deserves stressing that the role of the Federal Reserve as an independent regulator has been preserved. It is my view that if you take political science in the 20th century, the greatest institutional model contributed by America was the decision made by Congress in 1913 to establish an independent Federal Reserve. That decision has made this country stronger and contributed significantly to global economic stability. The role of the Fed in regulation, as opposed to monetary policy, can in theoretical terms always be challenged, as it has been on the Continent. On the other hand, one of the aspects of the Fed that I appreciate is a professionalism and an independence that has served the country well. We change institutional balances at great risk, particularly if change includes a greater prospect of politicizing regulation.
In this regard, it should be noted that in an emergency the U.S. Treasury is a misnomer: It has no treasury unless Congress acts. The Fed, on the other hand, has the capacity to liquefy the world at its own discretion, based on existing statute. Hence the Fed, as a regulator, is particularly important in difficult times. Alan Greenspan is properly getting a great deal of credit for his stewardship of macroeconomic policy, but care should be taken to recognize that the strength of the Fed is its independent authority not any particular head. This may be "The Age of Greenspan" and Alan surely is the strongest and most important Fed chairman ever, but the world depends more on the existence of an independent Federal Reserve than the wisdom of its chairman, as great as it currently is.
And that relates to the importance of the Fed in its financial regulation role, as well as to the formulation of monetary policy.
STERN: We certainly understand that.
LEACH: Here the quality and professionalism of the staff at the regional Federal Reserve banks, such as your own, is greatly appreciated.
STERN: And we appreciate the kind words. One further item before we go: In the Federal Deposit Insurance Corp. Improvement Act, depending on circumstances, of course, when the Fed needs to act in, say, large-bank problem situations that might have systemic implications, the Fed does need the approval of the Secretary of Treasury and the administration, as well.
LEACH: What has occurred in this bill, as a balancing powers compromise between the Fed and the Treasury, is that the Fed's regulatory turf has been protected, but the policy involvement of the Secretary of the Treasury has been somewhat enhanced in recognition that the Treasury reflects electoral accountability as an important arm of the executive branch. The Fed and the Office of the Comptroller of the Currency will split regulatory roles, but the Secretary of the Treasury will come to share certain policy accountability with the chairman of the Fed.
STERN: Thank you very much, Congressman Leach.
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