oversight

Financial Regulation: Bank Modernization Legislation

Published by the Government Accountability Office on 1997-05-07.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                          United States General Accounting Office

GAO                       Testimony
                          Before the House Committee on Banking
                          and Financial Services




For Release on Delivery
Expected at
10:00 a.m., EDT
                          FINANCIAL REGULATION
Wednesday
May 7, 1997

                          Bank Modernization
                          Legislation
                          Statement of James L. Bothwell
                          Chief Economist
                          Office of the Chief Economist




GAO/T-OCE/GGD-97-103
Summary

Financial Regulation: Bank Modernization
Legislation

                  The laws governing the financial services industry and the regulatory
                  structure that oversees it were developed for an industry
                  compartmentalized into commercial banking, investment banking, and
                  insurance. In recent decades, however, these activities have converged to
                  where many financial products and services offered by banks, securities
                  firms, and insurance companies are more alike than different. Attempts by
                  financial regulators to adapt to the rapid changes taking place in the
                  financial marketplace have been incremental and ad hoc, resulting in
                  overlaps, anomalies and even some gaps. Thus, Congress could improve
                  the functioning of our regulatory system by modernizing our banking laws.
                  However, modernization should not ignore other goals, such as
                  maintaining the safety and soundness of the financial system and the
                  deposit insurance funds, preventing undue concentrations of economic
                  power, and protecting consumers from conflicts of interest. GAO suggests
                  that specific safeguards be included in any modernization legislation.

              •   Financial services holding companies should be regulated on a
                  consolidated, comprehensive basis, with appropriate firewall provisions to
                  protect both consumers and taxpayers against potential conflicts of
                  interest and to prevent the spread of the federal safety net provided to
                  banks and any associated subsidy to nonbanking activities.
              •   Capital standards for both insured banks and financial services holding
                  companies should exist that adequately reflect all major risks, including
                  market and operations risk as well as credit risk.
              •   Clear rulemaking and supervisory authority should be established that
                  results in a consistent set of rules that are consistently applied for similar
                  financial activities and minimizes regulatory burden.

                  Furthermore, while the case for modernizing our banking laws is clear,
                  GAO would urge that Congress proceed cautiously if it decides to relax the
                  current separation of banking and commerce. GAO found that the potential
                  benefits of mixing banking and commerce generally lacked empirical
                  support or could be realized without removing the current restrictions.
                  GAO’s work also indicated that eliminating the current separation could
                  pose a variety of risks to the safety and soundness of the financial system,
                  the deposit insurance funds, and to consumers and taxpayers.




                  Page 1                                                   GAO/T-OCE/GGD-97-103
Statement

Financial Regulation: Bank Modernization
Legislation

              Mr. Chairman and Members of the Committee:

              We are pleased to be here today to assist your continuing efforts to
              modernize our financial services regulatory system. As you are well aware,
              both the laws governing the financial services industry and the regulatory
              structure that oversees it were developed for an industry that was
              compartmentalized into commercial banking, investment banking, and
              insurance. Since that structure was established more than 60 years ago,
              however, these activities have converged to the point where many of the
              financial products and services offered by banks, securities firms and
              insurance companies are more alike than different. Some of the most
              notable examples include: (1) competition by money market and mutual
              funds that has been so successful that the value of such funds—many of
              which permit check writing—now exceeds the value of insured bank
              deposits; (2) the issuance of guaranteed investment contracts by insurance
              companies that compete directly with both mutual funds and bank
              certificates of deposit, (3) the securitization of over $2 trillion in
              mortgages and other loans that a few years ago would have been held in
              portfolio by insured depository institutions; (4) the increasing involvement
              of commercial banks in the sale of insurance products, in mutual funds,
              and in securities underwriting through “section 20” holding company
              affiliates; and (5) the increasing involvement of securities firms and
              insurance companies in making and syndicating commercial loans in
              competition with banks.

