Implications of Relaxation or Repeal of Glass-Steagall Act for Safety-Net Responsibilities

In our recent report on issues surrounding repeal of the provisions of the Glass-Steagall Act² separating the banking and securities businesses, we made a number of recommendations for changes that would need to accompany any relaxation of prohibitions on banking powers. All have relevance for the question of central bank responsibility, because they all would change various aspects of the federal financial safety net.

Owner-supplied capital is an essential element for coping with safety-and-soundness difficulties and their potential to disrupt financial stability. Because of the sad state of affairs in the thrift industry, we recommended that expanded powers, such as securities underwriting and trading, be engaged in only by firms that have sufficient capital to absorb the losses that will invariably be sustained from time to time by firms conducting such activities.

In addition to the regulation of its expanded activities, the structure of a financial organization has an important bearing on safety and soundness, as well as market stability. In our view, the holding-company structure provides the greatest degree of legal, economic, and psychological insulation of insured deposits from nonbanking activities. For this reason, we recommended that any firm wishing to engage in combined banking and securities businesses adopt this form of organization. We envision each subsidiary of the holding company being subjected to functional regulation. But we also believe it is absolutely essential that the Federal Reserve oversee the holding company itself. Because of the growing importance and complexity of the Federal Reserve’s role in providing financial stability, which we discussed earlier, it must have this vantage point in order to stay abreast of events, acquire needed information, and deal with market crises if they arise. Furthermore, because we view responsibility for dealing with crises as being shared between the banking system and the Federal Reserve, and because we are concerned about extension of the lender-of-last-resort function, as well as deposit insurance, to nonbanking activities, we recommended that the holding company maintain sufficient capital to act as a source of strength for its depository and, perhaps, its securities affiliates.

Some of the proposals to modernize financial regulation would simply move the wall separating the banking and securities businesses, which currently is required by the Glass-Steagall Act, inside each organization offering both banking and securities products. Those who hold this view would encase the banking part of the organization within a set of so-called firewalls designed to prevent the spread of problems in nonbanking affiliates to the bank itself and thus avoid jeopardizing insured deposits.

In our view, complete insulation of banking organizations may be impossible to achieve, should not be relied on as the only means to control risk, and may increase the burden of the Federal Reserve in maintaining financial-market stability. Insulation strategies should be viewed as but one of a number of measures—such as increased capital ratios, the creation of incentives for management to operate in a safe and sound manner, and regulatory oversight—that can be used to protect bank safety and soundness. We are most concerned about proposals that would prohibit loan transactions between banking and securities affiliates. The events of October 19 revealed the importance of banks as providers of liquidity to securities firms, and we are very concerned that the proposed outright prohibitions could have a destabilizing effect if these events are repeated. If such a prohibition inhibited the flow of liquidity during another market crisis, this would simply increase the burden on the Federal Reserve to supply liquidity, and it might also portend the provision of lender-of-last-resort assistance by the Fed directly to securities firms rather than through the banking system. In our view, the current Federal Reserve Act’s Section 23A and 23B³ restrictions that limit interaffiliate transactions provide ample safeguards against abusive or unsafe and unsound practices, although we would support increased penalties for violations.

Finally, we expressed the view that the degree of comfort that one has with repeal of the provisions of the Glass-Steagall Act will depend on one’s faith in the regulators’ ability to oversee effectively the newly allowed activities in terms of safety and soundness and protection of consumer interests. And, in our opinion, the regulatory resources available to oversee activities of financial institutions and markets are inadequate in today’s environment and would be woefully inadequate in tomorrow’s much more complicated one. We do not believe powers should be expanded until this situation is corrected.

Implications of the Market Crash for the Federal Reserve’s Responsibilities

I have dealt at some length with the merging of the banking and securities businesses and the implications of this for central bank responsibilities. Let me now discuss the implications of the October 1987 stock-market crash for central bank responsibilities.

The events of October 1987 laid bare (for those who were not already aware of it) the fact that, in many important respects, the financial-futures and cash-equity markets in this country are linked. Events in one market rapidly affect price formation in the other, and, given the uses that are made of these markets by major investors, disruptions that break the links between the two markets have proven to be highly destabilizing. However, these two markets are overseen by different regulators and operate under very different rules.

Because of this situation, we recommended that several steps be taken to better integrate the workings and regulation of the futures and equity markets in order to enable both market participants and regulators to cope more effectively with the new market demands.

