Congress is embarking on its third attempt in ten years of inter-industry battles to reform the 1933 Glass-Steagall Act, a law that separates commercial banking from most forms of investment banking. Welcome though this is, the financial services marketplace has moved beyond any simple legislative revision and demands more fundamental reform, not only to reduce unnecessary regulatory charges but also to achieve greater efficiencies in serving customers.

Legislation to reform the Depression-era Act has passed both the House Banking and Financial Services Committee and the Commerce Committee. This bill simply recognizes the current state of affairs, requiring a bank holding company to use a separately capitalized affiliate for securities business, subject to a number of statutory firewalls and restrictions. It also establishes a new regulatory regime that allows investment bank holding companies to be affiliated with commercial banks if they satisfy a number of conditions.

New competitors are operating outside the old regulatory regime and providing customers with the services they demand

If the Republican-led Congress and the Democratic administration care about promoting economic growth, allowing capital to flow freely, abolishing unnecessary regulatory taxes, and serving consumers efficiently, then more market-oriented reform must be introduced and the terms of the current Congressional debate must shift dramatically. New bank competitors are on the scene, operating outside the old regulatory regime and providing customers with the cost-effective products and services they demand in a safe, sound environment.

New market realities

While concerns linger in Washington about the mixing of banking and commerce, they do not stand up in the light of reality. Since 1956 and the coming into force of the Bank Holding Company Act (BHCA), which set out to separate banks from commercial ownership, both the marketplace and regulation have changed.

In 1987, Congress sanctioned the entry of numerous "new bank" competitors, which now have a formidable presence and a notable regulatory advantage. It "grandfathered" consumer banks and made certain other banks (such as Utah industrial loan companies) exempt from both BHCA and Glass-Steagall restrictions. Federal savings associations, including federal savings banks, have always been exempt. Congress thus gave the green light to many eminent corporations—GE, American Express, AT&T, Fidelity Investments, Prudential Insurance, Merrill Lynch and Leucadia National among them—to own full-service, FDIC-insured banks without suffering any restrictions on their product, service, acquisition, or affiliation strategies.

A review of market facts reveals the truth behind the illusion of keeping banking and commerce separate. Examining the most recent comparable market data, we find that including both bank and nonbank assets, the top 25 old banks have roughly $1.9 trillion in assets, and the 25 largest new competitors an impressive $1.3 trillion—only about one-third less. Analyzing other market indicators reveals that these new banks consistently outperform their older rivals.

Old banks are disadvantaged

The top 25 new banks have almost twice the market capitalization of the top 25 old ones ($321.7 billion compared with $168 billion). The average new bank has an 85 percent greater market capitalization than the average old bank. The five-year market-to-book ratio of new banks is 60 percent higher on average, while their top performer posts a 5.4:1 ratio as against 2.1:1 for the best old bank.

When five-year shareholder returns are examined, similar results emerge. On average, new banks have achieved returns more than 130 percent higher than those of their older rivals. The top new bank posted a staggering 2,200 percent return, while the most successful old bank turned in just over one-tenth of that amount.

Traditional accounting measures of profitability tell the same story. On average, new banks produced a 46 percent higher five-year return on equity, while the figures for the top new and old bank stood at 29 and 15.9 percent. New banks also enjoyed a five-year return on assets more than 440 percent higher on average, at 3.7 percent, compared with 0.7 percent for old banks.

The need for reform

For reasons of simple equity and parity, as well as achieving greater efficiency, regulations should be brought up to date

For reasons of simple equity and parity, as well as in the interests of promoting greater efficiency and cost-effectiveness, regulations governing traditional banks should be brought up to date and into line with those that apply to new competitors. Regulation must not be set at the lowest common denominator of poorer-performing banks, as has often been the case in the past. Rather, regulation and supervision should be set at the highest level, enabling both superior market service for customers and greater efficiencies for institutions’ corporate governance and structural options.

Broad market reform is required to keep pace with innovation, technology, and changing customer demands. One market-driven reform that could easily be grafted onto the pending legislation is the complete repeal of the BHCA. This would enhance three management skills essential in meeting future customer needs: speed, flexibility, and agility. All product and service restrictions would be eliminated, and all current procedural obstacles (for example, filing regulatory applications for supervisory approval) would disappear. Old banks would then be at parity with their new competitors.

It is hard to imagine how any more safety and soundness regulations could be heaped onto insured banks

Congress removed one of the remaining justifications for the BHCA last year when it permitted full nationwide banking in 1995, though needlessly delaying full branching consolidation for purely political reasons until 1997. The outright repeal of the BHCA would neither harm bank safety and soundness nor remove antitrust laws. In addition, the Act is clearly not necessary for Federal Reserve monetary policy. After the 1991 re-regulatory FDIC Improvement Act, it is hard to imagine how any more safety and soundness regulation could be heaped onto insured banks.