              As we testified before this committee two years ago, our various financial
              regulators have been attempting to adapt to the dramatic and rapid
              changes taking place in the financial marketplace on an incremental and
              ad hoc basis.1 As a result, as our work over the past few years has shown,
              our existing financial regulatory system has significant overlaps,
              anomalies and even some gaps. Thus, Congress, by updating and
              modernizing our banking laws, could substantially improve the functioning
              of our regulatory system, and we commend the committee’s efforts to do
              so. However, the goal of financial modernization should not be achieved at
              the expense of other important goals, such as maintaining the safety and
              soundness of the financial system and the deposit insurance funds,
              preventing undue concentrations of economic power, and protecting
              consumers from potential conflicts of interest.


              1
               Financial Regulation: Modernization of the Financial Services Regulatory System
              (GAO/T-GGD-95-121, Mar. 15, 1995). See also, Separation of Banking and Commerce
              (GAO/OCE/GGD-97-61R, Mar. 17, 1997), Bank Oversight: Fundamental Principles for Modernizing the
              U.S. Structure (GAO/T-GGD-96-117, May 2, 1996).



              Page 2                                                                 GAO/T-OCE/GGD-97-103
                     Statement
                     Financial Regulation: Bank Modernization
                     Legislation




                     Toward this end, our work suggests that the following specific safeguards
Safeguards Are       should be included in any modernization legislation:
Needed
                 •   Financial services holding companies should be regulated on a
                     consolidated, comprehensive basis, with appropriate firewall provisions to
                     protect both consumers and taxpayers against potential conflicts of
                     interest and to prevent the spread of the federal safety net provided to
                     banks and any associated subsidy to nonbanking activities.2 Our work on
                     past financial institution failures has shown the importance of having an
                     umbrella supervisory authority to assess how risks to insured institutions
                     may be affected by risks in the other components of a holding company
                     structure. While firewall provisions can be extremely important safeguards
                     in preventing potential conflicts of interest and protecting insured
                     deposits, firewalls may not hold up under stress or if managers are
                     determined to breach them. Moreover, consolidated supervision is
                     consistent with the way that most, if not all, large bank holding companies
                     are managed today — on a consolidated basis with the risks and returns of
                     various affiliates being used to offset or enhance one another.3 It is also
                     compatible with a functional approach to financial regulation.4 For
                     example, the SEC could be the regulator for a securities affiliate of a
                     financial services holding company, the OCC the regulator for a nationally
                     chartered bank affiliate, with either of these two agencies or the Federal
                     Reserve being responsible and accountable as the umbrella regulator for
                     the operations of the holding company in its entirety. This basic approach
                     — i.e. having consolidated supervision of banking organizations with
                     coordinated functional regulation of individual components — is also
                     consistent with the approach taken by five other major industrialized




                     2
                      Firewalls are systems of controls that are meant to keep bank resources from improperly being used
                     to support other activities, such as securities underwriting, and to protect against potential conflicts of
                     interest. The federal government provides a safety net to the banking system that includes federal
                     deposit insurance, access to the Federal Reserve discount window, and the final riskless settlement of
                     payment system transactions. This safety net, while helping to ensure the safety and soundness of the
                     banking system, also provides a subsidy to commercial banks and other depository institutions by
                     allowing them to obtain low-cost funds.
                     3
                      Currently, the Federal Reserve acts as the overall regulator for bank holding companies, which
                     includes setting consolidated capital requirements for the company as a whole, exercising supervisory
                     authority over the company, determining what types of activities can be affiliated with banks under the
                     holding company structure, and approving such holding company activities as mergers and
                     acquisitions.
                     4
                      For a detailed discussion of functional regulation, see appendix I.



                     Page 3                                                                        GAO/T-OCE/GGD-97-103
    Statement
    Financial Regulation: Bank Modernization
    Legislation