We recommended that the self-regulators and federal regulators work together to develop an integrated contingency plan to deal with any market breaks that might occur in the future. In our view, this plan should, at a minimum, contain the following elements:

• a contingency committee or control center to be activated in the event of a market crisis, with established lines of authority for decision making;

• a clarification of the regulators’ and markets’ duties and responsibilities in a crisis and a consideration of the circumstances in which these organizations should undertake identified tasks; and

• a clear delineation of, and emphasis on, communication channels and procedures to be used during a market crisis, including identification of liaison personnel and the conditions under which the communication channels should be opened.

In our view, these plans should foster confidence by assuring the market that the possibility of a repetition of the October 1987 events has been considered by those responsible for regulating these markets and an approach to dealing with the problems that might be created by such an outcome has been developed.

While the development of contingency plans may enable markets and the regulators to cope better with another market emergency, a more appropriate intermarket regulatory structure needs to be developed. Regulation of futures and equity markets must be coordinated and decisions must be made on such issues as intermarket products and strategies, margin regulation, clearing systems, the provision of liquidity during normal and abnormal times, and the growth of linkages across international boundaries.

The President’s Task Force on Market Mechanisms expressed the view that the Federal Reserve is in the best position to accomplish the necessary coordination and decision making. We are not convinced at this time that the Fed should play this role, nor are we convinced that a single market regulator is needed to oversee and coordinate regulation of the linked aspects of these markets.

However, as of mid-April 1988, no contingency plan had surfaced. And, the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) have not been able to resolve fundamental disagreements over margins, limits on trading, and other matters which are crucial to more harmonized regulation of these markets. In addition, the New York and Chicago markets appear to be taking unilateral actions which threaten to decouple, rather than fuse, important aspects of their operations. It remains to be seen whether the separate regulators can work out their differences. If they cannot in the relatively near future, then a focal point for the development of a contingency plan and for coordination of the regulation of the linkages may have to be identified.

Regardless of the outcome, the Federal Reserve has an important stake in the smooth functioning of futures-market and equity-market mechanisms. The central bank was ultimately responsible for picking up the pieces last October, and it will no doubt have to involve itself once again to protect the credit markets should the events of last October be repeated.

Of particular concern to us is the possibility of a catastrophe resulting from a breakdown of the payments and securities/futures clearing systems during a future period of financial stress. Problems that occurred in these systems on October 19 and 20, 1987, though not catastrophic, caused some participants to leave the market. In the future, depending on events, and as these systems become increasingly linked to their foreign counterparts, the potential for a serious breakdown in meeting financial commitments grows. We intend to begin studying this issue this summer.

Let me sum up by re-emphasizing my view that central bank responsibility for financial market stability, while shared in many important ways with the banking system and other aspects of the financial safety net, is still one of last resort. Given the momentum toward further integration of financial services and the linkages between the futures and equity markets, we need to preserve the liquidity-provision functions of the banking system; strengthen oversight and regulation; harmonize regulation of the futures and equity markets; and ensure, to the greatest extent possible, that the Fed’s role as lender of last resort is preserved so that it does not become the lender of first resort to any and all participants that may experience difficulty or threaten to destabilize the financial system.

DANIEL L. GOELZER

I am very pleased to be here today. In a way, I feel slightly out of place; the Securities and Exchange Commission (SEC), of course, is not a central bank; it is not a bank regulator; and its responsibilities are for the securities markets, not for the banking system, although, of course, there is an obvious interrelationship or intertwining between the health of the securities markets and the banking system.

I certainly agree with the basic conclusions in Mr. Fogel’s excellent paper; I would like to reiterate some of the points I heard him make. I certainly think that one of the things we learned in October of last year is that the financial markets and the securities markets worldwide are linked and have very rapid impacts on one another. Also, we learned, if we did not know it already, that the stock market in the United States and the market for financial futures—that is, for futures on stock indexes—are closely linked, constituting one interrelated, interdynamic system. We have also learned something about the regulatory structure that we currently have for regulating those markets and the need to restudy it, redesign it a bit perhaps, to make sure that it can cope with the kind of events that we had last October. For that matter, I think we have learned something about the need for contingency planning, which Mr. Fogel also mentioned.

I would like to take a couple of minutes to give a brief SEC perspective on some of these events. The views I will express are my own and not necessarily those of the SEC or of my colleagues on the SEC staff.

