FROM THE OFFICE OF PUBLIC AFFAIRS

On the last day of 1896, a journalist embarked on a rogue steamship smuggling ammunition from the United States to Cuba. He had won fame recounting the American Civil War. Now he sought to witness Cuba's struggle for independence. But the ship sank, and the journalist drifted for days in a small open boat through the jagged, wintry waves of the Atlantic. As the boat neared the Florida coast, breakers swamped it, tossing the journalist into the sea. Cold, exhausted, gripped by an undertow, he contemplated his own death as a welcome relief. Here's how he described what happened next:

APresently he saw a man running along the shore. He was undressing with most remarkable speed. Coat, trousers, shirt, everything flew magically off him.

AThen he saw the man . . . come bounding into the water. . . . He was naked, naked as a tree in winter, but a halo was about his head, and he shone like a saint. He gave a strong pull, and a long drag, and a bully heave at the correspondent's hand. The correspondent, schooled in the minor formulae, said: 'Thanks, old man.'@

The shipwrecked journalist was Stephen Crane, author of The Red Badge of Courage. He described the rescue in a short story entitled AThe Open Boat.@ And, as it happens, the rescuer shedding what he knew would be the dead weight of his clothing was my great-great-grandfather, John Kitchel.

Now I'm not planning to talk about any financial shipwrecks here. Our financial system is healthy -- healthier than it's been for many years. But this ancestral disrobing provides a metaphor for current efforts to shed the dead-weight encumbrance of outmoded, overly restrictive laws like the Glass-Steagall Act and the Bank Holding Company Act.

Strengths of Our Financial System

I'd like to begin by talking about the strengths of our nation's financial system. Let me name six of those strengths, and put them in a global perspective.

First, we have the broadest, deepest capital markets in the world -- capable of financing innovation and growth at relatively low cost.

Second, our financial workforce is highly skilled, from the backroom to the boardroom. It's a tremendous, and often under-appreciated, resource.

Third, our financial institutions and financial markets are highly competitive and responsive to customers' needs.

Fourth, our nation's consumers are knowledgeable and demanding.

Fifth, our system has, to a great degree, democratized credit. Most people in this country have access to some form of credit. Credit is not, as it once was, the preserve of the affluent. That's not to say the system works perfectly. It doesn't. But compared to many other countries or to this country a century ago, consumers in the United States generally have very good access to credit.

And sixth, our financial system is remarkably innovative and adaptable. (Of course, given our legal and regulatory structure, it has to be.) Americans remain the Thomas Edisons, the Henry Fords, even the Michelangelos of the financial world.

Outmoded and Overly Restrictive Bank Structure Laws

Against the backdrop of these strengths, our financial system does have some very real shortcomings. One of the more conspicuous shortcomings is a set of outmoded and overly restrictive bank structure laws, notably the Glass-Steagall Act and the Bank Holding Company Act. As I will contend, these laws dampen innovation and impose needless costs -- costs not necessary for safety and soundness or anything else worth having.

Now that's a bit ironic because, as I've indicated, innovation and adaptability are hallmarks of our financial services sector. Naturally, financial institutions put this same ingenuity to work inventing their way around, or flourishing in spite of, outmoded legal constraints. As Adam Smith noted 220 years ago:

AThe uniform, constant, and uninterrupted effort of every man to better his condition, the principle from which public and national, as well as private opulence is originally derived, is frequently powerful enough to maintain the natural progress of things toward improvement, in spite both of the extravagance of government, and of the greatest errors of administration.@

But spending time devising ways to circumvent Glass-Steagall and the Bank Holding Company Act diverts resources that financial institutions could more productively employ elsewhere. It's the financial services equivalent of swimming in the Atlantic fully clothed.

Expertise in circumventing laws and regulations has much more limited utility than other financial innovation. If you develop electronic money or home-banking software, you could potentially market some variation of it worldwide. But you'd sure have trouble exporting Glass-Steagall avoidance techniques, or the latest strategies for coping with Regulation Y. Since other countries don't inflict the same constraints on themselves, they have little use for these innovations.

