by Paul M. Connolly, First Vice President and Chief Operating Officer, Federal Reserve Bank of Boston
USA – Ireland Mutual Fund Conference
Dublin, Ireland
June 14, 2000

     It is an honor to be asked to speak to you this morning. First, the Dublin Funds Industry Association and NICSA have put together an exciting agenda for this conference, and I appreciate being invited to participate. Also, this setting in Dublin Castle is very special. Dublin Castle has been prominent in the history of Ireland, including a prominent role during the birth of the free nation. In this inspiring setting, capturing so much that is past, someone had the vision to see a modern conference center: a center to host international meetings, a place in which to engage the world. This combination of a rich history and a stepping forward to embrace the future may capture much of today’s Ireland. It is a combination in which the nation and all who live here can take pride, and in which many of us connected to Ireland by family take pride as well.

    This morning I wish to share with you some personal perspectives on two important forces which certainly affect financial services in the United States, and also have a bearing on the broader U.S. economy.

    The first is the new environment for U.S. financial services, resulting from the enactment, in November of last year, of new legislation, known as the Gramm-Leach-Bliley Act.

    The second is the activity of the individual investor, and its implications.

    In addressing first the new legal environment, I want to provide some of the essential information about the new powers that have been granted to Financial Holding Companies; the new FHC itself; the so-called umbrella supervision assigned to the Federal Reserve and how it relates to the roles of the other financial regulators; and the personal privacy issues that have come to the fore as this new environment has come into being.

    The new Financial Holding Company, which I will be explaining, is authorized to engage in an array of financial activities, and in other related activities.

    The new law specifies several allowed financial activities, including:

• Securities underwriting;
• Securities dealing;
• Insurance underwriting;
• Insurance sales, as in an insurance agency;
• Merchant banking, meaning investment in private or public equity securities for a period of time, followed by resale;
• All of the financial services already allowed for Bank Holding Companies; for example;

• Lending,
• Investment advisory services,
• Financial data processing;

• And activities previously specified by the Federal Reserve Board as connected with international banking, such as travel agency, and certain management consulting services.

    The law also authorizes the Federal Reserve and the U.S. Treasury, together, to define new activities as "financial" in nature.

    And, the law authorizes the Federal Reserve to determine that Financial Holding Companies can engage in certain nonfinancial activities, if such an activity is deemed complementary to a financial activity, and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.

    So, we can look forward over time to some evolutionary expansion of the financial and complementary activities allowed for these new Financial Holding Companies.

    Well, what then is this new Financial Holding Company, or FHC?

    In its essence, it is an augmentation of the well-established Bank Holding Company. In fact, an organization must become a Bank Holding Company in order to become a Financial Holding Company. Then, as I mentioned, the FHC is authorized to do all that a Bank Holding Company can do, and to undertake the new activities not previously permitted for banking organizations.

    In the U.S. there are about 5 thousand bank holding companies, many of them consisting of just one or a few fairly small banks. For all existing bank holding companies, large or small, the Federal Reserve has provided a streamlined process to become a FHC.

    Essentially, a bank holding company files with the Board a written declaration that it elects to become a FHC, and an attestation that each depository institution within the bank holding company is well-capitalized and well-managed; both of these characteristics have been defined in terms of risk-based capital standards and bank supervisory ratings. This is basically a self-certification process. The Federal Reserve itself will verify that each insured depository institution within the holding company has a satisfactory rating under the provisions of the Community Reinvestment Act, or CRA. If so, the bank holding company can become a FHC. The election to be a FHC becomes effective automatically on the 31^st day after the Federal Reserve receives that election, unless the Federal Reserve specifies otherwise during the first 30 days.

    There has been some concern this year about how this self-certification will work for banks owned by non-U.S. bank holding companies. The new law directed the Federal Reserve Board to establish "comparable" qualification requirements for foreign banks. This is no simple assignment, since it must cover banks in countries that have adopted the Basel Committee capital standards developed under the auspices of the BIS, and banks in countries that have not done so.

    As an interim measure, the Board provided that foreign banks electing to become FHCs meet the same risk-based capital standard as domestic banks, with a lower leverage standard: their Tier 1 capital must equal 3 percent of total assets, rather than the 5 percent required of U.S. bank holding companies. Some have argued on behalf of European banks that even this 3 percent leverage standard is too high, given their risk profiles, and that it imposes a requirement higher than those of the regulators in the home countries of these banks.

    The Board has provided that a foreign bank that does not meet the 3 percent standard can present other evidence of an adequate capital base.And two foreign banks have taken advantage of this option to become financial holding companies.

    Of the first 15 applications received from foreign banks, the Federal Reserve approved 13, and the other two were withdrawn for reasons not related to capital standards. We have more to learn in this area, and we will keep working to ensure that the process is equitable for non-U.S. banks.

