Mr. Chairman and Members of the Committee!

I am delighted you have afforded me the opportunity to testify this morning on H.R. 10 and related bills.

The Committee is dealing with issues that have long been debated among you. The time for action is now, this year. In fact, legislation is overdue.

It is also true that legislation should not come at any cost. I will not disguise my concern that there are provisions in the proposed bills that would be far too high a price to pay for legislation. Specifically, that is the case with proposals that would open the door to banking and commercial conglomerates and expose the economy to new risks and the Federal Government to added costs.

In the interest of full disclosure, I should remind you that I am a director of a major commercial bank now and prospectively heavily engaged in investment banking. I am also a director of a large insurance company as well as two commercial firms. I have recently managed a small investment banking firm, and in the distant past, I once directed planning for a major commercial bank. During most of my professional life, however, I have been in Government with responsibility, directly and indirectly, for supervising and regulating banks.

Perhaps it is needless for me to add that I am not representing any of those particular interests today. Rather I want to draw on my experience from a variety of vantage points to concentrate on a few questions crucial to maintaining a strong, competitive financial system for the United States.

You have also suggested I focus my remarks on several key issues. Consequently, I will not take much time to press once again the general case for the Congress, at long last, to provide a coherent legislative framework suited to today's competitive and technological realities in the market for financial services.

What is at issue is fair and vigorous competition. But that is not all. We must not lose sight of the continuing need for a safe and sound banking system -- a system strong enough to maintain stability and independent enough to assure dispersed and unbiased sources of credit.

As you are aware, there has been substantial adaptation to change, with blurring of distinctions among financial institutions. But that adaptation has proceeded by fits and starts, dependent in large part on new interpretations of old laws by regulators. For lack of consensus on new legislation, Congress and the courts have accepted rather benignly those decisions even when they have altered almost beyond recognition previously settled regulatory approaches.

The Glass Steagall separation of commercial and investment banking is now almost gone, and overlaps between banking and insurance are becoming common.

There can't be any doubt that accommodation and adaptation has been desirable and necessary. But the ad hoc approach has had uneven results. Every new ruling has a way of exposing fresh inequities and creating new uncertainties. In the absence of clear and up-to-date Congressional mandates, there is seemingly endless squabbling in the courts. Unfortunately, in some instances, important safeguards are being weakened, and the playing field is uneven.

Nor can there be any doubt about another practical consequence of piecemeal regulatory relaxation. Some sectors of the financial service industry and particular institutions find themselves in an increasingly advantageous position competitively. Perhaps understandably, they have been losing enthusiasm for broad reforms. Why, they ask themselves, should they forgo present advantage and potential future benefits that may accrue from agency rivalries or court decision-making.

I trust that this Committee, with its unique oversight and legislative responsibility will reject those inherently divisive interests. The opportunity is here to provide clear and decisive leadership that reflects not parochial pleading but the national interest.

A key part of that interest, in the United States or elsewhere, has been to protect the nation's banking and financial system from systemic breakdown -- the kind of banking crisis that would gravely impair the growth and stability of the economy as a whole as well as place a heavy burden on the system of deposit insurance. Experience over the past 10 or 15 years in most industrialized countries has demonstrated just how costly banking crises can be in both economic and budgetary terms. As a result, efforts have been and are being made in international forums as well as within individual countries to reform and adapt regulatory structures. Important steps have been taken to assure adequate capital, to assess better new risks, and to facilitate necessary international cooperation. The Director of the IMF has recently added his authoritative voice to those of other observers suggesting weaknesses in the banking structure of developing and emerging economies present the prime threat to their growth and prosperity.

I emphasize all of that because I believe it essential that, in considering the appropriate regulatory structure for finance, you take care of the need to protect the stability of the system and to provide appropriate regulatory oversight. In the end, whatever the particulars of law, the Federal Government will not escape ultimate responsibility and cost when a banking crisis appears.

The main areas that you have asked me to address this morning -- the separation of commerce and banking, the proper approach toward holding company regulation, and the role for fire walls and other regulatory safeguards -- bear directly on that fundamental issue.

Commerce and Banking

The long tradition of American banking -- following the Anglo-Saxon pattern -- has been to maintain a separation of "banking" and "commerce". That tradition has been incorporated legislatively in the Bank Holding Company Act. Even when there has been no explicitly prohibitory legislation, as there is not in the U.K. and some other countries, the practice de facto has been to maintain a broad distinction between the providers of money and credit -- the banking system -- and the ultimate users of credit -- the commercial and industrial world.