The fact that our bank structure laws are out of date is not for lack of trying. And we can take satisfaction that in 1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act largely resolved a debate over geographic restrictions on banking that went back more than a century -- perhaps the longest-running battle in American banking law.

Forces Transforming Our Financial System

Nonetheless, even after decades of debate, our bank structure laws still fail to provide the structural flexibility needed to maintain efficient production and satisfy customer convenience. This failure becomes all the more glaringly apparent when we consider the profound changes now occurring in our financial system.

The financial services industry looks very different today than it did a decade ago because of some very powerful forces beyond its control. I want to talk about three forces in particular: technological innovation, financial innovation, and globalization. That's hardly an exhaustive list, but it illustrates some of the key issues. Let me walk through them with you.

Technological Innovation

The first -- and perhaps most significant -- force for change is technological innovation. It has a remarkably broad reach. Technology has connected global markets, driven down the cost of backroom operations, brought us ATMs. It's at the forefront of electronic money and electronic banking. And technology may well be creating economies of scale and scope that could drive consolidation within the financial services industry for many years to come.

Much of the technological revolution has centered on information technology. We can process and communicate information more quickly and cheaply than ever before. And that brings us closer to the frictionless capitalism described by Microsoft Chairman Bill Gates, in which increasingly well-developed electronic markets link buyers and sellers directly.

This information revolution has profound implications for financial services. Think of how bank lending originated. People with money to lend often couldn't assess the credit of people who needed to borrow. But they knew the bank's credit -- represented by its reputation for meeting all its obligations. Moreover, the bank, as holder of its customers' deposits, enjoyed unique access to information on potential borrowers' financial condition. That informational advantage was its stock in trade.

What does it mean for banking, then, if information and communication improve to the point that investors, and borrowers, and other participants in financial markets can link up with one another much more readily than in the past? Of course, that's exactly what happened with large corporations' commercial borrowing. Corporations turned from commercial loans to commercial paper. But it does appear that this process -- this disintermediation -- will spread into new areas. If market participants can communicate directly with one another, share information, buy, and sell almost effortlessly in a virtual marketplace, then we have to expect that the pace of disintermediation will accelerate. As former Citicorp Chairman Walter Wriston noted a decade ago:

AThe technology that creates, transmits and stores the almost unlimited and constant flow of data will neither abate, slow down, nor stop. . . .

AIf we in the banking business are to do anything but try to protect old turf and hold on to yesterday a little longer, we have to address the real issue of operations in a changed world. The real issue is that the information society is robbing us of our comparative advantage and we have to find new products and new customers to survive over time.@

Financial Innovation

Technological innovation has also played an important role in facilitating financial innovation, a second major force for change. Let me use one example. Thirty years ago, Americans couldn't legally own monetary gold. Today, they can buy CMOs, MBSs, floating rate bonds, interest-only and principal-only strips, financial futures, options on indexes, knock-out call options, caps, floors, collars, income warrants, dual currency bonds, commodity-linked bonds, yield-curve notes, interest-rate swaps, currency swaps, equity swaps, floor-ceiling swaps, ratio swaps, spread locks, wedding bands, swaptions, and, yes, even a Libor-squared turbo swap.

It's a dizzying array of financial products. And some recent episodes make clear that those who use them don't always understand what they're doing. But these seemingly exotic instruments, properly used, play an important and legitimate role in managing risk. Financial innovation has meant lower costs, greater flexibility for users, increased liquidity, and better risk allocation. Yet the complexity of many of these financial products has perplexed regulators. For example, are institutions using those products to hedge existing risks or to create new exposures? Often it's hard to say. This presents enormous challenges for regulators and has contributed to the federal banking agencies' decision to orient examinations more toward assessing banks' systems and procedures for managing risk and less toward detailed analysis of current portfolios (which can, after all, change very rapidly).

Globalization

Globalization is a third force transforming our financial system. As in every other line of commerce, global financial competition promises enormous benefits for consumers in the form of better, more varied, and less expensive services. Financial markets are increasingly integrated, with large volumes and ranges of financial instruments being traded across borders. Firms today can Apass the book@ and engage in 24 hour trading in markets around the globe. Large multinational offerings of stock are commonplace and mutual funds have strong international components as investors chase the higher returns of riskier emerging markets or seek to invest in equities on the London or Tokyo exchanges. In some recent years, foreign institutions supplied 30 percent or more of the dollar amount of commercial and industrial loans to U.S. borrowers.

