Winners And Losers.

The U.S. Congress overturned Glass-Steagall. Now that the reform process has begun, guess who's coming out on top ?

Gramm-Leach-Bliley, the bill that overturned the depression-era Glass-Steagall law, will force institutional changes in the regulation of financial enterprises in the United States. Until now, we regulated entities -- a bank was a bank, a broker was a broker, an insurance company was an insurance company. Banks, even if they did a little securities business or sold insurance, reported only to the Comptroller of the Currency or the Federal Reserve and a state banking superintendent. Brokers and dealers, mutual fund proprietors, and investment bankers reported to a Self-Regulatory Organization that got its brief authority from the Securities & Exchange Commission (SEC). State insurance commissioners supervised insurance agencies and underwriters.

Anything an entity could do, its supervisor could supervise. Banks were limited in the securities activities they could pursue, even if the bank regulators kept pushing the envelope. But a nationally chartered bank could conduct its securities business without registration or examination by the SEC. In 1995, 287 banks were doing some sort of brokerage business that was not registered with the SEC. Trust funds run by banks were examined by the trust examiners of the banking regulators. But an identical mutual fund run outside a bank would be examined by SEC examiners. Similarly, the insurance activities of banks okayed by the Comptroller in recent years were not subject to regulation by the state insurance commissioners. The Comptroller regulated nationally chartered banks and everything they did.

Under the new law, the various regulators regulate functions. Just about everybody who does securities business will be regulated by the SEC. The exemption for banks that was written into the old law was written out of the new one (they can still run trust departments if they don't offer mutual fund services to outsiders). And when banks join with insurance companies to form the "financial holding companies" contemplated in the new law, the insurance part of the enterprise will be subject to supervision by the state insurance commissioners.

The Comptroller liked it better the other way. Soon after the new act passed, a deputy in that office said, "You call it functional. We call it fragmented." But the troth is that the Comptroller lost the great turf struggle of 1999: Chairman Alan Greenspan at the Fed and Chairman Arthur Levitt at the SEC ate the Comptroller's lunch.

Now they have to digest it.

The Fed has the most on its plate, because the Fed was greediest. The Fed will be the "umbrella supervisor" of the financial holding companies that are the big dogs. It promises to give "great deference" to other regulators, but if it feels some other subsidiary of the holding company is doing something that endangers the bank, it can cry "halt." One of the oddest provisions of the law is that the Fed cannot countermand a ruling issued by the SEC it disagrees with, but it can sue the SEC in the Court of Appeals for the District of Columbia.

Since 1956, when the first Bank Holding Company Act was passed, the Fed has regulated bank holding companies. The Comptroller in 1956 was Ray Gidney. Ronnie Phillips of Colorado State University has pointed out that Gidney had spent his working life at the Fed (and was the president of the Federal Reserve Bank of Cleveland when he left). So the Comptroller had not gone after the business. By the time the Bank Holding Company Act of 1970 was passed, the Fed acted as if supervision of holding companies was its birthright, without which it could not make sound monetary policy or prevent systemic collapse. It also believed the only safe way for a bank to do anything other than a straight banking business was through the holding company, where the different parts of the enterprise were separable.

Both the Bush and the Clinton Administrations recommended reorganizing financial supervision in order to permit nationally chartered banks to perform securities and insurance services within "operating subsidiaries" that would be part of the bank and not subject to supervision by the Fed. (Remember, the Comptroller's office is part of the executive branch while the Fed is not.) Greenspan fought them off when the Congress was Democratic. And when he got a Republican Congress (and a new essentially non-political Secretary of the Treasury who likes economists better than lawyers) he worked his will into the law.

Even before the bill passed, the Fed had begun flexing its muscles. Section 23 of the Federal Reserve Act has always prohibited transactions between a bank and its "affiliates" on anything but a collateralized arm's-length basis. In 1998, to the outrage of the national banks and their lawyers, the Fed declared that this rule also applied to transactions between a bank and an operating subsidiary. The new law encourages experiments in "merchant banking," where a bank makes an investment in a company intending to profit by its sale after the bank has licked it into shape. The Comptroller thought that was just like a loan (maybe safer), requiring an allocation of capital of only 5 percent of the investment. Noting in passing that the Treasury secretary supports it, the Fed has ruled that 30 to 50 percent of any such investment should be the bank's own money, making the activity much less attractive. So much for deference.

