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F o r release Wednesday, 3:00 P . M . (4:00 P . M . on d c l i v e i y November 8, 1978 C.S.T. E.S.T.) v-J THE FIANCIAL S Y S T E M IN AN A G E OF CHANGE R e m a r k s by G. William Miller Chairman B o a r d of G o v e r n o r s Federal Reserve System b e f o r e the Robe i t M o r r i s A s s o c i a t e s Dallas, Texas N o v e m b e r 8, 1978 It is a p l e a s u r e for me to be able to appear before you today. A s you know, we have had some busy days of late in Washington, attempting to put in plaee policies that can deal e f f e c t i v e l y with the m a j o r economic problems on the domestic and international fronts. We are making p r o g r e s s in the continuing w a r to defeat inflation and to l e s t o r e stability and reason to world financial markets. While our battles a r e by 110 means won, it is an appropriate time to examine some other, longer-run i s s u e s — i s s u e s that have clung to the cloaks of bankers for a long, long time impervious to whether c r e d i t conditions have been tight or e a s y , o r whether the economy has been in boom o r r e c e s s i o n . I am r e f e r r i n g , of c o u r s e , to i s s u e s involving the regulation and supervision of c o m m e r c i a l banks. The banking industry has undergone tremendous change in the past two decades. Y o u r e x c e l l e n t p r o g r a m these past days r e f l e c t s the current magni- tude and diversity of the industry. Y o u r s e s s i o n s have covered a wide variety of contemporary topics ranging f r o m international lending, to marketing techniques for c o m m e r c i a l loans, to compliance p r o c e d u r e s under Regulation B. Today, let me touch on a number of the recent changes and on the i s s u e s that relate to them. Changes in the nation's financial s y s t e m a r i s e f r o m the constant changes, of both a c y c l i c a l and a s e c u l a r nature, that occur in the economy i t s e l f . At times, this changing financial s y s t e m lias bumped head on into the existing s t r u c t u r e of financial regulations — s o m e t i m e s causing problems -2r fo r us all. My purpose today will not be to o f f e r pat solutions f o r all the outstanding p r o b l e m s , but to excite your interest and to e l i c i t your help in resolving a r e a s of potential c o n t r o v e r s y . The F e d e r a l R e s e r v e tries to l i s t e n , but we cannot hear if you are silent — if you do not share your reasoned arguments with u s . I will c o v e r only a s m a l l sample of the m a j o r s u p e r v i s o r y and regulatory duties of the F e d e r a l R e s e r v e — duties which a r c often interrelated with our responsibilities in the arena of domestic and international monetary p o l i c i e s . It s e e m s appropriate to begin with the B o a r d ' s special responsibilities under the Bank Holding Company A c t . The Bank Holding Company Movement Holding companies have become the dominant organizational f o r m in banking. Today there a r e more than 2,000 bank holding companies and they control 71 p e r cent of domestic bank d e p o s i t s . Hie F e d e r a l R e s e r v e p r o c e s s e s about 1,000 c a s e s each y e a r involving holding company applications to purchase existing banks, to f o r m new banks, or to engage in one of the 17 p e r m i s s i b l e "non-banking" activities approved by the B o a r d . Indeed, much of the time spent by the Board at its regular meetings involves deliberations on holding company applications. Where has all this taken u s ? The chief feature of the holding company movement so f a r , is that it represents a response — a natural response — to -3- the evolving f r a m e w o r k of laws and bankers' actions. regulations that constrain and c o n s t r i c t L e t me cite s e v e r a l e x a m p l e s . F i r s t , during the 1960's, the holding company f o r m of organization allowed banks to tap nondeposit s o u r c e s of funds - - mainly c o m m e r c i a l paper and l o n g e r - t e r m debt markets — at rates not subject to Regulation Q c e i l i n g s . During high rate p e r i o d s , when Q ceilings w e r e binding, these nondeposit s o u r c e s of funds w e r e important to banks. Second, nondeposit funds raised at the holding company l e v e l have been used » to finance nonbank activities f r e e of reserve requirements. Third, funds raised by the holding company parent have been t r a n s f e r r e d downstream to bank s u b s i d i a r i e s in the f o r m of equity. This procedure — s o m e t i m e s called " d o u b l e - l e v e r a g i n g " — has had the e f f e c t of increasing the l e v e r a g e of the o v e r all organization, while maintaining o r increasing the equity of the bank s u b s i d i a r y . Holding companies generally appear to have had important e f f e c t s on the operations of the banks they a c q u i r e . Affiliated