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For Release on Delivery
Expected at 12:00 N o o n , E S T
T h u r s d a y , N o v e m b e r 8 , 1979

Remarks by
F r e d e r i c k H . Schultz

Vice C h a i r m a n , Board of Governors of the Federal Reserve



A s s o c i a t i o n of Bank Holding Companies

Tarpon Springs, Florida

November 8, 1979


Hie persistent inflation and successive rounds of disintermediation
over the past decade and a half have spawned economic and competitive incentives
driving the process of financial innovation and related changes taking place
in our financial system.

These innovations include new instruments--such as

CDs, NOW accounts, floating rate notes, and money market certificatesnew concepts of funds management--such as liability and cash management-and new institutions such as money market mutual funds and our present-day
one-and multi-bank holding companies.

The critical feature of many of the

more significant of these innovations is that they are attempts to avoid
binding regulatory constraints such as deposit rate ceilings, reserve
requirements, and limits on product and geographic expansion.

In this

respect then, regulation and regulatory response to change has played,
and will continue to play, a central role in shaping the evolution of
financial markets.

It affects financial structure and the array of

services available.

Even more important, it also affects the risk

factors and stability of our institutions and markets.
It is also true, however, that financial regulation has not
always achieved its intended goals.

In fact, it has sometimes had

significant unintended effects that transcend its original purpose.
For example, Regulation Q ceilings on time and savings deposits
have not achieved their intended purpose.

They were intended to limit

competition between banks and thrifts, to protect thrift institution
earnings during periods of rapidly rising interest rates, and to help
buffer the housing industry from the effects of financial restraint.


Insteaci, however, the inflows of small time and savings deposits to
both thrifts and banks have become cyclically more unstable.


instability has resulted in sharp contractions in mortgage lending
during periods of disintermediation and has imposed serious adjustment
costs on the housing industry.

In addition, depository institutions

have been forced to rely on more interest sensitive sources of funds
to finance their growth which has squeezed their profitability and
subjected them to greater interest rate risk.

Finally, the ceilings

have discriminated against small savers and created an unneeded subsidy
to higher-income borrowers at the expense of the lew-income saver.


is for these reasons that the Board has long advocated the relaxation of •
deposit rate ceilings and has supported the expansion of NOW accounts.
We have consistently urged the passage of the pending legislation that
would phase out the Regulation Q ceilings and extend NOW accounts
In a similar fashion, our review of the McFadden Act indicates
that many banking organizations are devoting significant and costly
resources to achieve an interstate presence and to meet increased
competition in ways that do not violate the McFadden Act or the Douglas

The growth of nonbanking activities of major bank holding

companies, the spread of loan production offices (until the recent court
decision), and the establishment of Edge Act and Agreement Corporations
are clear examples.

This expansion is the logical response to the

evolution of many banking activities that transcend state and local
boundaries and of banks' desires to follow their customers. We have
concluded that the usefulness of interstate banking restrictions in
their present form has passed.


However, relaxation of these constraints requires the balancing
of many factors.

Our review does not demonstrate the clear superiority

of one type of banking organization or structure.

The evidence indicates,

for example, that the most apparent advantages of multi-office banking
lie in greater public convenience, in greater availability of credit—
especially to locally limited customers—and in the competitive benefits
resulting from reduced barriers to entry into n&v markets.
The problems lie in the higher market concentration levels that
are nearly always found in multi-office banking environments and in the
potential for higher prices that seem to be associated with higher concentration.

We are also concerned that greater regional and national

concentration will result in undue concentration of economic and
political paver.
Because of the inevitability of continued market innovations to
avoid restrictions on interstate banking, my colleagues and I have generally
concluded that some relaxation of current restrictions on interstate banking
appears warranted.

However, because of our concerns about increases in

concentration we felt that unrestricted interstate branching and bank
holding company expansion is not appropriate at this time.


consideration should be given to options that lie somewhere in between
the status quo and unrestricted multi-office banking.

For example,

restrictions on interstate banking between large SMSAs could be removed,
expansion within geographic regions of the nation could be permitted,
or de novo expansion only into highly concentrated banking markets might
be allowed.


As financial innovation proceeds and the distinctions auorig
financial institutions are narrowed, the equity and scope of regulation
become increasingly important problems.

Hie several bank holding company

bills pending in the Congress represent an interesting collection of
responses to these problems.

The proposal to permit bond underwriting

attempts Co clarify and update the traditional separation between banking
and the securities business.

The property and casualty insurance

prohibitions are efforts by the independent insurance agents to protect
themselves from prospective inroads into their business by bank holding

Proposals to relax regulatory limits on the maturity structure

of acquisition debt in bank holding company formations would afford
investors greater opportunity for tax advantages and leverage possibilities
but could adversely impact our flexibility to ensure the safety and
soundness of these institutions.
I don't want to go through a detailed discussion of this

But, generally, 1 can say that, except for the revenue bond

bill and a few other minor technical amendments, this legislation is quite

Rather than promoting competition and increasing the

flexibility of both financial institutions and the regulators, it tends
to do just the opposite.

As such, the Board went on record opposing

much of this legislation.
I'd like now to say a few words about the longer run concerns
I see inherent in financial innovation and its interaction with regulation.
Two points seem clear.

First, the path we are on suggests that more and

financial innovations will be forthcoming as institutions attempt


Co avoid regulatory, constraints and with this will come the need for ever
increasing financial regulation.

Regulation breeds more regulation.

Second, there are several reasons to believe that this path
may have adverse implications for the stability of the banking system.
For example, the dependence upon more managed liabilities implies that
greater earnings variability is to be expected over the cycle.
The greater reliance upon foreign sources of funds and the growth
of foreign banks in the United States means that the U.S. system is
becoming irore intertwined with that of the rest of the world.


suggests greater vulnerability to destabilizing shocks resulting from
foreign business cycles, exchange rate risk and political instability.
The increased competition for funds with less regulated nonfinancial
and nondepository institutions means that banking organizations will
have less flexibility, relative to other competitors, in adjusting to
changes in economic conditions.

To meet this increased competition and

to operate profitably during periods of rising rates, banking organizations
have increased incentives to conduct their activities in an unregulated
or less regulated environment.

Hence, they are under constant pressures

to spin activities and functions out of subsidiary banks and to operate
through bank holding companies and foreign subsidiaries.
In view of the implications of financial innovation and the
often risk-inducing nature of regulation, we need to begin to explore
ways to increase the flexibility of banking organizations to compete
with unregulated firms and to better enable them to adapt to interest
rate cycles.

While I don't have specific proposals at this time, part


of the solution would seem to be to remove those regulations and constraints
that are not achieving their intended goals.

I believe that deregulation,

if properly done, holds the key to the future health and viability of our
financial system.