Financial Regulation: Bank Modernization Legislation (Testimony,
05/07/97, GAO/T-OCE/GGD-97-103).

GAO discussed the modernization of the U.S. financial services
regulatory system.

GAO noted that: (1) 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; (2) 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; (3) 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; (4)
thus, Congress could improve the functioning of the U.S. regulatory
system by modernizing the banking laws; (5) 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; (6) GAO suggests that specific
safeguards be included in any modernization legislation; (7) 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; (8) 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; (9) 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; (10) furthermore, while the
case for modernizing banking laws is clear, GAO would urge that Congress
proceed cautiously if it decides to relax the current separation of
banking and commerce; (11) GAO found that the potential benefits of
mixing banking and commerce generally lacked empirical support or could
be realized without removing the current restrictions; and (12) 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.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  T-OCE/GGD-97-103
     TITLE:  Financial Regulation: Bank Modernization Legislation
      DATE:  05/07/97
   SUBJECT:  Bank holding companies
             Bank management
             Banking law
             Banking regulation
             Capital
             Conflict of interest
             Financial institutions
             Insured commercial banks
             Regulatory agencies
IDENTIFIER:  Canada
             United Kingdom
             Germany
             France
             Japan
             
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Cover
================================================================ COVER


Before the House Committee on Banking
and Financial Services

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

FINANCIAL REGULATION - BANK
MODERNIZATION LEGISLATION

Statement of James L.  Bothwell
Chief Economist
Office of the Chief Economist

GAO/T-OCE/GGD-97-103

GAO/OCE-97-103T


(972630)


Abbreviations
=============================================================== ABBREV

  SEC - x
  OCC - x
  FDIC - x

FINANCIAL REGULATION:  BANK
MODERNIZATION LEGISLATION
====================================================== Chapter SUMMARY

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. 


FINANCIAL REGULATION:  BANK
MODERNIZATION LEGISLATION
==================================================== Chapter STATEMENT

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). 


   SAFEGUARDS ARE NEEDED
-------------------------------------------------- Chapter STATEMENT:1

Toward this end, our work suggests that the following specific
safeguards should 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.\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 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. 

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. 


--------------------
\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. 

\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). 


   BANKING AND COMMERCE
-------------------------------------------------- Chapter STATEMENT:2

Mr.  Chairman, while our work shows that the case for modernizing our
banking laws is clear, we would urge that Congress proceed cautiously
if it 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. 


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


------------------------------------------------ Chapter STATEMENT:2.1

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. 


AN EXPLANATION OF CONSOLIDATED
HOLDING COMPANY REGULATION AND
FUNCTIONAL REGULATION
=========================================================== Appendix I

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. 


   CONSOLIDATED REGULATION OF THE
   HOLDING COMPANY
--------------------------------------------------------- Appendix I:1

Under current bank holding company regulation, the Federal Reserve
System is responsible for regulating the company as a whole.  This
means that the Federal Reserve sets capital requirements on a
consolidated basis 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. 


   FUNCTIONAL REGULATION
--------------------------------------------------------- Appendix I:2

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

   Figure 1:  Regulation of a
   Hypothetical Bank Holding
   Company

   (See figure in printed
   edition.)


POTENTIAL BENEFITS AND RISKS OF
ELIMINATING THE CURRENT SEPARATION
OF BANKING AND COMMERCE
========================================================== Appendix II

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
     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 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 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 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. 


--------------------
\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. 

\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.. 

\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). 

\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). 


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