In Germany, and to a lesser degree in some other Continental European countries, such linkages have been more common, although not general practice. In Japan the major banks have long maintained cross-holdings of equity with groups of commercial and industrial customers, rather typically forming "keiretsus" implying especially close ties of cooperation. Some banking systems in developing or emerging economies also have banking and commercial ties.

What immediately stands out from all this experience is that it is countries in the Anglo-Saxon tradition that have the most competitive, innovative, and flexible banking systems. It is their capital markets that are the envy of the world. No country can begin to match our system in the variety of large and small banks and other financial institutions, in the provision of risk capital in support of small and emerging ventures, and in providing narrow margins between borrowing and lending rates.

Moreover, our banks today are more profitable than in many years; with relatively strong capital positions, they increasingly are in a position to retire their stock. Should they need more capital, they have ready access to the markets on attractive terms.

In contrast, there is plenty of recent experience in other parts of the world to suggest the potential problems with banking/commerce links are not just theoretical. For instance the drastic decline in the value of Japanese stocks has aggravated pressures on bank capital, helping to retard economic recovery. The successive and very costly official rescues of France's largest bank have been greatly complicated by their ventures into commerce, including American movie making. Similarly, a few years ago one of Spain's largest banks with aggressive management pushing toward substantial industrial ties faced failure.

In Germany, significant severe and unexpected losses in industrial affiliates of banks could be handled without substantial systemic damage primarily because of the exceptional capital strength and the underlying profitability of its major banks. But I do not think that today many observers look to Germany or Japan for a model of an effective, innovative banking system. Quite the contrary. And it is an ironic fact that, just as some here would let down the bars on banks owning industrial firms or industrial firms owning banks, doubts have arisen in both those countries about the wisdom of such linkages.

One need not look abroad for illustrations of the dangers. Right here in the United States, it was not so long ago that savings and loan associations were provided authority under some state laws, and to a degree under Federal law, to make what were antiseptically labeled as "direct investments" -- in other words to take controlling interest in non-financial businesses. We had academic authorities, some sponsored by the industry, writing of the theoretical benefits of "diversification" into new businesses -- even as much of the activity took the form of real estate development, surely among the riskiest of commercial activities.

There were other important factors in the savings and loan debacle, importantly including imprudent and inadequately supervised commercial lending. But it is clear the non-financial businesses greatly contributed to the more than $100 billion dollar cost of stabilizing the industry. In the wake of the crisis, legislative and regulatory rules were tightened. But how much better to have foreseen the predictable problems. And how discouraging to see the proposals today for banks to undertake real estate development.

The main thrust of the legislation before you is to permit and to encourage a broadening of the powers of bank and so-called financial services holding companies. Organizations with commercial bank affiliates would be permitted broadly to enter into other areas of finance -- investment banking, money management, and insurance. Reciprocally, other financial firms would be able to acquire banks or otherwise compete directly in banking. That process has already, as you well know, gone very far under the impetus of technology and with the support of the regulators and the courts. But much remains to be done to even the playing field, to remove outmoded restrictions, and importantly to assure competent and suitably comprehensive supervision.

While a great many smaller and specialized financial institutions will remain, one highly likely result will be greater consolidation of the financial services industry. The clear corollary, it seems to me, is to reinforce, not weaken the importance of maintaining the traditional separation of banking and commerce.

This country has always had a strong aversion to massive concentrations of economic power. Pragmatically, we like lending decisions and the sale of bonds and stock to reflect independent and widely dispersed financial judgments, without the bias, conflicts of interest, and opportunities for self-dealing inherent in the business interests of affiliated companies.

As nearly as I can tell, there is no groundswell of political support for changing our traditional approach. Consumer groups, retired people, unions, small business and community organizations, are not to my knowledge supportive -- quite to the contrary. My sense is that most larger banks and other financial institutions are themselves doubtful of the merits of broadly combining banking and commerce.

There are, indeed, some insurance companies and a handful of investment banks that have ties to commercial firms and "non-bank banks". You have heard from a number of them that they would like to extend their operations more broadly into commercial banking. Some industrial firms would like direct access to the payments system, bypassing their existing banks and establishing an essentially captive source of credit for their customers. Banks and bank holding companies are typically much more highly leveraged financially than commercial firms, another perceived advantage of bank affiliation. But is any of that a sufficient reason for overturning a tradition that has served us well, of diminishing the role and strength of independent banks, of placing greater burdens on the system of deposit insurance? I think not.