banks are l e s s liquid than their independent counterparts, holding g r e a t e r proportions of loans and State and local government s e c u r i t i e s in their portfolios, and l e s s e r amounts of cash and Treasury securities. A l s o , holding company banks have l o w e r capital ratios than s i m i l a r sized independent banks.' Whether such added risk-taking is o f f s e t by g r e a t e r geographical and financial d i v e r s i f i c a t i o n is not known. The F e d e r a l R e s e r v e has reacted to these changes — introduced through the holding company movement - - with different responses at different t i m e s . F o r e x a m p l e , the Board has taken the view that the holding company is an integrated organization for purposes of determining bank capital adequacy. That i s , l e v e r a g i n g by the parent is viewed in a light s i m i l a r to l e v e r a g i n g by the bank s u b s i d i a r y . At other t i m e s , the F e d e r a l R e s e r v e has viewed holding company innovations as an acceptable response to weakness or inconsistency in underlying regulation. F o r instance, the Board generally has been s y m p a - thetic to interstate expansion by holding companies in the consumer finance and mortgage banking a r e a s — provided that such expansion is conducted by b a s i c a l l y sound banking organizations and in a procompetitive manner. A f t e r a l l , many competitors of banks, including retail f i r m s and certain nonbank financial institutions, a r c not shackled by the branching and c h a r t e r i n g restrictions which constrain banks, and the holding company movement provides one means of partially restoring needed competitive equality. The full potential of this aspect of bank holding companies has not been fully r e a l i z e d , however, since nonbanking activities account for l e s s than 4 p e r cent of holding company a s s e t s . In e f f e c t , holding company "nonbank" expansion represents a minor chink in the a r m o r of the McFaddcn A c t — a subject which I will mention a little l a t e r . My emphasis on competitive equality leads me to turn naturally to another a r e a of responsibility for the F e d e r a l R e s e r v e which i n c r e a s i n g l y b e a r s on the competitive structure of U . S . banking — namely, the U . S . activities of foreign banks. U . S . Activities of Foreign Banks and the International Banking A c t of 1978 - • A s of May this y e a r , about 230 foreign bank branches and agencies w e r e operating in tins country. Such foreign branches and agencies have grown much more rapidly domestically than the large money center banks with which they compete. Total a s s e t s at foreign branches and agencies have quadrupled f r o m $18 billion in 1972 to o v e r $75 billion in 1978, a rate of growth more than five times that of the domestic operations of money center banks. While the foreign bank branches and agencies in the United States were founded principally to finance the foreign trade of their home countries, they have rapidly d i v e r s i f i e d into the domestic banking b u s i n e s s , p a r t i c u l a r l y by making business loans to U . S . corporations. In addition, U . S . branches of foreign banks have experienced a rapid growth in deposits f r o m domestic c u s t o m e r s , mostly corporate d e p o s i t o r s . Such deposits grew f r o m $ 1 . 4 billion in 1972 to $7.8 billion in mid-1978. F o r e i g n banking institutions also have c h a r t e r e d or purchased domestic banks. The a s s e t s of A m e r i c a n banks owned by foreign institutions now total $20 billion, a fivefold i n c r e a s e during the past sLx y e a r s . A s s e t s of f o r e i g n - owned domestic banks may grow even more rapidly in the n e a r future through the acquisition of existing banks you are well aware of the pending applica- tions by foreign institutions to purchase Marine Midland", National Bank of North A m e r i c a , - a n d Union Bank of California. total a s s e t s in e x c e s s of $20 billion. These U . S . banks have combined -G- IIow lias the F e d e r a l R e s e r v e viewed this rapid expansion into domestic banking by foreign institutions? f r o m whatever s o u r c e . Of c o u r s e , we welcome increased competition Competition is the lifeblood of A m e r i c a n industry and its benefits apply no l e s s to banking than to other s e c t o r s of the economy. But competition cannot be f a i r if one side is playing with a stacked deck, nor can the benefits f r o m competition be fully realized if one side is shackled by s p e c i a l laws and regulations. T h e r e a r c two important ways in which A m e r i c a n banks have been operating at a competitive disadvantage compared with U . S . branches and agencies of foreign banks. F i r s t , l a r g e domestic banks — those which compete in the United States with foreign branches and agencies — a r e a l m o s