As I said at the beginning, our responsibility at the Securities and Exchange Commission is to ensure investor protection and the maintenance of fair and orderly securities markets. Banking safety and soundness is not part of our mandate, although it is obviously something to which we cannot be oblivious. By the same token, the futures markets, including the markets for futures on the very securities we regulate in the securities markets, are not directly under our jurisdiction. The Commission does not do all of its regulating itself. We have exchanges—so-called self-regulatory organizations—that are, in turn, under our jurisdiction. These organizations cannot change their rules or, in fact, take any important steps to modify their operations without the SEC’s approval. In this country, of course, there are bank regulators and the Federal Reserve Board which do have the direct responsibility for the safety and soundness of the banking system. The Fed also sets the margin requirements for trading in securities, the markets for which the SEC regulates. Thus, it is up to the Fed to determine how much money must be put down in order to purchase a security or an option on a security, but the Fed has no jurisdiction over the margins on financial futures on securities.

The Commodity Futures Trading Commission (CFTC), for its part, regulates the futures market, which includes futures on agricultural commodities, gold and silver, and monetary commodities, as well as futures on groups of securities—stocks that trade on the New York Stock Exchange or other stock markets. The CFTC does not have authority over margins in the futures markets. Those are set by the boards of trade on which the futures are traded.

This little overview, I think, might persuade you that the regulatory system we have in the United States in this area is not the one you would design if you sat down to construct one from scratch. The SEC regulates the securities markets and the options markets; the CFTC regulates the futures markets; and the Fed regulates stock margins. Each of these agencies is independent—that is, there is no one in the U.S. Government who can issue binding orders to any of these agencies. These agencies proceed according to majority vote of their members. Their members are appointed by the President and serve for fixed terms of years. For example, members serve for five years at the Securities and Exchange Commission. Thus, at various times, the Commission may have a majority of members who were not even appointed by the man who is currently President of the United States.

What occurred in October 1987? As I mentioned, we saw that trading in financial futures—futures on indexes of stocks—has a direct and immediate effect on trading in the stock market itself. What were the magnitudes of the events in the stock market? The Dow Jones Industrial Average dropped about 37 percent from its high on August 25, 1987 to its low on October 20. At the low point of the break, it had dropped from 2722 to 1708. On October 19, 608 million shares changed hands on the New York Stock Exchange. That was somewhere between three to four times the former record for single-day volume, and on October 20 the record was broken again. On that day, 613 million shares were traded, and the market went up 102 points. There were comparable price movements in other U.S. securities markets and in the stock-index-futures markets.

Index-arbitrage trading—that is, trading in the stock market that is offset or related to some sort of trading in a financial future in the futures markets—constituted, according to our figures, about 21 percent of the trading on October 19 in the stocks that made up the Standard and Poor’s 500-Stock Index. At various half-hour periods during that day, index-arbitrage trading ranged from 30 percent all the way up to 65 percent of the total trading in those 500 stocks.

We have spoken several times about the international effects of the market break and the fact that we have, or are coming close to having, an interrelated worldwide system. That was demonstrated in October. The London Financial Times Index declined about 22 percent for October 19–20, while the U.S. stock-market averages were declining about 35 percent on those days. The Tokyo Exchange fell, according to my figures, about 17 percent on those two days. Other exchanges were affected comparably. The Hong Kong Exchange, for example, closed for a week at the time of the market break in the United States.

The impact of the market break on the banking system in the United States was tremendous. Our figures show that on the Wednesday of the week prior to the break, bank loans to brokers or other loans made to borrowers to permit them to carry securities in the United States amounted to about 15 billion dollars. By October 21, that figure had risen to 22 billion dollars, which was about a 50 percent increase. By November 4, it had dropped again to about 12.2 billion dollars, and, as Mr. Fogel commented, officials of the Federal Reserve Bank in New York were instrumental in encouraging the banks to continue lending to securities firms to enable them to meet their liquidity needs.

At least from the SEC’s perspective, what does all this mean? What should be done to address it? Mr. Fogel mentioned contingency planning. It is certainly hard to disagree with that. The regulators need to be able to communicate with each other. They need to have regular lines of information. They need to know—and their subordinates need to know—who to contact at each agency to get information and to discuss developments in the markets. I think we had that to some degree before October. We have that to a greater degree today. The President, as has been mentioned here, has established a working group consisting of representatives of the Treasury, the SEC, the Commodity Futures Trading Commission, and the Federal Reserve Board. They are supposed to come up with a report by May 18, in which they will make recommendations for regulatory action based on the various studies that have been done.