    Well, what about firms which are not already bank holding companies? If they wish to become FHCs, they must apply, through a more involved process, to become bank holding companies. And if they choose, they can apply at once to become both. The first example of using this new path was the application by the Charles Schwab Corporation to become a banking company by acquiring one, the U.S. Trust Corporation of New York and its subsidiary banks. As part of its proposal, Schwab also filed its election to become a Financial Holding Company. The Board approved Schwab’s application on May 1. This initiative illustrates the "two-way street" intended under the new law: banking organizations can expand into new financial activities, and other financial services firms can expand into banking.

    Another important entity to understand along with the Financial Holding Company is the Financial Subsidiary. A financial subsidiary is a direct subsidiary of a bank. Under the new law, some activities can be undertaken by a financial subsidiary, while others can be undertaken only by subsidiaries of the financial holding company.

    To some this may seem to be a distinction without much of a difference. However, the distinction goes to how best to protect a bank and its insured deposits from business activities, and funds flows between affiliated businesses, that could affect the safety and soundness of the bank. There are different views about how best to provide such protection. For instance, while the new law was being debated, some argued that a bank should be permitted to engage in merchant banking through a direct subsidiary, and others argued that this activity should be housed in a subsidiary of the FHC. The law now prohibits merchant banking in a bank subsidiary, but allows the Federal Reserve and the Treasury to revisit this question together after 5 years of experience.

    In this new regime the Federal Reserve will function as a so-called "Umbrella Supervisor". That is, we will exercise consolidated oversight of the financial holding company. We will evaluate the consolidated strength and activities of the company to ensure that its financial condition does not threaten the viability of the depository institutions within the FHC. This overarching supervisory view matches well with the enterprise-wide, consolidated approach to risk management taken by most large and sophisticated financial services firms.

    However, this umbrella supervision does not mean that we intend to impose bank-like supervision upon financial holding companies or their non-bank subsidiaries. In fact, the law limits the Federal Reserve’s authority to examine or impose requirements on subsidiaries that already are regulated by others. Under the umbrella, then, we will have "functional regulation" by entities including the U.S. Treasury, the Securities and Exchange Commission, the state insurance regulators, the Commodities Futures Trading Commission, the Federal Trade Commission, and others.

    The new law clearly intends that functional regulators, other bank supervisors such as the Treasury’s Office of the Comptroller of the Currency, and the Federal Reserve as umbrella supervisor will respect each other’s responsibilities and make use of each other’s expertise.

    I am sure that all of us will do so. Still, doing so will pose new challenges for all of us. Regulators, within the U.S. and abroad, take different approaches and even use different terminologies. We regulators have a lot to learn about each other, even as we are learning about the new FHCs. For instance, if we in the Federal Reserve are to rely as much as possible upon examinations conducted by the SEC, we need to learn as much as we can about how the SEC examination process works. We have worked together effectively in the past, most recently on Y2K preparedness, but the new requirements take us much further.

    In a similar way, we need to do even more than before to be well coordinated with financial services supervisors worldwide.

    Through key organizations such as the Basel Committee on bank supervision, working relationships among bank supervisors have been strengthened, and the supervisory principles and standards for sound banking practices developed under these auspices have improved banking supervision around the globe. Now, such international cooperation must extend to the full range of regulated activities conducted by large international financial organizations.

    One new way to deal with these new needs will be through the Joint Forum, with representatives of agencies regulating banking, securities, and insurance from numerous nations. More such collaborative approaches no doubt will be needed. Taking coordination and cooperation to a new, more demanding level will be challenging, and, I trust, exciting, for all of us.

    If there was a genuine "surprise issue" as this new law made its way through the Congress during 1999, it was privacy for individuals. I call this a surprise not because the privacy of people’s financial and other information was not being considered during the many years of effort to pass a comprehensive financial modernization bill; it was. However, it became one of the hottest and most debated issues, more or less all of a sudden, as 1999 progressed. Its emergence was due in part to some well-publicized marketing practices at a few banks, and in part to a growing awareness of privacy issues associated with the use of the Internet by consumers. As the privacy issue gained attention, it quickly gained rather broad and bipartisan support in the Congress. As a result, the new law includes privacy requirements with broad applicability.

    The law imposes 3 basic requirements.

    First, financial institutions must provide an initial notice to consumers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties.

    Second, they must provide annual notices of their privacy policies to consumers with whom they establish a customer relationship.

    And third, they must provide a method for consumers to opt out of disclosures to nonaffiliated third parties.

    nbsp;   These privacy provisions apply to all U.S. financial institutions engaged in financial activities. It includes banks, insurance companies, securities firms, finance companies, and even travel agencies.

    All of these requirements were to become effective in November of this year, just one year after enactment of the law. In May the banking and securities regulators announced that compliance with these requirements would be voluntary until July 1 of 2001, in effect providing an additional 8 months for financial services firms to prepare to meet these requirements.

    At the same time, with the ink barely dry on these new privacy requirements, a number of parties have proposed or advocated new legislation to make the privacy requirements more stringent. One proposal is to extend the restrictions to the sharing of information between affiliated entities within a financial organization. Another proposal is to change the "opt out" provision to an "opt in" provision, meaning that a consumer would have to give his or her affirmative consent before any personal information could be shared.