    countries that we recently studied.5 In these five countries — Canada,
    United Kingdom, Germany, France and Japan — if securities, insurance, or
    other nontraditional banking activities were permissible in bank
    subsidiaries, functional regulation was provided by the appropriate
    authority. While bank regulators generally relied on those functional
    regulators for information, they remained responsible and accountable for
    ascertaining the safety and soundness of the consolidated banking
    organization as a whole.
•   Capital standards for both insured banks and financial services holding
    companies should exist that adequately reflect all major risks, including
    market and operations risk as well as credit risk. Because our work on
    failed banks has shown that capital can be quickly eroded in times of
    stress and can be a lagging indicator of an institution’s true financial
    condition, regulators should be required to conduct periodic assessments
    of risk management systems for all the major components of a financial
    services holding company, as well as for the holding company itself. While
    the FDIC Improvement Act of 1991 requires bank regulators to take prompt
    corrective action against troubled institutions before their capital is
    completely eroded, our recent review showed that the implementation of
    these provisions may not be as effective in preventing deposit insurance
    losses as Congress originally intended.6
•   Clear rulemaking and supervisory authority should be established that
    results in a consistent set of rules that are consistently applied for similar
    financial activities and minimizes regulatory burden. This is particularly
    important for critical matters, such as consolidated capital requirements,
    firewalls, and permissible activities, and can be accomplished in a number
    of ways. Having the Federal Reserve serve this function, which is the
    approach taken in H.R. 10, is one obvious alternative, at least for large
    financial services holding companies. Still another approach would be to
    have a special interagency rulemaking board or committee. We found that
    each of the five major foreign countries that we recently reviewed had
    unique ways to ensure that their banking institutions that were conducting
    the same lines of business were generally subject to a single set of rules,
    standards, or guidelines. The important point is to have some mechanism
    to achieve consistent, effective oversight and rules and to limit
    unnecessary overlaps and regulatory burden on our financial institutions.

    5
     Bank Oversight Structure: U.S. and Foreign Experience May Offer Lessons for Modernizing U.S.
    Structure (GAO/GGD-97-23, Nov. 20, 1996). See also, Bank Regulatory Structure: The Federal Republic
    of Germany (GAO/GGD-94-134BR, May 9, 1994), Bank Regulatory Structure: The United Kingdom
    (GAO/GGD-95-38, Dec. 29, 1994), Bank Regulatory Structure: France (GAO/GGD-95-152, Aug. 31, 1995),
    Bank Regulatory Structure: Canada (GAO/GGD-95-223, Sept. 28, 1995), and Bank Regulatory Structure:
    Japan (GAO/GGD-97-5, Dec. 27, 1996).
    6
     Bank and Thrift Regulation: Implementation of FDICIA’s Prompt Regulatory Action Provisions
    (GAO/GGD-97-18, Nov. 21, 1996).



    Page 4                                                                  GAO/T-OCE/GGD-97-103
              Statement
              Financial Regulation: Bank Modernization
              Legislation




              Mr. Chairman, as you and other members of the committee are well aware,
              the number of banks has declined substantially over the past five years
              and there has been considerable consolidation among our largest banking
              organizations in particular. Because these trends could be accelerated
              even more by financial modernization, it is also important, through
              effective enforcement of our antitrust and banking laws, to prevent any
              monopolistic exercise of market power and to assure that entry into the
              financial services marketplace is not restricted unnecessarily. For without
              competitive markets, the benefits of financial modernization are unlikely
              to be passed on to small businesses and consumers.



              Mr. Chairman, while our work shows that the case for modernizing our
Banking and   banking laws is clear, we would urge that Congress proceed cautiously if it
Commerce      decides to relax the current separation of banking and commerce. Our
              recent review of the existing economics literature, which is discussed in
              detail in appendix II, found that the potential benefits of eliminating the
              current separation generally lacked empirical support and that most such
              benefits could be realized through other means.7 Furthermore, the
              available literature, as well as our own extensive work on the causes of
              past financial institution failures, indicated that eliminating the current
              separation could pose a variety of risks to the safety and soundness of the
              financial system, to the deposit insurance funds, and to consumers and
              taxpayers. While the exact magnitudes of such risks are uncertain and
              would depend, in large part, on the effectiveness of the legislative and
              regulatory safeguards that are put into place, our work shows that a
              compelling economic argument for the unbridled mixing of banking and
              commerce has simply not yet been made.


              Mr. Chairman, this concludes my prepared statement. My colleagues and I
              would be happy to respond to any questions that you and other members
              of the committee may have.




