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SECURITIES ANDEXCHANGE COMMISSION

Washington, D. C. 20549( 2 0 2) 2 7 2.- 2 650

REMARKS TOTHE EXCHEQUER CLUB

WASHINGTON, D.C.October 21, 1981

Gr~ASS-STEAGALL :THE MAGINOT APPROACH TO REGULATION

Bevis Longstreth

Commissionec

GLASS STEAGALL: THE MAGINOT APPROACH TO REGULATION *

In 1930, with memories of the Great War still fresh,France determined to concentrate its nefense efforts O~building a protective line on its northeast frontier to preventanother German attack. The idea for this concrete and steelbarrier grew out of the success which certain modern fortresseshad enjoyed in withstanding German artillery a decade before,as well as the savings in manpower it produced. In 1940, nowwell-prepared to fight World War I, France paid the price forits tactical rigidity and lack of foresight. When Germanyattacked, France's Maginot Line was outflanked by tanks infour hours; within a week the Germans had made their way acrossFrance to the English Channel.

In 1933, with fresh memories of banking excesses andabuses which contributed to the Great Depression, Congressenacted a far-ranging program of corrective legislation de-signed to regulate thp. zinancial marketplace of the time.Portions of that program -- the securities laws are a proudexample -- have proved to have an enduring flexibility. Onenotable exception was that portion of the Banking Act of1933, commonly known as the Glass-Steagall Act, which soughtto erect an unyielding and permanent barrier between commercialbanking and certain investment banking practices mostnotably the underwriting of securities.

The Glass-Steagall Act served its immediate purposewell by restoring public confidence in our banking system --a confidence which had been severely eroded by the Crash andthe subsequent failure of over 7,000 banks.

Today, Glass-Steagall is embattled, facing challeng~sno less difficult or important than those it faced at t~)eoutset. The seemingly ir.resistable pressures of inflationatop the sweeping social anti economic changes of: the last50 years have radically redrawn the neat divisions which in1933 distinguished competitors and their products in the fin-ancial markets. The results are revolutionary, with major new

* The views expressed in this paper are my own and do notnecessarily represent those of the Commission or my fellowCommissioners

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developments seeming to arrive almost daily. Lest there beany doubt that today' s financial landscape would be a trulyalien exp~cience for Senator Glass and Representative Steagall,let me briefly describe some notable landmarks:

money market funds, which accept what somewould call "deposits," pay the functionaleqivalent of "interest" and provide checkcashing privileges, today hold aggregateinvestments of over $160 billion, or threetimes the gross national product for 1933.Merrill Lynch's Cash Management Account,which looks, smells, feels and tastes somuch like the product of a commercialbank that it has been called "the bankof the future," holds $10 billion inassets without so much as a nod tothe bank regulators.Private pension funds -- virtually non-existent in 1933 -- today control assetsof over $360 billion.Commercial banks -- the "slow growthgiants" of the 1930's and 1940's -- arevigorously marketing a wide cange ofcorporate finance and retail investmentservices and products including thepackaging of securities offerings forprivate placement, the underwriting ofcommercial paper domestically and ofcorporate securities outside the UnitedStates, and the sponsoring of closed-endinvestment companies and automatic invest-ment plans.Insurance companies -- which have alreadyexpanded into new products, including vari-able life policies, guaranteed insurancecontracts, and universal life policies --are beginning to entec into direct competi-tion with securities firms through acquisi-tions such as that of Bache, Halsey, Stuartby Prudential.

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Sears -- that f.riendly giant which publishesfarm equipment catalogues -- has committedto establish a money markp.t fund, acquire amajor broker-dealer, Dean Witter, and thenation's largest real estate brokerage firm,Coldwell, Banker; in short, to become thenation's largest financial services supermarket.Thrift institutions -- those traditionalsources of home mortgage credit and 5-1/2 %interest on deposits -- are offering retailrepurchase agreements collateralized by u.s.Government securities, with returns two tothree times the maximum levels permitted fortheir savings accounts, and some are seekingauthority to organize a nation-wide brokeragefirm.