    And finally, the law already allows any of the 50 states to set tighter privacy standards. If some states do so, then financial firms operating nationally will have to keep track of, and comply with, some array of different requirements.

    I think you can see in these privacy provisions and their popularity further evidence of the misgivings about concentrations of financial power that have persisted in the U.S. from the early days of our nation, as well as growing concerns about privacy in an age of massive electronic data bases and widespread telecommunications, which many nations and their people share.

    Well, that is a look at the new legal and regulatory environment for financial services in the U.S. Now, I would like to look more briefly with you at investor activity, which is another factor affecting the financial services environment as well as the performance of the domestic economy.

    Here, then, are a few perspectives on recent investor behavior; the savings rate; and the wealth effect.

    To simplify somewhat, I might summarize recent investor behavior, with particular respect to individuals investing in mutual funds, as follows.

    The investor has high expectations. Surveys indicate that most of them expect their equity investments to appreciate by 15 percent or more annually, even after the enormous gains of recent years; and as you know, many expect returns much greater than that.

    The investor pays daily or near-daily attention to his investments, and takes actions in response to changes in the markets. While some thought that workers with investments in retirement accounts might be content to leave their funds alone for years at a time, looking upon these funds as money they will not spend for decades, this has not been the norm.

    The investor has demonstrated mobility with her money. When markets have dropped, as in September and October of 1999, households have switched funds from equities into money-market accounts and other alternatives. Then, when markets have risen, as in late 1999 and early 2000, their money has flowed back into equity funds. More recently, we saw some switching from equity funds into money market accounts and bank certificates of deposit this spring as market declines occurred.

    And investors cumulatively are concentrating more of their money in the most highly rated mutual funds. The investor has been rather impatient and unforgiving, which I suppose might be said about today’s markets generally.

    There has been some confusion about the national savings rate in the U.S., and what constitutes savings. Let me offer a few points on this topic.

    First, national savings differs from personal savings. National savings includes saving by consumers, business, and government. During most of the 1990’s national savings, in proportion to the gross domestic product, or GDP, increased, from about 4 percent in 1993 to about 7 percent in 1999. The major source of the increase was in government savings, reflecting the progression from sizable federal budget deficits to budget surpluses.

    Meanwhile, though, personal savings by consumers declined substantially, so that recently it has been close to zero. Personal savings consist of what we save from our incomes. Money that we earn and then put into a bank account, or a mutual fund, or another investment vehicle counts as savings. However, the appreciation on our invested money does not count as savings. Therefore, consumers may look at their mutual fund statements and say that they are saving more than they ever did before, and so feel more comfortable spending all of their income from their jobs. Or, as one person invests a lot of her income, another incurs that amount of debt. In the national accounts, all of this will appear as a savings rate close to zero.

    Another factor when we consider the savings rate is that it looks at the difference between current income and current spending. Recently this difference has been small, indicating little savings. However, some of what consumers spend today reflects their anticipation of higher incomes in the future. They spend ahead of their incomes, while the national accounts look at both spending and income in the present tense.

    What is important about savings for the overall economy is the availability of funds for investment. Investment in lieu of immediate consumption enables economic growth, allowing for increased future production and consumption. While total national savings has increased, as I mentioned, the decline in personal savings leaves us without sufficient national savings to meet the increased demand for domestic investment. This shortfall, about 2 percent of GDP in 1999, has been covered by foreign investment. That foreign investment is needed and welcome, but more personal savings would provide a greater sense of comfort that the nation can count upon its own resources to fund needed investments.

    The low savings rate is one manifestation of what people call the wealth effect. People – and businesses also – have done well with respect to income, and they are continuing to do well, and they expect to do well as they move along. These prospects encourage more consumption by individuals, as well as more capital spending by businesses.

    The "drivers" of the wealth effect, then, extend beyond the higher valuations in the stock market. They also include rising incomes, higher values for other assets, particularly people’s homes, and confidence about the future.

    Interestingly, even with the wild ride in the stock market during March and April, consumer confidence stayed close to its high levels in those months, and moved higher still in May.

    Strong consumption, spurred by the wealth effect, has carried the economy forward, with support from business investment, and with both apparently reflecting an optimistic view of the future.

    That noted American economic analyst, Yogi Berra, once said, "I never make predictions, especially about the future". A prudent rule to follow, I would say. However, if we assume that incomes and profits and asset values may not continue to grow as robustly as some seem to expect, then we have to have concern for the impact of the deceleration in spending that probably would ensue.

    Obviously, when we have some cooling in our hot economy, we all hope for a soft rather than a hard landing. We hope that people, as consumers and investors, will adapt to new, less robust expectations, help the economy to "simmer down", spend at a more moderate rate, but not change suddenly from hot to cold, from optimistic to pessimistic. Some additional savings will be welcome as well.

    I hope these perspectives on financial services and investor activity in the U.S. have been helpful. Thank you.