              7
               Separation of Banking and Commerce (GAO/OCE/GGD-97-61R, Mar. 17, 1997).



              Page 5                                                              GAO/T-OCE/GGD-97-103
Appendix I

An Explanation of Consolidated Holding
Company Regulation and Functional
Regulation
                        The closest model for a financial services holding company is the existing
                        bank holding company structure. This appendix explains how bank
                        holding companies are regulated, as well as the concepts of consolidated
                        regulation of the holding company and functional regulation.

                        Large Bank holding companies are complex. They consist of combinations
                        of banks, thrifts, subsidiary holding companies, securities firms, and other
                        nonbank firms (such as mortgage, finance, or data processing companies).
                        In total, these large firms typically have many separate subsidiaries, with
                        operations conducted throughout the U.S. and overseas.

                        The regulation of a bank holding company can be shown with a simplified
                        illustration of such a company, as in figure 1. The company in this
                        illustration consists of a national bank, a subsidiary bank holding
                        company, a thrift holding company, a securities firm registered with the
                        SEC, and another nonbank subsidiary. The diagram also shows how each
                        entity is regulated.


                        Under current bank holding company regulation, the Federal Reserve
Consolidated            System is responsible for regulating the company as a whole. This means
Regulation of the       that the Federal Reserve sets capital requirements on a consolidated basis
Holding Company         for the company as a whole, has authority to supervise all parts of the
                        company, determines what activities can be affiliated with banks, and
                        approves holding company mergers and acquisitions. Consolidated
                        supervision typically involves concentrating on capital structure, key risk
                        management systems, and the flow of funds within the company.

                        The holding company regulation provided by the Federal Reserve can be
                        referred to as “umbrella” type regulation because it is in addition to other
                        regulation of holding company subsidiaries or of the markets within which
                        the entities of the holding company operate. This other regulation is
                        provided by various federal and state regulators. The authority of the
                        Federal Reserve is limited in that in some circumstances a bank regulator
                        such as OCC can, for example, authorize activities for a national bank that
                        the Federal Reserve cannot authorize at the holding company level.


                        The concept of functional regulation refers generally to a regulatory
Functional Regulation   process in which a given financial activity is regulated by the same
                        regulator regardless of who conducts the activity. In discussions about




                        Page 6                                                  GAO/T-OCE/GGD-97-103
Appendix I
An Explanation of Consolidated Holding
Company Regulation and Functional
Regulation




regulation of financial service holding companies, the concept can be used
in somewhat different ways.

Functional regulation is sometimes used to refer principally to the idea of
regulating a complex company in a way that eliminates the umbrella role,
the role now played by the Federal Reserve for bank holding companies.
Referring to figure 1, this approach to functional regulation means that the
Federal Reserve regulation of the parent and of nonbank subsidiaries
would disappear from the diagram. Regulation would then be focused
solely on the various regulated subsidiaries. For example, OCC would
continue to regulate the lead national bank and the national bank in the
subsidiary holding company, while the SEC (in part through the
involvement of securities regulation) would regulate the securities
affiliate. OCC would be responsible for setting the capital requirements for
the national banks and using its supervisory authority over those banks to
see that capital is not drained away by the actions of the holding company
parent or of any affiliates. OCC also would enforce the firewall limitations
applicable to the national banks, in which capacity it would have the
ability to obtain records from other parts of the holding company.

Functional regulation can also be used to emphasize the way in which
regulatory responsibilities are divided up among the various regulatory
bodies. This concept is particularly important because the U.S. regulatory
system combines both regulation of markets (securities exchanges,
futures exchanges, and over the counter trading) and regulation of firms
(banks, securities firms, thrifts, and insurance companies). With functional
regulation defined in this way, the SEC, as regulator of securities markets,
would set rules that apply to all firms active in those markets, whether
those firms are banks, registered broker dealers, or insurance companies.
The enforcement of the SEC rules can be done either by the regulator of the
market or the regulator of the firm.

As the activities of various types of financial institutions have converged,
the concept of regulating by function is likely to take on greater
significance, extending across traditional definitions of markets as well as
firms. For example, sales practice rules could be developed to apply to
many products sold by many different firms in many different markets.
Functional regulation viewed in this way is not inconsistent with
consolidated supervision of the activities of companies which participate
in many different markets.