In this fusillade of change, will the Glass-Steagallline hold? When the smoke clears, will it have been outflankedand overtaken by developments, 1ike Minister Andre Mag inot' sLine? Some, most notably the major banks, have suggested thatthis already is the case -- and that the Act should be rescindedas an unnecessary barrier to the operation of a freely competi tivemarket. Others, especially from the in-vestment banking industry,seek Congressional reaffirmation of the Act, declaring itessential to avoid the banking excesses of the 20' s, and tocontinue, incidentally, the protection from bank competi tionafforded by the Act's restrictions. Thus goes the debate,before a public audience, 70% of whom weren't even born whenGlass-Steagall was signed into law. The issue is now joinedin the Congressional forum, where Senator Garn has introduceda bill to "enhance the competitiveness of depository institu-tions, to expand the range of services provided by such institu-tions, to protect depositors and creditors of such institutionsand for other purposes."

Although the highly complex issues clustered about Glass-Steagall have received extensive and intelligent attentionthrough testimony before Congress and a number of studiesover the years, clear solutions remain marvelously elusive.As the landmarks just noted suggest, the principal difficultyin reaching solid judgments about Glass-Steagall is t ha t thegame being played, thp. field on which it is played, and theplayers, are constantly changing.

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Let me try to illustrate this point by reference to theHunt Commission. In 1970, President Nixon formed a "blueribbon" Commission, charged with the broad mandate to "reviewand study the structure, operation, and regulation of theprivate financial institutions in the United States for thepurpose of formulating recommendations that would improve thefunctioning of the private financial system." With the benefitof hindsight, it is nothing short of amazing that the Commissiondid not study investment banking or other facets of thesecurities industry, did not reflect the competitive or anti-competitive effects of Glass-Steagall in its recommendations,and did not include, in the Blue Ribbon panel, a single repre-sentative from the investment banking or brokerage industries.

Of course, we cannot just throw up our hands and walk awayfrom the problems because solutions remain elusive. Thereare continuing pressures for legislative change, as seen mostrecently in the form of Senator Garn's bill, which would,among other things, legalize bank underwriting of investmentcompany shares and municipal revenue bonds. These types ofchanges should be undertaken only with an adequate understandingof the overall regulatory structure, its effect on the underlyingmarkets and the role played in these matters by Glass-Steagall.

For the balance of this talk, I would like to share withyou some Observations on the Glass-Steagall Act, and the conclu-sions to which they point. I will then briefly apply theseconclusions to the Glass-Steagall legislation now pending. Inso doing, I hope to describe some neutral principles that can beapplied to analyze any issue arising under Glass-Steagall.

The Purpose and Limitations of the Act

The purpose of Glass-Steagall was simple enough. As ex-plained by Representative Steagall in 1933:

"The purpose of this legislation is toprotect the people of the United Statesin the right to have banks in which theirdeposits will be safe. They have a rightto expect of Congress the establishmentand maintenance of a system of banks inthe United States where citizens mayplace their hard earnings witb reasonableexpectation of being able to get them outagain on demand."

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This purpose was achieved in part by prohibi ting comme rciaIbanks from underwriting and otherwise dealing in secur i t ies andin part by providing federal insurance for deposits. The con-cerns of Congress were thus quite broad -- anything that threat-ened the sta~')ility or security of the banking system. Butviewed against the bdc~drop of the federal deposit insuranceprogram, the barrier against in~estment banking was somewhatnarrow.

Thus, although Glass-Steagall was interpreted by theSupreme Court "to prohibit commercial banks from going intothe investment banking business," a number of the activitiescarried on by investment bankers were left open to commercialbanks as well. For example, the Act specifically contemplateddirect involvement by commercial banks in the underwr.itingof certain government and municipal securities, and in agencysecurities transactions for retail customers. Moreover,when operating in their trust capacity, commercial bankswere permitted to offer pooled investment funds whose realworld econom ic distinction from mutual funds was, at best,elusive. Commercial banks were also free to render a varietyof financial services to corporate issuers, including thepackaging of offerings for private placement, and investmentadvice to customers. 'l'heseare all securities activities,and each puts the banks in direct competition with segmentsof the securities industry.

The Glass-Steagall barrier was intended to stamp outa number of evils which Congress found banks to have engagedin prior to the Great Depression. These included:

self-dealing by bank officers,

unsound lending practices,

conflicts of interest, and

fraud in the marketing of securities.

Each of these abuses was seen as having its root in thetemptations and pce ssures created by the diversion of COH1-mercial banking facilities into specultative operations fos-tered by the aggressive and promotional cha rac t e r of theinvestment banking business. at c~urse, today, each of theseabuses could be dealt with more flexibly than through the

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construction of a rigid barrier such as Glass-Steagall. Acombination of state law, federal securi ties and banking laws,and bank regulatory agency oversight and rulemaking, could holdthese abuses in check. Concepts such as the "Chinese Wall,"developed by the banks and securities firms themselves to dealwith inside information and other conflicts within a single firmor group of affiliated firms, afford creative solutions to accom-modate diversification of function within a single enterprise.