If the BHCA disappeared tomorrow, risk-based capital and deposit premiums would still exist, plentiful "prompt corrective action" measures would remain available, and exposure to the federal safety net would continue to be limited. Moreover, new managerial and operating guidelines for safety and soundness standards will soon be in place, and all existing consumer compliance rules remain unaffected.

In fact, it could be argued that repeal of the BHCA would enhance the safety and soundness of traditional banks by expanding their opportunities for diversification and encouraging the free flow of capital to its most productive use as determined by management, not regulators—the same argument that applied to last year’s nationwide banking reform. Perpetuating the BHCA only piles regulatory taxes—direct and indirect—onto old banks, makes them less profitable, and raises costs for consumers. New banks subject to fewer regulatory taxes are on average more profitable, have lower costs to pass along to consumers, and pose no known safety and soundness concerns.

Either Congress can recognize market developments, or management teams can start planning to go their own way

Either Congress can recognize market developments and repeal the BHCA now, or individual management teams can start planning to go their own way by 1997, since many state banking laws and the 1863 National Bank Act permit banks to operate subsidiaries. Indeed, Treasury’s Office of the Comptroller of the Currency has a proposal pending to make uninsured operating subsidiaries easier to use in the future, thus eliminating the need for both the BHCA and the extra layer of holding company regulation that it entails for both the parent company and all its nonbank affiliates.

Our work with a number of regional bank holding companies suggests that the regulatory burden of taxes that exceed what senior management estimates is necessary to maintain safety and soundness, ranges roughly from 10 to 12 percent of companies’ noninterest expense (NIE). Separate studies by the American Bankers Association and the Federal Financial Institutions Examination Council came to similar conclusions. This calculation was made before the full rollout of the FDIC Improvement Act, so the figure could easily have risen to between 12 and 15 percent, despite nascent efforts to contain the regulatory burden.

One bipartisan goal for Congress and the administration could be to cut unnecessary regulatory taxes in half by 1996—that is, to no more than 5 to 7 percent of noninterest expense. This goal should be attainable. If regulatory taxes on commercial banks stand at 10 percent of NIE and are cut by 50 percent, the after-tax saving in the base year would be roughly $5.5 billion, and over five years, almost $27.7 billion. If taxes are as high as 15 percent of NIE, then a 50 percent reduction would produce savings of $8.3 billion in year one, and almost $42 billion over five years. Such savings would be healthy for banks, their customers, and the whole economy.

Congress can start by nurturing the Glass-Steagall seed of reform in three ways: by pruning dead wood with amendments; by grafting on market-driven reform; and by encouraging new economic growth via reductions in regulatory taxes.

First, several pruning amendments are in order. Management should retain the freedom to choose its corporate structure—either a holding company affiliate or an uninsured operating subsidiary—for its own strategic reasons, without regulatory interference. Either structure can be effectively protected from the federal safety net.

Rigid statutory firewalls that are difficult to change as the market advances should be replaced by flexible supervisory guidelines, like those the FDIC currently operates for separately capitalized, bona fide securities subsidiaries of state-chartered, nonmember banks (for example, Wilmington Trust). A genuine two-way street should also be established to remove all obstacles in the way of efficient affiliations between commercial and investment banks.

Second, genuine market reforms should be grafted onto the legislation, starting with the repeal of the Bank Holding Company Act. Such a move would have several immediate benefits, including: a positive effect on cost savings; the achievement of regulatory parity between old banks and new banks, regardless of their ownership, without in any way compromising safety and soundness regulation; and greatly improved market efficiencies in delivering new products demanded by consumers and businesses, without regulatory delays and interference on such issues as pricing, delivery channels, or forms of corporate structure that are better left to the discretion of management.

Finally, the industry should set a goal of cutting unnecessary regulatory taxes by at least one-half by a given date, and then work with regulators and policy makers to identify all possible ways to meet that goal. Adopting incentive-based regulation for well-managed companies—where eligible businesses are subject to differential supervision and a drastically reduced regulatory burden—would be a good starting point. Current efforts in this direction in the banking agencies and Congress could be extended and enhanced significantly.

Swift action would allow consumers of financial services to be served more efficiently

These efforts should proceed rapidly and simultaneously. Swift action would accelerate the free allocation of capital to its most productive use, reduce many unnecessary regulatory taxes, foster long-term economic growth, and allow consumers of financial services to be served more efficiently by companies subject to full regulatory parity with respect to products, services, acquisitions, corporate structures, and management agility.