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Madame Chairwoman and Members of the Subcommittee:

For virtually all my adult life -- as student, as banker, as teacher, most of all as a Treasury and Federal official -- I have been concerned with matters of banking regulation and supervision. I have been among those regulated, today as a bank and insurance company director. More often, I have been among those doing the supervision. In between, I've sometimes been a sponsor and participant in independent analyses and research-

Your responsibility today, and mine, is not to look back but to look ahead into the twenty-first century. But as you might expect, my experience over the past half century has confirmed the wisdom of certain principles that have long provided the conceptual bass for American bank regulation. As I see it, the essence of effective reform is not to abandon those principles but to adapt them to the circumstances of today and tomorrow. I welcome the invitation to appear before you today to develop that point.

I recognize that the process of reform has been long, contentious and tedious. It must be as frustrating to you as it is to me that the agenda before you -- including notably Glass Steagall repeal, the scope of bank holding company activities, and the locus of supervising authority -- is hardly different from when I used to appear regularly before this Committee as Chairman of the Federal Reserve Board 15 or so years ago. Legislatively, we have been stuck near dead center, frozen amid the interplay of particular interests, each amply financed and represented. What has been lacking is the will and capacity to cut through those competing claims to reach a consensus demonstrably in the general interest.

What has not been frozen -- what can't be frozen -- is change in the marketplace. As you well know, the combination of new technology and an innovative spirit, each in ample supply and richly rewarded, has greatly speeded that process. New ways of doing business, within and around old institutions and regulations, is the order of the day. In response, a few piecemeal adjustments have eventually been made in law; more often regulatory authorities and the courts, sometimes stretching established interpretations of law beyond recognition, have tried to play catch up.

That market driven process, while following no coherent legislative design, has had useful results. Markets and institution are in fact more competitive and innovative, with more new products and services, than if they had been frozen in time. But I don't think anyone would argue the result is optimal, whether on grounds of effective competition, fairness, or safety and soundness.

Now happily, there is a new opportunity for action. Market and political forces seem now to be coalescing in a way consistent with thoroughgoing rationalization and revamping of the legal structure surrounding the whole financial services industry. Quite obviously, this Subcommittee can play a key role in capitalizing on that opportunity by clarifying the issues and cultivating consensus.

I do not intend in this brief statement to enter into all the detail. I do not deprecate the importance of that work, which is bound to occupy much of your attention in the weeks and months ahead. But I want this morning to emphasize that not all "the devils are in the details". What is fundamentally important is some understanding of the basic legal and regulatory philosophy that should drive the effort. without such an understanding, the ability to reconcile or if necessary to override the competing private interests will be limited, once again placing constructive and comprehensive legislation beyond reach.

I will emphasize this morning just a few key elements that, taken together, should provide much of the conceptual framework for new legislation. In particular, I want to remind you of the continuing importance to the financial system as a whole, and to the economy generally, of certain core functions long associated with commercial banking. Banks are creators of money and the main conduit for monetary policy. They operate the payments system nationally and globally. They can be mobilized to provide needed liquidity or required to restrain credit in response to changing economic requirements.

For that reason commercial banks here and almost every where are , on the one hand, relatively heavily regulated and supervised, and on the other hand privileged in access to Federal financial support. The point is the economy as a whole has a large stake in the strength and stability of the banking system. That concern, as you well know, gave rise to a substantial reform at the supervisory framework a few years ago. Any new design for financial reform must also recognize the implication.

Given that requirement, I believe new legislation must take account of certain other realities:

• The evolving financial services industry must be dealt with as the closely interrelated complex it has become.

• Provision must be made for capable, comprehensive and coherent oversight of institutions participating in a variety of markets, insofar as those institutions include within their ambit care banking functions.

• Finally, with the traditional separation of commerce and banking as a basic element, there must be meaningful structural protection against conflicts of interest in the provision of capital and credit and the concentration of economic resources.

The Need for Broad Legislation

The traditional distinctions among financial institutions, still embedded in present law, are rapidly eroding . New technology, global competitive pressures, and powerful business logic have simply overpowered the idea that commercial banking, investment banking, and investment management are distinct and separate lines of business. In truth, the overlaps are large and growing. Many large institutions feel a compelling need to engage in all or most of those activities to remain competitive not only with their domestic counterparts but internationally. Even relatively small banks are pressured by competition to provide their customers with access to brokerage, mutual funds, and increasingly insurance.