t all m e m b e r s of the F e d e r a l R e s e r v e S y s t e m . They must hold required r e s e r v e s in the f o r m of non-earning vault cash o r deposits witli the F e d . other hand, have not heretofore been subject to F o r e i g n a g e n c i e s , on the reserve requirements. U . S . branches of foreign banks generally have held only State-required And reserves. State r e s e r v e requirements often can be met by holding earning a s s e t s o r "duef r o m " balances held in the ordinary course of b u s i n e s s . Thus, foreign banks operating in the U . S . have not borne the s a m e r e s e r v e burden as their d o m e s t i c * competitors. Second, the multistatc o f f i c c s of foreign banks have given them some added flexibility not available to domestic banks. A U . S . bank cannot branch -7- outsidc its " h o m e " state — and may even by subject to b r a n c h i n g restrictions within its home state. Of c o u r s e , domestic banking organizations may open c o m m e r c i a l loan production o f f i c e s in other s t a t e s , and through nonbanking s u b s i d i a r i e s may make consumer loans in more than one state, but their ability * to raise deposit funds is impaired by the prohibition of interstate branching. In 1974, with a view toward eliminating such inequities, the F e d e r a l R e s e r v e proposed legislation to the C o n g r e s s dealing with U . S . activities of foreign banks. It is encouraging that such e f f o r t s helped lead the way to p a s s a g e of the International Banking A c t of 1978. The A c t provides that U . S . units of foreign banks will be subject to r e s e r v e requirements — as determined by the F e d e r a l R e s e r v e a f t e r consultation with State s u p e r v i s o r s — and, in turn, may have a c c e s s to F e d e r a l R e s e r v e S y s t e m s e r v i c e s . A l s o , the F e d e r a l R e s e r v e is required to write new regulations revamping the powers of Edge c o r p o r a t i o n s . These regulations will be intended to p e r m i t Edge s u b s i d i a r i e s of domestic banks to compete more e f f e c t i v e l y with existing and future units of foreign banks. F o r e i g n institutions would be allowed to open interstate branches with limited s e r v i c e , if e x p r e s s l y permitted by State law, provided that the deposittaking powers of such b r a n c h e s a l e s i m i l a r to those of Edge c o r p o r a t i o n s . In e f f e c t , foreign and domestic institutions will now be able to compete nationwide in international -trade-related business — on equal t e r m s — through Edge co lp o rations o r E d g e - l i k e b r a n c h e s . -8- C l e a r l y , the International Banking A c t will go a long way toward equalizing competition between domestic and foreign banks. The A c t is a p r i m e example of the dramatic ways in which laws and regulations will have to change in o r d e r to accommodate the equally dramatic changes that the financial industry itself has undergone. Indeed, one section of the International Banking A c t portends such future change and, quite conveniently, leads me to my next topic of d i s c u s s i o n . S p e c i f i c a l l y , the A c t requires the P r e s i d e n t , in consultation with the banking a g e n c i e s , to review the McFadden Act and report to the C o n g r e s s , within one y e a r , on the impact of McFadden on the nation's banking s t r u c t u r e . Interstate B r a n d l i n g and the McFadden A c t The McFadden A c t of 1927 lias the e f f e c t of prohibiting f e d e r a l l y chartered banks f r o m branching a c r o s s state lines. In addition, banks are often faced with branching restrictions within their home s t a t e s . Thirty states are unit banking o r limited branching s t a t e s , and 10 of these states prohibit quasi-branching through multi-bank holding company. In contrast, f e d e r a l l y chartered thrift institutions have not had their branching powers limited by statute — although they have been limited somewhat by the F e d e r a l Home Loan Bank Board regulation. If thrift'institutions w e r e granted expanded a s s e t and liability p o w e r s , such as c o n s u m e r loans and nationwide-NOW accounts, there would be a substantial competitive disadvantage for c o m m e r c i a l banks. -9- If state b r a n d l i n g r e s t r i c t i o n s and the policy of the McFadden A c t w e r e l i b e r a l i z e d , competitive inequities would be much reduced, but competition in the industry would become much more intense. Increased competitive intensity should be w e l c o m e , for expanded competition brings with it many public benefits ranging f r o m g r e a t e r s e r v i c e s to increased credit availability for local c o m m u nities. There is even some evidence that banks with branches are l e s s prone to failure because of their geographical d i v e r s i f i c a t i o n . The