The challenge for the SEC is to find a way to supervise the international securities activities of the financial holding companies. When Long Term Capital Management (LTCM) went near-bust, the Comptroller's office noted with delight that LTCM had its hooks only in state-chartered and foreign banks regulated by the Fed, not by the Comptroller. The Fed could have known, and didn't. But the SEC could not have known about the big investment banks recruited to the bail-out, because its supervisory authority stopped at the water's edge.

Incidentally, this has been problematic for the big U.S. houses abroad. A European Union directive requires one EU country to consolidate its supervision over a firm that is also active in the other countries. That country can then give the financial house a "passport." But the SEC cannot supply a passport to American securities firms, because it has no jurisdiction over what the firms do in London or anywhere else outside the United States. What the big houses have done is to create informal "international executive committees," which relate to the Financial Services Authority in Britain. The British then give the American firms their passports. Under the new law, an investment bank that does not own a commercial bank (no deposits) can form a slightly different kind of financial holding company for which the SEC holds the umbrella. But, as of now, the SEC's regulations only cover domestic operations.

Among the more interesting questions is whether an investment house that acquires a little bank and converts to the status of a Fed-supervised financial holding company can then use the Fed's "umbrella" as its passport to Europe. No answer yet. An even more interesting question, from the viewpoint of the investment house, is whether the passport would be worth the nickel-and-dime nitpicking the Fed requires from the progenitors of bank holding companies. Right now, there is some question of how useful a reference from the Fed may be. By quibbling over the capital requirements for subsidiaries of foreign banks that wish to achieve status as financial holding companies in the United States, the Fed has got the Europeans steamed.

What makes the present situation disconcerting is that, eventually, the SEC will have to inherit the umbrella supervision role from the Fed. Across the world, governments are taking banking supervision away from central banks, on the grounds that central banks slowly become overly kind to decaying banks since the central banks fear triggering a crisis. The LTCM bailout gets cited here, of course.

There is general agreement among the supervisory and academic communities that today's globe-girdling banks cannot be governed in the old ways, and that regulators will have to rely heavily on the markets to discipline miscreants. But markets cannot give useful signals unless participants in the markets have more information than central banks have ever been willing to release. (In the United States, it is still a crime to let anybody not in the bank examiner's line of command see his report.) The big fight between the SEC and the Fed has been over mark-to-market accounting. The Fed has insisted that banks must have the right to carry assets on their books at historic cost, which means, among other things, that different banks purchasing identical paper on different days can carry it at different values. Only the securities regulators have the commitment to transparency the umbrella regulator will need.

Even to handle the expanded responsibilities in GrammLeach-Bliley, the SEC will need more authority. It's mind-boggling that the SEC can't find out what the big Wall Street houses are doing in London and Tokyo and Frankfurt and Paris. And the Commission will need a lot more budget. Someone will have to sit Phil Gramm down in a comfortable chair and convince him that if the SEC does not have the resources to play its role in the new regime that bears his name, he is likely to go down in the history books as the new Jake Gain, author of banking legislation that ultimately cost the taxpayers a fortune.

Fed Chairman Alan Greenspan fought off the reformers when the Congress was Democratic. And when he got a Republican Congress (and a new essentially nonpolitical Secretary of the Treasury who likes economists better than lawyers) he worked his will into the law.

The truth is that the Comptroller lost the great turf struggle of 1999: Chairman Alan Greenspan at the Fed and Chairman Arthur Levitt at the SEC ate the Comptroller's lunch. Now they have to digest it.

Martin Mayer is a Guest Scholar at The Brookings Institution and contributing editor to OnMoney.com. His book The Fed and the Markets will be published early next year.