There is, as well, increasing recognition of the large investment element in much of what is still labeled insurance. conversely, insurance companies themselves, like many other financial institutions, have felt the need to compete over a broad range of services and to seek new marketing outlets.

I need not belabor the point because it is so widely recognized Moreover, in one important area of overlap, that is between investment and commercial banking, the institutional separation embodied in the Glass-Steagall Act has been in practice largely abolished by regulatory fiat, implicitly blessed by the Congress and explicitly by the courts. But an ad hoc approach is hardly a satisfactory way of proceeding.

The effort to adapt and reconstruct outmoded law by regulatory liberalization has inevitably been incomplete, with a residue of essentially arbitrary and dysfunctional distinctions among particular institutions. As a result, some organizations are relatively advantaged over others. Moreover, to my mind, there have been elements of unhealthy competition among regulatory authorities as they adapt novel or aggressive interpretations of law in ways that leave the playing field uneven.

In the process, artificial incentives to engage in or to restrict certain activities arise, at the expense of efficiency and effectiveness. At best efficiency suffers competitive inequities. At worst, prudential safeguards may inadvertently be weakened, neglected or applied inconsistently.

There are those, to be sure, who may be relaxed about that situation, feeling they are, by design or otherwise, in a competitively privileged position. But that is hardly an equitable result nor does it effectively serve the broad public interest.

I referred earlier to one element in that public interest that deserves special emphasis. Certain core commercial banking functions -- as custodian of the payments system, as the conduit for money creation and monetary policy, as residual suppliers of liquidity -- are especially critical for the orderly functioning of the financial and economic system. it is these functions that have long justified more intensive Government regulation and supervision, as well as the special support system embodied in deposit insurance and Federal Reserve liquidity facilities. I know of no legislative proposals under active consideration that do not rightly respect the continuing need for such support to protect the stability of the financial system.

At the same time, a strong banking system requires that commercial banking institutions be able to participate in more rapidly growing and profitable sectors of the financial services marketplace- That is the powerful logic behind the need to expand the powers of a bank holding company (or, as some would prefer terminological, a "financial services holding company"). Commercial banks can now engage competitively in fund management, and there is, I believe, now wide agreement that they should be able to affiliate with investment banks -- and that, reciprocally, those financial businesses can acquire a bank affiliate. The time may well have come to extend that same logic to the insurance business in whole or in parts.

That much is common ground among most of the proposals for reform. The challenge is to achieve that competitively desirable result consistent with the safety and soundness of the banking system, and with financial stability generally.

The Need for Capable and Coherent Oversight

Experience in one country after another over the past decade has forcibly reminded us of one fact of financial life: the advances in technology and the new and sophisticated techniques of risk management have not ended the risk of financial crises. Markets have a way of exaggerating moods of optimism and despair. Profitable and attractive leveraging of capital in an equable economic environment can quickly threaten bankruptcy when conditions worsen. The possibility is real that particular failures will impact on others so that the consequences are amplified through the markets -- so-called systemic risk. Indeed, the risk may be increased by the closer institutional and even global interdependencies today, reflected in the daily movement of trillions of dollars.

We have learned first hand of the enormous financial and economic consequences of crisis -- in the savings and loan failures of the 1980's and banking strains of the early 1990's. The effects of the sudden Mexican crisis in late 1994 are still felt in that country and in other parts of Latin America. In Japan, the aftermath of the financial bubble almost a decade ago is still restraining growth.

I can think of no recent exception to the rule that faced with crisis, and whatever the specifics of law, Government will de facto step in to support and stabilize the banking system. But, of course, it is better to head off the crisis, by effective regulation and supervision, and to deal with points of strain before the system as a whole is threatened. Essentially that is why the United States, like other countries, has long regulated and supervised commercial banking institutions and provided for them an official 'safety net" by means of deposit insurance and Federal Reserve lending.

A key question that you must deal with in financial reform is how to maintain the necessary degree of protection for core barking functions in a world in which many banking organizations will be active in other areas of finance. Extending the degree of regulation appropriate for banks through the whole of the financial system is not attractive. Even less should we want to contemplate spreading Federal insurance or direct access to Federal Reserve credit to nonbanking functions. The challenge is to find a workable balance -- a means of credibly protecting the essential care, the money supply and the payments system, while minimizing intrusive regulation and the Government's

financial exposure.