No one is proposing that those financial firms with commercial ties lose any option they now have. This is not a "grandfathering" situation. In the context of the bills before you, investment banks and insurance companies will continue to be able to own commercial or industrial companies, and vice versa. Investment banks and insurance companies will be able to buy commercial banks. What they could not do is associate with both a commercial bank and a commercial firm -- and none of their competitors could either.

I know the force of these arguments is rather widely appreciated. Yet there is an urge to compromise, to try to somehow reconcile all the claims. I suggest to you that is just not possible. The proposals for various baskets involve highly arbitrary distinctions that cannot logically and practically be maintained. What is the logic for instance, of a basket that would permit a large bank to affiliate with large commercial firms, aggravating concentration and conflicts of interest, while a large firm could not be affiliated with a small bank? What is the relevant measure of size -- capital, revenue, employees, or something else and would not the appropriate measure vary industry by industry? What happens when the size of a commercial affiliate increases or the bank shrinks? Are affiliated commercial firms to be prohibited from growing or merging with another? What is the practical difference between the hundredth largest company and the hundred first, or the thousandth and the thousand first, and won't those rankings constantly change? If a bank can buy a commercial firm, shouldn't a commercial firm be able to buy or start a bank to handle its business, even it the net result is to weaken the system as a whole?

Surely, various compromises could be devised that so restrict bank/commerce combinations that the dangers of affiliation are de minimum. That may be the case with H.R. 10. But there simply can't be any doubt that, once the foot is in the door, the pressures to ease the necessarily arbitrary limits, lubricated by ever larger political contributions, will grow stronger. The fissures in the dike will erode, new compromises will be struck, and the risks and concentrations will inexorably mount.

I realize, at the margin, elements of administrative judgment will be required in implementing legislation separating banking and commerce. At what point, for instance, is the provision of computer services or management consulting sufficiently "closely related" to finance to permit its affiliation with a bank? But we have lived with those kinds of distinctions for years, and Congress can provide fresh guidance.

Moreover, regulators can be asked to make distinctions between controlling and non-controlling holdings of industrial or commercial firms. Congress should also set out the extent to which equity acquired in the ordinary course of underwriting and merchant banking activities might be permitted for a limited period. Present law already provides some scope for such activities and permits non-controlling holdings of equity.

That, it seems to me, is the key point. We can permit incidental and non-controlling equity holdings in the ordinary course of business. What we want to avoid is banking and industrial firms coming under common control, with all that implies for concentration of resources, biased lending decisions, and new risks for the stability of the banking system.

Holding Company Regulation

Rather comprehensive supervision and regulation of banking and financial institutions is commonplace around the world; it is the essential corollary of the official support provided in the face of threats to the stability of a banking system. Nor can there be any doubt that, whatever their ideological predispositions, major banks do benefit from and rely upon the presence of a Federal safety net in time of strain. To some extent, that has become the expectation of other regulated financial institutions as well.

Those facts have important implications for financial regulation. A business organization will be managed as a cohesive whole. They may be centralized or decentralized in operation, but one part is necessarily affected by the fortunes of another. And it is, of course, precisely the search for "synergies" in marketing, in production, and in joint use of shared resources that is the driving force for business combinations.

The clear implication is that, if the banking system is to be officially protected and supported, then the regulators and supervisors need to be concerned about the well being of the business organization as a whole. As a practical matter, it is neither desirable nor feasible that such regulatory oversight be extended into the commercial and industrial world. That is itself a powerful reason -- conclusive in my mind -- to avoid the bank/commerce affiliation.

The situation is different with respect to financial institutions which are already subject to official regulation, by states if not by Federal agencies. There are scores of such regulators within and among states; there are more than half a dozen at the Federal level with significant responsibility for enforcing prudential safeguards.

Obviously that diversity presents complications in regulating and supervising institutions ranging over many areas, functionally and geographically. But the number of regulators also reflects continuing realities. A variety of significant objectives are served and different agencies have different priorities and areas of competence. Moreover, the American style of government abhors unnecessary concentration of authority.