The Glass-Steagall Act and Competition

The Glass Steagall Act reflected a clear Congressionaldetermination that avoidance of the "hazards" and "financialdangers" to banking that arise when commercial banks engagein investment banking, outweighed the advantages of competi-tion, convenience, or expertise which might support bank entryinto investment banking. In the words of Justice Harlan, "ifanything, the Act was adopted despite its anticompetitive effectsrather than because of them."

This bright line approach and the underlying Congressionalbalancing of interests served well for more than 30 years --as long as the markets were willing to cooperate. In recentyears, however, the realization has grown that the balancemay have to be restruck that changes in the financialmarketplace have so heightened the effects of Glass-Steagallon competition that the original concerns which prompted Congressto act might no longer be viewed as dominant.

To take one aspect of the debate -- money market funds --the banks argue that, far from protecting the banking system,the Glass-Steagall barrier is weakening that system by blockingthe banks' ability to compete, as depositary institutions, forthe public' s funds through sponsorship of such investment com-panies. On the other side, the Investment Company Instituteargues that Glass-Steagall is essential to avoid giving unfaircompetitive advantages to the banks and fostering undue con-centrations of economic power in their hands. While these concernsmay be legitimate ones to weigh in today's debate, they werenot, as the ICI suggests, among the original concerns underlyingGlass-Steagall.

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Conclusions Drawn From Experience With The Act

Nearly 50 years of experience with Glass-Steagall promptstwo important conclusions:

First, many of the concerns underlying the Act remainas valid today as they were in 1933i and

Second, the Maginot line approach to dealing with tho~econcerns should give way to more flexible regula-tory solutions.

Allow me to expand briefly on these conclusions.

1. The REIT ExperienceThe temptations and conflicts which were thought to arise

when commercial banks engage in investment banking were con-firmed as recently as the 1970' s by the history of bank-sponsored REITS, where most if not all of the perils predictenfor the joinder of investment banking with commercial bankingoccurred when bank holding companies sponsored REITS bearingtheir names and sold them to the public, through investmentbankers to be sure, but on the basis of bank expertise andcommitment.

Among the principal concerns underlying the Glass-Steagallline of defense were the following:

Congress feared that banks and theirfinancial affiliates would be closelyassociated in the public's mind,with the result that, should theaffiliate fare badly, public confi-dence in the bank might be i~paired.

• To avoid such a loss of confinence,the bank might be tempted to shoreup the affiliate through unsoundloans or other aid.Congress feared that the promotionalpressures on the bank to ma~e itsfinancial affiliate successful wouldcause it to make its credit facilitiesmore freely available to its affiliate,even to the point of making unsoundloans.

•

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A few highlights from the REIT debacle should suffice toshow how brilliantly that experience validated these Congress-ional concerns.

At the peak of REIT activity, in 1976, there were39 bank-sponsored REITS out of 216, accounting forsome $6 billion of invested assets or 30% ofthe industry total. At least 30 of the bank-sponsored REITS used their bank names, includingChase Manhattan Mortgage and Realty Trust, thelargest of all the REITS. The public was led toexpect that the bank's reputation for prudence,safety and solvency would shelter its sponsoredREIT. As one Miami banker, William Duncan, wasquoted as saying:

"Because it was the Chase, the implicationwas the project had to be good. Nothingcould go wrong, and even if it did go wrong,the bank was there to back it up."

The record suggests that banks extended excesscredit to their REITs, both to earn high returnson their loans and to generate large profits forthe affiliated adviser to the REIT, whose fee wasbased on size of assets under management.

Some commentators suggest that banks directed theriskier loan applications to their sponsoredREITS, who were obvious candidates for such loansin view of their need to charge a higher returnon their loans than was charged by the bank orother suppliers of capital to the REIT.

The record is also clear that, as their sponsoredREITs developed problems, the banks engaged inunsound asset swaps and other transactions withtheir REITs in order to shore them up. The Chasebank, for example, after purchasing about $160million of its REIT's loans to help stave off thatREIT's bankruptcy -- loans that no other purchaserwould buy on comparable terms -- had a loan expos-ure to its REIT of 140% of its total reserve forall loan losses. In 1976, the Washington Postreported that the Chase Bank was included on theComptroller of the Currency's confidential listof "problembanks."