One approach with surface attraction is to isolate the essential commercial banking functions from affiliated organizations by the creation of strict "fire walls", at the extreme prohibiting cross marketing, linked services, use of a common name, and even geographic proximity. But that approach runs directly across the logic of a bank or financial services holding company. The point is not to run a group of isolated businesses but to seek synergies in the provision and marketing of services. Moreover, the reputation and commercial effectiveness of one part of the organization cannot be insulated from its affiliate. The natural tendency of management, faced with the possibility of failure of one part of the organization, will be to bring the resources of the whole to bear. Given the fungibility of money and the resourcefulness of financial managers, no practical system of fire walls can be fully successful in isolating a problem.

Clearly, some degree of separation of the care banking functions can be maintained as it is at present. As a matter of policy, official assistance can be directed to the banking affiliate rather than to other parts of a holding company. But for that approach to be effective, I believe there is a compelling need to continue oversight by a single supervisory authority charged with assessing the overall safety and soundness of the entire holding company.

I do not mean to suggest that the current arrangements need to be replicated in all its aspects. The authority exercising oversight need not have exclusive or primary jurisdiction over the various affiliates. The SEC, the Comptroller, State banking and insurance authorities, and others could be "functional" regulators, providing consistency with their own legislative purposes and responsibilities. But in the end, someone must be able to evaluate any bank holding company as a whole, lest some parts become so weak, or so large a drain on the whole, that the core banking functions are jeopardized.

It will not surprise you when I suggest that, as a practical matter, the appropriate agency for under-taking the oversight of a holding company containing a bank within its structure is the Federal Reserve. No other agency today has the same combination of resources (including financial resources), of independence, of breadth of responsibility and of experience. The only alternative to the Fed as overseer, it seems to me, would be to start afresh with a now umbrella organization, a difficult and uncertain task. And, if that route were to be chosen, certainly the Federal Reserve should have a large degree of influence in its governance and in the implementation of its policies.

The Question-of Commerce and Banking

I emphasized at the start the need for new legislation to respect the need for strong structural protection against conflicts of interest in the provision of credit and undue concentration of resources. In my judgment, permitting banks or bank holding companies to extend their activities into commerce and industry -- contrary to Anglo-Saxon traditions of finance -- would be directly contrary to that need.

I am frankly puzzled as to why this question recurs each time the Congress considers broad legislation. I understand, of course, 'that there have been a handful of large companies, some of which already have substantial finance company or credit card arms, who feel that ownership of a bank would enhance their market position and permit greater financial leverage. Conversely, there may be a few commercial or investment banks may have ambitions to expand their activities into industry. But it has never been clear that these interests are widespread, and the concept, for good reason, has never commanded broad public or legislative support.

It is interesting how the rationale of the advocates has changed over the years. A decade or so ago, the German (or Continental) system, which has de facto permitted some substantial and controlling ownership of large industrial firms by large banks, was cited with admiration for its strength and stability. Few would make that claim today in the face of the difficulties experienced by some of the largest and proudest banking firms in German, France, and elsewhere as a result of industrial holdings. it is an ironic fact that, just as the proposal to relax our restrictions is pressed by some, debate has emerged in Germany and elsewhere about the wisdom of their approach, partly because of the implications for corporate governance and for concentrations of economic influence.

I trust that those supporting banking and commerce combinations are not contemplating replication of the Japanese kiretsu system. In that system, large banks and trading companies have a network of reciprocal stock holdings. individually those holdings are relatively small, typically 5 percent or less of a company's capital stock. In combination, however, those holdings are associated with close and relatively favored trading and financial arrangements within the group, with anti-competitive implications that have frequently been a matter of concern for American companies wanting to penetrate the Japanese market.

A few years ago, it was alleged banking equity was in such short supply that banks needed to draw upon stronger industrial firms to shore up their capital position. That argument never made much sense as an excuse for basic

structural change, implying as it did that American financial markets are unable to allocate capital with reasonable efficiency.

The fact, of course, is the American capital market is the envy of the world. It is New York and London -- not Frankfurt or Paris or Tokyo -- that are the centers of innovation, of trading, of capital raising in all shapes and sizes. American banks are as well capitalized as at any time in memory. Far from being unable to raise capital, many are buying back their own stock in the market. All that has been achieved without relying on industrial ownership or alliances. Surely, it is precisely the fact that such alliances play a relatively little role in our banking and financial markets which helps account for their adaptability and flexibility.