Of course, this increased globalization carries with it many risks, as well as many opportunities. Today financial services increasingly operate in an enormous, unpredictable market. As financial markets become even more integrated, and even more globalized, numerous questions arise: Could new challenges to systemic stability arise? What is an appropriate regulatory scheme? How should home countries and host countries allocate responsibility for various supervisory functions, including the lender of last resort for domestic offices of foreign institutions? We must think through these and other issues very carefully.

Some Implications

These changes have dramatic implications for our financial system, and I'd like to touch on several of them.

Disintermediation is virtually certain to continue, reducing the role of traditional financial intermediation and increasing the role of informational intermediation. In short, knowledge is power, and those who deal in information -- for example, non-financial firms such as developers of computer software -- will be important participants.

The convergence of different types of financial services and financial institutions will continue, thereby undercutting the existing regulatory structure.

This still leaves us with a specific problem: Markets have changed, and customers' needs have changed, but financial intermediaries remain constrained by antiquated laws designed for different circumstances. Of course, this has led to calls for financial modernization -- which in Washington is often equated with repeal of the Glass-Steagall Act.

In Glass-Steagall we have an easily identifiable target -- the separation of commercial and investment banking. And we want to remedy the problem.

But we still need to ask the following question: Is Glass-Steagall reform what we need for the next century? Is it responsive to the changes that have occurred, and continue to occur, in the financial services industry? You can answer that question in two ways.

The first answer is: Yes. Glass-Steagall repeal is a necessary, long overdue part of financial modernization. Glass-Steagall is an artificial constraint, imposed under dramatically different circumstances, that raises financial institutions' operating costs. These increased costs are not justified by the Act's contributions to safety and soundness -- a conclusion supported by a long and growing list of empirical studies over the past two decades. Despite the old conventional wisdom to the contrary, the evidence does not indicate that securities activities contributed to the banking collapse of the 1930s. Nor does the evidence indicate that we need to segregate such activities in a holding company subsidiary to protect banks from the risks of those activities. Maybe some day, when you peruse an economics textbook on CD ROM, you might just click on the words Amisallocated resources@ and get pictures of Carter Glass and Henry Steagall.

The second answer is that Glass-Steagall reform as currently proposed -- accompanied by scores of statutory pages specifying how to conduct the activities and prescribing a cumbersome structure for organizations that choose to offer them -- is a short-term fix that represents only a marginal improvement over what a decade or two of regulatory and legal rulings have already put in place.

Looking ahead, what we really need is a regulatory and legal structure that will bring us into the 21st century -- a structure that will support the institutions and products that comprise the future financial services industry in such a way as to promote efficiency, stability, and equity. Globalization and disintermediation are realities. But is the regulatory and legal system equipped to meet their challenges?

I can't tell you what the financial services industry of the next century will look like. I don't have a crystal ball. But I can tell you that it must, by and large, be shaped by the market -- not the government. Certainly, the government will continue to address such issues as safety and soundness, systemic stability, and access. But the government also needs to create a legal and regulatory structure that enhances free-market competition.

Financial modernization in that respect is an issue for the long-term, but we should be addressing it right now. If we wait too long, we run the risk of falling behind our competitors around the globe, who operate in the same global marketplace but without the same restrictions.

My concern is that the bill currently pending in the House would have the effect of locking the financial services industry into the 1980s or early 1990s. This bill provides some nice irony. It's being advanced in the name of modernizing our financial system. Yet its very premise is an archaic segregation of financial services. It segregates deposit-taking from securities activities, and reinforces the separation of banking and insurance. This flies in the face of serious research on the subject and the direction taken by virtually all other major industrial countries, both of which suggest the desirability of allowing such combinations to facilitate integrated risk management or to achieve potential economies of scope.

Yes, let's modernize our financial system. But let's not do it in a half-hearted way that would actually impede future change. The cost of taking a few steps forward should not be having our feet nailed to the floor. Let's shed the dead weight and move on.