Page 7                                                  GAO/T-OCE/GGD-97-103
                                         Appendix I
                                         An Explanation of Consolidated Holding
                                         Company Regulation and Functional
                                         Regulation




Figure 1: Regulation of a Hypothetical Bank Holding Company




                                         Page 8                                   GAO/T-OCE/GGD-97-103
Appendix II

Potential Benefits and Risks of Eliminating
the Current Separation of Banking and
Commerce
                  Eliminating the current separation of banking and commerce involves
                  both potential benefits and risks. Specifically, the major potential benefits
                  that have been mentioned in recent years in support of eliminating the
                  separation of banking related activities and commerce include
                  (1) increased economies of scale, (2) greater diversification of risks, and
                  (3) synergies that may result from affiliations between banks and
                  commercial firms.

              •   Increased Economies of Scale. Some observers claim that the U.S. banking
                  industry would benefit from the relaxation of banking and commerce
                  restrictions because it would allow banks to expand their scale of
                  operations and lower their unit costs of production. While some early
                  studies seemed to indicate the presence of significant scale economies in
                  banking,8 the results of more recent work have been mixed.9 Moreover, to
                  the extent that scale economies exist and are significant in banking, banks
                  should be able to capture them through mergers with other banks. Banks
                  do not need to combine with commercial firms to be able to achieve scale
                  economies.
              •   Greater Diversification of Risks. Some observers also claim that banking
                  and commercial conglomerations would be beneficial because they would
                  allow for greater diversification of risks across more product lines and
                  thus reduce the variability of corporate earnings. Because the gains from
                  this type of diversification rise when firms’ earnings are less correlated,
                  and fall when firms’ earnings are more correlated, this argument rests on
                  the assumption that the earnings of commercial firms fluctuate
                  independently of the earnings of banks. We found the empirical evidence
                  on this point to be inconclusive. One study we reviewed found some
                  evidence that the returns on banking stocks and commercial firm stocks
                  were not highly correlated, and thus concluded that diversification
                  benefits were possible.10 However, a more comprehensive study that
                  examined a longer time period and controlled for more factors found that
                  the variation in the stock returns of bank holding companies and




                  8
                   A review of the literature is provided in G. Bentson, G. Hanweck, and D. Humphrey, “Scale Economies
                  in Banking: A Restructuring and Reassessment,” Journal of Money Credit and Banking, 14 (1982),
                  435-456.
                  9
                  See L. Mester , “Efficient Product of Financial Services: Scale and Scope Economies,” Federal Reserve
                  Bank of Philadelphia Business Review, January/February (1987), 15-25, and S. Shaffer, “A
                  Revenue-Restricted Cost Study of 100 Large Banks,” mimeo, Federal Reserve Bank of New York, 1988,.
                  10
                    A. Saunders, and P. Yourougou , “Are Banks Special: The Separation of Banking from Commerce and
                  Interest Rate Risk,” Journal of Economics and Business, 42 (1990), 171-182.



                  Page 9                                                                    GAO/T-OCE/GGD-97-103
    Appendix II
    Potential Benefits and Risks of Eliminating
    the Current Separation of Banking and
    Commerce




    nonfinancial companies are reasonably highly correlated and concluded
    that the benefits of diversification are overstated.11

    Moreover, banks do not need to combine with commercial firms to reduce
    the variability in their earnings through diversification. For example,
    banks can diversify their assets through their loan portfolios and other
    investments, and their ability to diversify geographically was recently
    enhanced by the Interstate Banking and Branching Efficiency Act of 1994.

•   Synergies. Some observers argue that conglomerations of commercial
    firms and banks might result in other efficiencies, often referred to as
    synergies. Two possible sources of synergies are economies of scope and
    information efficiencies. Economies of scope exist if a combined firm can
    produce a mix of products at a lower cost than if the products were
    produced separately. The main source of the cost savings comes from
    using the same inputs to produce multiple outputs. The virtually
    unanimous finding in the literature is that economies of scope are
    insignificant in banking.12 We were unable to find any studies on the
    existence of potential economies of scope between banking and
    commercial activities.