Recognizing the force of those considerations, I know of no support for the idea there be a single monolithic regulator of bank or financial services holding companies, as simple and logical an approach that in the abstract may seem to be.

The presumption of most of the proposed legislation is that something like the current regulatory apparatus will remain: the banking agencies will regulate and examine banks; the SEC will write the rules for disclosure and investor protection, the states will regulate insurance activities, including sales practices. All that amounts to functional regulation, and it is broadly appropriate and practical as far as it goes.

But disparate functional regulation is not by itself enough. The overriding and distinctively Federal interest in safety and soundness requires that some authority, armed with adequate authority, be charged with broad oversight and surveillance over the entire holding company. Otherwise, the clearly protected and supervised part of the holding company -- the commercial bank -- will be "blindsided" and potentially overwhelmed by crises originating outside the bank itself. That is what happened when "direct investment" destroyed so many savings and loan associations in this country. Similarly the woes of financial and commercial affiliates have disrupted and damaged a number of European and Japanese banks.

Conceptually, one might perceive of an approach toward this problem by authorizing and convening a sort of council of regulators, meeting regularly to exchange information and coordinate approaches. But practical experience within the banking area -- which should be easier -- strongly suggests that approach is neither efficient nor consistently workable. At the least there would need to be a strong lead agency with clear responsibility for enforcing coordination among agencies with disparate priorities, traditions and competence.

The more effective approach would be to designate one agency for oversight responsibility insofar as prudential considerations are relevant. Functional regulation for a variety of purposes could and should continue. Individual state and Federal agencies, equipped with appropriate legal authority and competence, would implement their particular mandates. The primary assignment of the oversight agency would be to work with those agencies to assure itself that their approaches are reasonably consistent and adequate to protect the safety and soundness of the whole. Moreover, experience has demonstrated that with even closer and more intense competition across traditional lines, there is a compelling need to seek "functional equivalence" in regulatory approaches in some areas.

By nature of their responsibility and interest, only the Treasury or the Federal Reserve would appear logical candidates for the oversight function. It will not surprise you for me to suggest that between the two, by virtue of its experience, its resources (financial and otherwise) and its relative freedom from client and political pressures, the Federal Reserve would be the logical choice.

Firewalls

One approach toward minimizing the need for supervision of an entire financial services holding company would be to erect so-called "firewalls" between a commercial banks -- the institution we most want to protect because of its core functions of money creation and operation of the payments system -- and its affiliates. Indeed, some common sense restrictions on financing of affiliates by commercial banks and other kinds of self dealing have long been part of law and regulation and are retained in H.R. 10.

At the same time, it is an illusion to think firewalls can themselves meet the need. That would require restrictions on lending and or other financing transactions with third parties, prohibitions on cross marketing and linked services, and even limits on the use of common names and symbols. Such strong firewalls would run right across the grain of what businesses want to achieve when they combine. Few managers would want to be truly passive owners of another business. They will naturally want to bring to bear the resources of the entire organization, including the bank affiliate, when any important part is financially threatened.

In sum, given the fungibility of money and the resourcefulness of financial managers, no practical system of firewalls can be fully effective in insulating a bank from the difficulties of its affiliates without, at the same time, strangling the business operations. Indeed, what we are seeing in practice is a tendency to ease or remove existing restrictions on inter-affiliate transactions and management interlocks.

Conclusion

In sum, Mr. Chairman and members of the Committee, the need for new legislation to define and direct the world of financial services is clear. Probably more than ever before, industry participants are prepared for reform and key elements of a consensus have developed.

In encouraging and nurturing that consensus, it remains crucially important that we not neglect the costly lessons of the past, that we not abandon a legislative and regulatory philosophy that has served this nation well, and that we guard against financial crises and systemic breakdown. In the end, as you well recognize, the object cannot be to satisfy every particular interest or respond to individual wish lists. Encouraging combinations of banking and commerce or dispensing with effective and coherent oversight of consolidated bank and financial holding companies cannot be sensible public policy.

If at the end of the day -- more accurately before the end of this Congressional session -- you are not satisfied that the broad public interest in strong, diverse, and independently managed banks and financial institutions will be protected and enhanced or that the risk to the economy and the future taxpayer will be reduced rather than increased, then the implication is clear: better no legislation at all.

But there is no good reason to anticipate that conclusion. It is your Committee that carries the main responsibility for steering the needed effort in the right direction. I urge you to do just that.