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Now, if the REIT experience validated the under-lying concerns which gave rise to the Glass-Steagall barrier,why didn I t that barrier work? The barrier didn I t block theREIT abuses because it was outflanked by the banks. Itsrigidity -- intended as a strength -- was also its weakness.Neither the sponsorship of REITS, nor their use of bank names,nor the rendering of investment advisory and management ser-vices to the REITs, nor the making of loans to them consti-tuted activities proscribed under the Act. This leads to mysecond conclusion.

2. The Maginot Line approach should give way tomore flexible regulatory solutions.

While its purposes remain viable today, the Glass-Steagallapproach to achieving them, as not so subtly suggested bythe Maginot Line metaphor, is too rigid to serve the needsof our rapidly changing financial environment. If the goalis protection of a sound banking system, flexible regulationby agencies charged with implementing that goal through rule-making to condition or prevent bank diversification will betterserve the public interest. What was intended as a "brightline" distinction between commercial and investment bankinghas spawned much litigation, several Supreme Court decisions,and line drawing of the most delicate sort. Thus, by a splitdecision in Investment Company Institute v. Camp, the SupremeCourt traced the thinnest of lines between

(a) that which is lawful:management, by way of pooled orcommon trust arrangement, ofseparate funds held as fiduciaryin the technical sense, andmanagement of separate agencyaccounts of whatever size, and

(b) that which is unlawful:the pooling of those separateagency accounts for commonmanagement.

Or consider the super-refined application of Glass-Steagall bythe Supreme Court this year, when it construed the Act toprevent bank sponsorship, organization and control of open-endinvestment companies but to permit such activities as appliedto closed-end investment companies.

- 10 -In short, despite its rigidity, the Glass-Steagall line

is not bright. Despite the soundness, today, of the concernswhich cast it in concrete almost a half-century ago, its effec-tiveness is impaired by its inflexibility. For the future,then, a regulatory approach to those concerns will best serveour needs.

I do not mean to suggest that the regulatory solutionalways works. Indeed, in the REIT case, the Bank HoldingCompany Act probably afforded the bank regulatory agenciessufficient power to address most, if not all, of the conflictsand temptations which ripened into financial problems forthe banks who had sponsored REITs. In fact, in 1972 theFederal Reserve Board issued a rule permitting bank holdingcompanies and their non-banking subsidiaries to act as invest-ment advisers to "closed-end" investment companies, subjectto precisely the kinds of safeguards that would have beeninvaluable to the bank-sponsored REITs. That rule prohibited:

advisory services to an investmentcompany having a name similar to theholding company or any subsidiarybank~bank holding company or affiliatepurchases of the investment company'ssecurities, either for its own accountor as a fiduciary~ andloans to the investment company.

Now, with these thoughts in mind, I will briefly considerthat portion of Senator Garn's bill that would modify Glass-Steagall to permit banks to underwrite investment companyshares and municipal revenue bonds.

Brief Comments On The Garn Bill

In considering the Garn Bill, one is faced with twobasic questions:

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1. Whether the Glass-Steagall barrier shouldbe lowered to pecmit either of these twoactivities; and

2. If so, how it should be done?

First, as to whether., I think one can usefully lookseparately at the underwriting of (a) ~unicipal revenuebonds, (b) money market fund shares, and (c) other in~estmentcompany shares.

(a) Municipal revenue bonds can reasonably be viewedas a natural extension of the kind of underwriting activityexpressly approved for commercial banks by Glass-Steagall.Moreover, this type of financing which represented aninsignificant 2.5% of state and local issues when Glass-Steagall was enacted into law -- has grown to represent morethan 70% of the current new issues.

While legaL differences certainly exist bet~p.enthe two,revenue bonds can -- and often do -- present about equivalentdegrees of security for the investor.

Thus, subject to appropriate safeguards to assure thatbanks do not assume undue risks, it would seem that theGlass-Steagall concerns need not continue to stand in theway of this activity.

(b) As noted earlier, money market funds compete head-onwith commercial banks for funds. And, because of the legalcet lLnqs on interest payable by banks to their depositors,the money market funds are whipping the banks in this scuffle,despite the fact that federal insurance is available onlyfor bank deposits. Under these circumstances, it is r.easonableto view assets Lnvest.ed in money market funds, especiallythose investing exclusively in paper issued or guaranteed bythe federal government, as the functional equivalent of bankdeposits, and, therefore, more a co~~ercial banking, than aninvestment banking activity. Under this line of analysis,it would seem that Glass-Steagall concerns need not, andperhaps should not, stand in t.he way of bank sponsorship,underwriting, and advising of money ~ac~p.t funds, subject toappropriate safeguards for ~oth banks and investors.