    Another possible synergy might result from improved informational flows
    within a combined entity. For example, by combining with commercial
    firms, banks might obtain better information about the commercial firms’
    activities, which the banks could then use to reduce the default rate on
    their loans. In addition, the commercial firms could benefit by obtaining
    bank loans at lower interest rates. However, the increased information
    flows might also induce banks to approve more risky loans.13 We were
    unable to find any studies that attempt to quantify these potential effects.

•   Other Theoretical Arguments. Some observers have also argued that
    restrictions on bank affiliations lead to inefficiencies, because such
    restrictions impede the free flow of capital or managerial resources.14
    Although impediments to resource flows can lead to inefficiencies in


    11
     M.J. Isimbabi, “The Stock Market Perception of Industry Risk and the Separation of Banking and
    Commerce,” Journal of Banking and Finance, 18 (1994), 325-349.
    12
      Mester (1987) surveys a number of studies.
    13
     A summary of the trade-off is provided in K. John, T.A. John, and A. Saunders, “Universal Banking
    and Firm Risk-taking.” Journal of Banking and Finance, 18 (1994), 307-323.
    14
     See A. Saunders, “Banking and Commerce: An Overview of the Public Policy Issues,” Journal of
    Banking and Finance, 18 (1994), 231-254..



    Page 10                                                                   GAO/T-OCE/GGD-97-103
Appendix II
Potential Benefits and Risks of Eliminating
the Current Separation of Banking and
Commerce




certain cases, we found no clear evidence that such inefficiencies exist in
the banking industry at the present time.

Those who argue that there is a capital shortage in banking believe that
banks have a difficult time attracting capital, and that allowing banks and
commercial firms to affiliate is necessary to allow the banking industry to
attract capital from other industries. However, there are many sources of
capital, such as new stock issues, that are open to banks and we are not
aware of any empirical evidence that the U.S. banking industry is currently
suffering from a capital shortage. In fact, the banking industry currently is
very well capitalized by historic standards. The average capital asset ratio
in the industry in 1996 was 8.3 percent, compared to 6.7 percent in 1991.15
By regulatory standards, capital in the banking industry is also high. At the
end of 1995, 98.4 percent of banks were considered well capitalized,
compared to 93.8 percent at the end of 1992.16

Another argument, which holds that separating banking and commerce
causes inefficiencies by blocking resource flows, focuses on managerial
talent and cost consciousness. According to this argument, allowing banks
and commercial firms to merge would generate fears of a potential
takeover resulting from poor performance and thus would induce
managers to increase efficiency. It should be noted, however, that this type
of discipline can take place even if banks and commercial firms are not
allowed to merge. As long as better managed banks are allowed to
purchase weaker banks, this efficiency-enhancing mechanism, to the
extent that it works, would still be operable.

Our review of existing studies, as well as our own prior work assessing
past financial institution failures, indicated that eliminating the separation
of banking and commerce might subject the financial system, the deposit
insurance fund, and consumers and taxpayers to a variety of risks.17 The
primary risks include those associated with (1) a potential expansion of
the federal safety net provided banks to commercial operations, (2) the
potential for increased conflicts of interest within a banking and
commercial conglomerate, (3) the potential for contagion effects from

15
  The FDIC Quarterly Banking Profile: Commercial Banking Performance-Third Quarter 1996, p. 5.
16
 See Bank and Thrift Regulation: Implementation of FIDICIA’s Prompt Regulatory Action Provisions
(GAO/GGD-97-18, Nov. 21, 1996), p. 28.
17
  See, for example, Thrift Failures: Costly Failures Resulted From Regulatory Violations and Unsafe
Practices (GAO/AFMD-89-62, June 16, 1989), Bank Supervision: OCC’s Supervision of the Bank of New
England Was Not Timely or Forceful (GAO/GGD-91-128, Sept. 16, 1991), and Bank Insider Activities:
Insider Problems and Violations Indicate Broader Management Deficiencies (GAO/GGD-94-88, Mar. 30,
1994).