common f e a r , however, is that relaxing branching restrictions would a d v e r s e l y a f f e c t s m a l l banks with the concern that many would be driven out of business by a g g r e s s i v e l a r g e r banks. to support this. But, there is no substantial evidence In fact, the evidence shows that s m a l l banks can be as e f f i c i e n t as l a r g e r ones — and that they can compete e f f e c t i v e l y witli their big b r o t h e r s . In C a l i f o r n i a with extensive branch networks, f o r example, 75 banks — or onethird of the state total — have 110 branches at a l l , and G9 of these unit banks are located in m a j o r metropolitan a r e a s . Interstate branching would have f a r - r e a c h i n g ramifications f o r state l a w m a k e r s and for state and federal banking authorities. To avoid being regu- lated by a l a r g e number of state .authorities many banks might convert to national c h a r t e r . As a result, the C o m p t r o l l e r of the C u r r e n c y , through his federal chartering and s u p e r v i s o r y p o w e r s , could well become a more s i g nificant force in determining the nation's banking s t r u c t u r e . A l s o , the s u p e r v i s o i y -10- and examination duties of state and federal agencies might be more complex because of f a r - f l u n g branching s y s t e m s . Inevitably, jurisdictional disputes would a r i s e . T h e s e problems aside, it is likely that l a w m a k e r s and regulators may be outdistanced by the pace of e v e n t s . toward expanded interstate competition. The industry is moving inexorably Bank holding companies currently engage in "nonbanking" activities a c r o s s state l i n e s . loan production o f f i c e s . Banks have multistate E l e c t r o n i c fund t r a n s f e r has i n c r e a s e d dramatically the ease with which s e r v i c e f a c i l i t i e s can be placed in remote locations. In the end, the rule m a k e r s will have to accommodate these changes, not stand in their w a y . Liability Management; New Deposit Instruments L e t me turn now to another a r e a of change in the banking industry, an a r e a which, like banking s t r u c t u r e , has been shaped by the intensified c o m petitive atmosphere of the IDGO's and 1970's and by the regulations of the period. Of all the a r e a s of banking operations it is the liability s t i n c t u r e of c o m m e r c i a l banks that has undergone the g r e a t e s t recent changes. In the " c o n s u m e r " market, the changes have been dramatic and they s e e m to have o c c u r r e d within moments of one another in'our very recent past. NOW accounts liave been allowed in New Hampshire and Massachusetts since 1974; in 197G NOW's w e r e extended to all New England s t a t e s , and, with p a s s a g e of the Financial Institutions Regulatory A c t last month, NOW's have been extended -11- to New Y o r k State. In June of this y e a r , G-month money market c e r t i f i c a t e s tied"to the T r e a s u r y bill rate w e r e authorized f o r banks and thrifts. And last Wednesday, automatic t r a n s f e r s between bank savings and checking accounts came into being. In a v e r y short period of time these new instruments have reached s i z e a b l e s c a l c . NOW accounts balances total a l m o s t $4 billion at banks in New England, and G-month money market c e r t i f i c a t e s total $10 billion at banks, with another .$24 billion at thrift institutions. Of c o u r s e , it is still too e a r l y to tell how rapidly savings accounts subject to automatic t r a n s f e r will g r o w . T h e s e innovations in financial instruments have come about l a r g e l y because of competitive p r e s s u r e s and general economic conditions, and in some c a s e s , in response to regulatoiy action. The money market c e r t i f i c a t e s , for e x a m p l e , represent a conscious response to the threat of disintermediation during a period of rising interest r a t e s . In fact, the continued strong showing of mortgage lending at t h r i f t s , when contrasted with the last period of high r a t e s , is due in l a r g e m e a s u r e to their ability to o f f e r G-month c e r t i f i c a t e s at market r a t e s . environment. Automatic t r a n s f e r s arc another example of response to the The p r e s s u r e of i n t e r e s t - b e a r i n g share d r a f t s at c r e d i t unions and the possibility of nationwide NOW powers f o r thrifts should create even more incentive for banks to o f f e r their c u s t o m e r s added convenience. Bankers should regard their expanded powers to o f f e r such new s e r v i c e s as an opportunity -12- ihc opportunity lo learn about e f f e c t i v e pricing and marketing techniques in anticipation of the day when more institutions will be able to o f f e r a w i d e r range of deposit s e r v i c e s . Just as new " c o n s u m e r " liabilities have evolved in response