(c) To go beyond money market funds, however, as theGarn Bill would do, to permit sponsorshIp, underwriting and

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advising of all types of investment companies, raises broaderand more difficult questions of policy, which, I for one, havenot yet worked out. I do feel, however, that before theGlass-Steagall barrier is lowered to permit bank entry intothe investment company field generally, a broad review of thefinancial services industry should be essayed, focusing on therespective roles of competition and regulation in benefitingthe consumer of financial s~rvices.

In this regard, it is often said that, when differentsegments of the financial services industry compete, theyshould compete on an equal regulatory footing. Howeverimpeccable in its logic and compelling as an expression offairness, I submit that this notion is an ideal beyond thereach of a system that has been evolving for over 200 years.This is not to say that the "level playing field" idea iswithout merit. I simply believe it is an important, ratherthan overriding, principle, to be weighed in the legislativedebates along with other principles, such as stability in boththe banking and investment banking industries, and preservationof vigorous and effective competition.

Thus, I do not believe that bank deposits and moneymarket fund shares should be regulated in the same way, eventhough they now often compete for the same dollar and willdo so even more as interest ceilings are phaseo out. However,I do feel that, if banks are permitted to sponsor moneymarket funds, the bank regulators should be given ampleauthority to protect bank safety and soundness and, inaddItion, banks and their funds should be subject to thesame regulation as other money market funds and their sponsors.

2. Now, to my second question. Assuming Congress de-cides to lower the Glass-Steagall barriers to permit some orall of these activities, how should it be done? On thisquestion, I have a clearer-]udgment, which flows logicallyfrom the two conclusions reached earlier about our experiencewith Glass-Steagall.

As I read the Garn Bill, it would not empower thebank regulatory agencies to establish standards for theentry of commercial banks into the underwriting of municipalrevenue bonds and investment company shares. I view thisomission as a mistake.

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The REIT experience demonstrates that (a) the concernsunderlying Glass-Steagall remain valid today, and (b) they arenot easily dealt with by the Maginot approach of rigid legis-lation. Thus, I would urge that, if Congress proceeds tolower the barriers, it be done by empowering the appropriatebank regulatory agencies to permit these activities, subjectto appropriate regulatory safeguards designed to protect thebanking system from such self-inflicted wounds as occurredwith bank-sponsored REITs.

In addition to these Glass-Steagall issues, it is import-ant to consider the concerns of investor protection andcompetition which would arise if banks were granted entryinto these fields. Although the Garn Bill would enablebanks to sponsor, underwrite and advise investment companies,it would not subject banks to those provisions of the federalsecurities laws which regulate brokers, dealers, and invest-ment adv isers \'1ith a view to the protection of investors.The Bill would require bank regulatory agencies to set stand-ards of training, experience and sales practice on the partof those sell ing investment company shares. However, I amnot convinced that asking those agencies to establish suchstandards is the most effective way to protect investors inan area where Congress has established a comprehensive schemeof regulation involving the Securities and Exchange Commissionand the self-regulatory organizations.

The Garn Bill would also permit banks to underwritemunicipal revenue bonds, subject to certain restrictionsdesigned to protect the soundness of banks and prevent con-flicts of interest. Since the municipal securities activitiesof banks are fully regulated, this provision would not raiseinvestor protection concerns. The Bill, however, does nottake into consideration the tax advantage enjoyed by bankswhich allows them to carry tax-exempt securiti~s with borrowedfunds while at the same time deducting the interest paid onthose borrowings -- an advantage not available to Lnve st.merrtbankers conducting identical activities.

The Admillistration has considered these issues and favorsa bill that would allow banKs to enter these new fields, butonly through securities affiliates, subject to the samefederal securities and tax laws as investment han~ers.

I support this approach as a means of address ing theinvestor protection and competitive concerns which would ariseif banks were permi tteJ ":!ntry into these fields. As for

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Glass-Steagall's fundamental concern with the stability ofthe banking system, however, I remain convinced that, ifCongress is going to per~it these activities, it shouldassign to the appropriate bank regulators the power to condi-tion entry upon compliance with rules designed to insurebank safety and soundness.