Page 11                                                                 GAO/T-OCE/GGD-97-103
    Appendix II
    Potential Benefits and Risks of Eliminating
    the Current Separation of Banking and
    Commerce




    commercial operations spreading to insured banks, and (4) a potential
    increase in economic power exercised by large conglomerate enterprises.

•   Potential Expansion of the Federal Safety Net. Allowing conglomerations
    of banks and commercial firms would increase the risk that the safety net,
    and any associated subsidy, might be transferred to commercial
    operations and result in inappropriate risk-taking, misallocations of
    resources, and uneven competitive playing fields in other industries. While
    such risks could be mitigated by establishing firewalls between banks and
    their commercial affiliates, our work has shown that such firewalls may
    not work in times of stress, or where managers are determined to evade
    them.18 Moreover, firewalls require regular monitoring and enforcement by
    regulators and, if set too high, may prevent the realization of whatever
    potential benefits were expected to derive from allowing such
    conglomerations to occur.
•   Potential for Increased Conflicts of Interest. Allowing conglomerations of
    banks and commercial firms could also add to the potential for increased
    conflicts of interest and raise the risk that banks might engage in
    anticompetitive or unsound practices. For example, some have argued
    that, to foster the prospects of their commercial affiliates, banks might
    begin to restrict credit to their affiliates’ competitors, or tie the provision
    of credit to the sale of products by their commercial affiliates.19 Perhaps
    more likely, banks might begin to extend credit to their commercial
    affiliates when they would not have done so otherwise, thus increasing the
    risks to the deposit insurance fund and to taxpayers.20 Such behavior
    could also undermine the valuable monitoring function that banks provide
    in our economy. As long as banks are perceived as providing credible,
    objective assessments of the creditworthiness of companies and their
    activities, bank credit decisions can provide valuable information to the
    market about the soundness of these companies and their activities. The
    value and reliability of such signals could be diminished if banks were
    viewed as having conflicts of interest that adversely affected the
    objectivity of their credit decisions.
•   Potential for Increased Contagion Effects. Allowing conglomerations
    between banks and commercial firms could also increase risks to the


    18
      Using Firewalls in a Post Glass-Steagall Banking Environment (GAO/T-GGD-88-25, Apr. 13, 1988).
    19
     A. Saunders, “Banking and Commerce: An Overview of the Public Policy Issues,” Journal of Banking
    and Finance, 18 (1994), 231-254.
    20
      In our review of the 286 bank failures that occurred in 1990-1991, we found that insider problems and
    associated conflicts of interest were cited as contributing factors in 175 of the failures. See Bank
    Insider Activities: Insider Problems and Violations Indicate Broader Management Deficiencies
    (GAO/GGD-94-88, Mar. 30, 1994).



    Page 12                                                                     GAO/T-OCE/GGD-97-103
               Appendix II
               Potential Benefits and Risks of Eliminating
               the Current Separation of Banking and
               Commerce




               deposit insurance fund and taxpayers if affiliated commercial firms were
               to extend any financial stress they experienced to their banking affiliates.
               Even if firewalls were able to keep such problems from actually being
               transmitted to bank affiliates, depositors who believed that commercial
               affiliates were experiencing financial problems might decide to withdraw
               their funds from the commercial firms’ bank affiliates for fear that the
               banks’ soundness might also be in jeopardy. If enough depositors did this,
               the fear could be self-fulfilling in that the viability of both the affiliated
               banks and the commercial firms could become threatened.
           •   Possible Increased Concentration of Economic Power. There are also
               concerns that ending the current restrictions between banking and
               commerce could promote the formation of very large conglomerate
               enterprises with substantial amounts of economic power. Such enterprises
               could adversely affect the efficient operation of the economy and place
               consumers at risk of increased prices if they began to exert market power
               in either their banking or commercial operations. This risk would be
               enhanced to the extent that these new conglomerates could effectively
               access the subsidy inherent in the safety net and gain advantages over
               their competitors.




(972630)       Page 13                                                  GAO/T-OCE/GGD-97-103
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