to economic p r e s s u r e s and to regulation, in the " w h o l e s a l e " market traditional deposit s o u r c e s of funds have been replaced by large c e r t i f i c a t e s of deposit, funds p u r c h a s e s , and repurchase a g r e e m e n t s . Federal L a r g e CD's have grown f r o m $11 billion in 1970, when Q ceilings on these C D ' s were r a i s e d , to $88 billion in 1978 at money center banks alone. And F e d e r a l funds/HP's now total o v e r $95 billion at all banks. The evolution of the F e d e r a l funds/RP market is a s p e c i a l example of response to the environment. No l o n g e r are F e d e r a l funds used solely for the traditional purpose of borrowing needed r e s e r v e s f r o m another m e m b e r bank that has e x c e s s reserves. Partly in response to more liberal interpretations by the F e d e r a l R e s e r v e of what is an "exempt l e n d e r , " m e m b e r banks now borrow immediately available funds from all banks, savings and loans, mutual savings banks, and U . S . o f f i c e s of foreign banks, without being subject to r e s e r v e requirements o r i n t e r e s t rate c e i l i n g s . A l s o , the bulk of large banks' HP funds now come f r o m corporate business s o u r c e s . A s the phenomenon of "liability management" has grown and evolved, it lias had important implications for the F e d e r a l R e s e r v e ' s s u p e r v i s o r y and -13- monetary responsibilities. F o r instance, in our s u p e r v i s o r y capacity, we examine a bank's liability structure closely when a s s e s s i n g the adequacy of its capital or liquidity positions. And, in our role as monetary authority, we have been studying evidence that the growth in F e d e r a l funds/HP's may be linked with a shift in the demand f o r M i . F u r t h e r development of "liability management" techniques and cash management s e r v i c e s may continue to have a m a j o r influence on projections of the monetary a g g r e g a t e s . .The Changing Hole of the F e d e r a l R e s e r v e My a i m today has been to review some of the important recent changes that have shaped — and will shape — the banking industry. have o c c u r r e d , so has the F e d e r a l R e s e r v e changed. As these changes We a r c no longer charged only with the responsibility of conducting monetary policy. Through our r u l e - making responsibility, we have had to write regulations, that a r c in e f f e c t that we must administer and, on occasion, e n f o r c e . role has evolved into that of "public a r b i t r a t o r " . laws And most recently our F o r example, when d e l i b e r a t - ing on a bank holding company application to engage in a nonbanking activity, we are required by law to determine whether the proposed activity constitutes a net Public benefit. r T h e s e growing responsibilities of the F e d e r a l R e s e r v e have rarely been the F e d ' s own idea. Often, legislation has mandated that we take on new duties. So it was that legislation in the 1960's greatly expanded our duties in the s u p e r vusi0n and regulation of banking organizations. A f t e r legislation passed in 19G0 -14- and 1966, the F e d e r a l R e s e r v e had to c o n s i d e r both the "convenience and needs" of the community as well as possible " a d v e r s e competitive e f f e c t s " of banking a c t i v i t i e s . In 1968, the TruLh-in-Lending legislation ushered in a decade of extensive rule-making responsibility for the Fed in the consumer protection and anti-discrimination a r e a s . Regulations 13, C , Z , and A A . The result, so far, has been The latest legislation to add to the F e d e r a l R e s e r v e ' s m l e - m a k i n g responsibilities has been this y e a r ' s International Banking A c t and Financial Institutions Regulatory A c t . We are as concerned as you are o v e r this constantly changing and e v e r - g r o w i n g set of federal regulations burdening the financial s y s t e m . One manifestation of our concern is reflected in our new " P r o j e c t A u g e a s " in which we have undertaken to review e v e r y F e d e r a l R e s e r v e a view toward simplifying or deleting w h e r e v e r p o s s i b l e . regulation with Cleaning out our stables will be a difficult task, but we have a sense of excitement o v e r the prospect — and its e f f e c t on our, and y o u r , future. The changes of the past will be replaced by still more changes — and those changes are likely to be substantial. will be a challenge f o r all of us e s p e c i a l l y , central b a n k e r s . Adapting to our new environment b a n k e r s , bank c u s t o m e r s , and perhaps, If we comprehend the opportunities available to us through e m b r a c i n g and charting constructive change, rather than it then we will be motivated to meet that challenge. what we will do. resisting I believe that is exactly
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