I believe there is an instinctive -- and valid -disposition in this country to avoid combinations of our largest banks and industrial firms. This morning, I join with many others in advocating a broadening of the powers of bank or financial holding companies. No doubt, the result will encourage some further consolidation among financial institutions. In 'those circumstances, it becomes even more important to maintain the traditional distinction between banking and commerce.

We should want decisions on the allocation of credit, on the underwriting of bonds, an the sale of stock to reflect unbiased financial judgments, free of taint of serving the interests of a commercial affiliate. We do now make some rules to limit and regulate transactions directly among different parts of a holding company. But as a practical matter, full insulation is impossible, and effective policing of transactions with third parties is beyond reach. How likely would it be, for instance, that a bank affiliated with a powerful retail chain will eagerly lend to a local or regional competitor? What about the one bank town, where the choices of smaller borrowers are already at best limited? What about the temptations to lend to or otherwise support a weak commercial affiliate?

I discussed earlier the compelling need for supervisory oversight over an entire banking holding company. To do otherwise would unnecessarily jeopardize the safety of the bank and place the economy and the American taxpayer at added risk.

To go further and permit combinations of commerce and banking would be to produce an insoluble dilemma for supervision. To forego any oversight of important, and perhaps dominant, parts of the holding company would create new risks for the bank, and thus for the financial system and the taxpayer. But to extend regulation and supervision into the non-financial world would imply an enormous stretch of government oversight. The practical and policy implications of either choice are simply not acceptable.

No doubt, you will hear arguments that these concerns are exaggerated and they can be dealt with or ameliorated by compromise. There are already combinations of finance companies -- some very large -- and industrial firms. There are some limited "non-bank banks" owned by commercial companies, a residue of earlier attempts to square the circle. Surely, it will be said, that these existing situations should, in an extension of the principle of grandfathering, be accommodated in new legislation that liberalizes the powers of bank holding companies.

Beware of the implications!

The Bank Holding Company Act today already permits what amounts to incidental holdings of the stock of non-financial companies, defined as less than 5 percent of the total capital stock and absence of control. That leeway is not much used, precisely because control is the issue; there is no strong incentive to own stock if there is not a common business strategy and absence of strategic influence. It is precisely when there is common business interest and reciprocal influence that the conflicts and incentives for self-dealing arise.

A number of touted initiatives to combine commercial and financial firms have fallen by the wayside in recent years. Other combinations have become large and profitable without any need to perform core commercial banking services. Those organizations can and should be given a clear and perfectly equitable choice: continue without a bank affiliate, or give up the industrial or commercial affiliation. That is the same choice that should face any non-bank financial firm: remain free to affiliate with an industrial firm or with a bank, but not with both.

You know better than I that the idea of making limited exceptions to a general rule breeds complications and inequities- By adopting special "baskets" or other compromise approaches to accommodate particular interests this year, you will be presented in the years ahead with the argument that the compromises are arbitrary and inequitable. An enlarged phalanx of lobbyists will appear, dedicated to enlarging whatever room for maneuver has been achieved. And the arguments will be more forceful because there will then be established economic interests to defend and enhance.

Concluding Remarks

I have argued this morning the logic and practical desirability of finally eliminating Glass-Steagall restrictions, of generally enlarging the powers of bank holding companies in the financial area, and of providing effective supervisory oversight over bank and financial holding companies.

All of that is important. And finally, after 15 years of recurrent effort, the necessary intellectual consensus and will to act in a comprehensive way seems to be coalescing. Failure by the Congress to seize this opportunity to modernize the legislative framework for banking and finance would be sad indeed.

But I also have to say none of that would be worth the risks and costs of embarking on a new experiment - an experiment foreign to our traditions and experience -- of relaxing prohibition on combinations of banking and commerce. The Hippocratic injunction to, above all else, do no harm has its application to banking legislation.

In my judgment, the Subcommittee Could make no greater contribution to speeding constructive legislation than by making clear now, at the very start of the legislative process, that the idea of combining banking and commerce should remain "off the table," just as it has in the past. After all, your agenda is full, without adding such an indigestible and foreign ingredient.