The nature of emergencies, especially emergencies in the financial markets, is such that there are limits to contingency planning. It is difficult to construct a plan that says that if X happens, then we are going to do Y, because X will never happen exactly that way, and even if it does, then Y may turn out not to be exactly the right thing to do. Thus, I think that, to some degree, it is a matter of communications, information exchange, and of being ready to act rather than having a specific plan in mind. At the same time, one thing we have learned at the Commission is that we should have greater authority to take action in times of market stress. Currently, the Commission can suspend trading in any individual security for 10 days and, with the concurrence of the President, can shut down trading on all U.S. exchanges for up to 90 days. The latter is something that has never happened. Our sister regulator, the Commodity Futures Trading Commission, however, has broad authority to issue emergency orders in its markets. We feel we should have comparable authority to suspend trading generally for brief periods, to adjust the opening and closing periods of the exchanges, and to take any other kind of action that might be necessary in case of an emergency.

Something else that has been widely discussed is the need for what are called “circuit breakers” in the market—that is, predetermined triggers that stop trading for a certain period of time. I suspect that the President’s working group will make a recommendation of that nature when it issues its report. If the Dow Jones Industrial Average, for example, moves a certain predetermined amount—200 points, 250 points, 300 points, or whatever is selected—trading on the New York Stock Exchange and in the futures markets would stop for a preset period of time. This would be a brief period of probably half an hour or an hour. Perhaps the central area of dispute concerns who should have the final say if the regulators cannot agree among themselves (since, as I mentioned, they are all independent) as to what should happen in case of an emergency. There is at least one bill in Congress that would establish a committee of regulators that could act by majority vote. There have also been suggestions that the Federal Reserve Board should have the authority to direct the other regulators to take certain actions in times of emergency. At the Securities and Exchange Commission, perhaps not surprisingly, we feel that, to the extent the question is the protection of the securities markets, the Commission should have the ultimate authority. That does not reflect, I think, any desire on our part to be able to influence the Fed. It does reflect a view on our part that we cannot adequately police our markets if we do not have some degree of control over trading in financial futures on the very securities that we regulate and over the stock exchanges. I think we should have what is called “tie-breaker authority” over the Commodity Futures Trading Commission, at least in cases of emergency.

There has also been some discussion of the regulation of holding companies and financial conglomerates. At the Commission, we feel it is very important that to the extent the banks become, or are permitted to become, more involved in the securities business, they do that through separate affiliates, such as holding-company affiliates or subsidiaries. This would ensure that the regulation which the Commission applies to other participants in the securities markets could be made equally applicable to bank participants. That will not work if a bank itself is engaged in securities activities; but if it has a subsidiary or affiliate that is engaged in those activities, the SEC can regulate that affiliate without disturbing the bank regulators’ authority over the bank. That is the approach we support in this area.

We also believe that the Commission is going to need jurisdiction to get information from holding companies that own securities firms. For example, the Commission will need such jurisdiction to obtain information from holding companies without bank subsidiaries. Today, although we have pervasive jurisdiction over securities firms, we have no jurisdiction to get information from entities that own securities firms.

Something else that I suspect the President’s working group will address is the question of margin levels. As I said earlier, the Fed sets margin requirements for securities, but nobody in government sets them for futures trading. I think there might be some logic in giving the Federal Reserve Board authority to set margin levels across financial markets.

The market break has also illustrated the need for us to look at the amount of capital that we require people in the securities business to have; at the clearance system, as Mr. Fogel mentioned; and at the capacity of the markets to handle large volume. If somebody had suggested a year ago that there would be a 600-million-share day during 1987, that would have been regarded as incredible. Yet we have already seen that level reached on at least two different days.

Finally, the next frontier is the internationalization of the capital markets. Internationalization raises the issue of what type of coordination we are going to have among markets in the United States and markets in U.S. securities located outside of the United States. We have to ask ourselves how effective our regulation can be absent such coordination. It may not be possible, for example, to have trading halts instituted here if the same trading can simply continue in other countries. We have, at least, to think about the possibility of either coordinating regulation or discarding the idea that we should attempt to control trading or suspend trading in the United States. As Mr. Fogel indicated, the Fed certainly has an important stake in the smooth functioning of the futures and equity markets. In my view, the responsibility for the integrity of the securities markets rests with the SEC, and it should continue to rest there. Ultimately, however, our ability to have sound financial markets in this country depends on all the regulators working together. I think that this is happening. The public will have a better idea of how it is going to happen a week from today, when the President’s working group issues its report.

Thank you.