View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

For release on delivery
Expected 2:00 P.M., E.S.T.

Some Observations on Banking in the 80's
Remarks by
J. Charles Partee
Member, Board of Governors of the Federal Reserve System
before the
Boston University Center for Banking Law Studies Conference
Boston, Massachusetts
April 10, 1981

It is a pleasure to be here this afternoon to participate in this
conference on Banking in the 80's. I plan to focus my remarks on what I
believe to be one of the key challenges to you in the industry and to us as
regulators this decade— that is, the need to develop flexible and adaptive
management and regulatory policies which will enable the industry to navigate
through some potentially difficult times as inflation is being brought under

Such policies will be of critical importance if depository institutions

are to meet successfully new sources of competition and to respond to rapidly
changing conditions in financial markets.
As an economist, I am naturally inclined to look first to the economic
factors in sorting out the underlying causes for the radical change in markets
and structure now in process and that lie ahead.

Not surprisingly the roots

lie, as I have already alluded, in the inflation that has plagued our economy
for the last decade and a half.

We are all acutely aware of what inflation

has done to the purchasing power of the dollar.

But usually we are not so

conscious of how deep and pervasive its dislocating effects have been.

In fact,

inflation has been the driving force behind much of the structural change observed
in banking and finance over recent years.
Inflation, and the efforts to control it, have resulted in both the.
sharp run-up of interest rates over the past 15 years and the considerable
increase in the cyclical variability of rates around that upward trend.


interest rates in the market, in turn, have repeatedly driven banks against
deposit rate ceilings and other regulatory constraints, causing episodes of
liquidity stress and savings disintermediation.

The desire of depository

financial institutions to maintain their deposit base and of their customers


to achieve a fair market rate on their funds have spawned a host of financial

These innovations include new financial instruments, such as

CD's, MMC's, NOW accounts and rising rate notes; new technologies, such as EFT;
new management concepts, such as liability and interest rate gap management;
and finally, new institutional forms, such as the one-bank holding company.
High market interest rates have also created economic opportunities for less
regulated firms to offer financial services on more favorable terms and often
at rates above Regulation Q ceilings, which are now in the process of being
phased out.
The combination of these financial innovations and the entry and
expansion of nondepository institutions into the financial service industry
has radically affected the structure and functioning of financial markets
and has significantly altered the array of financial services being provided.
These developments are eroding the distinctions between banks and thrifts
and have opened the door to so many different providers of financial services
that it is now beginning to be difficult to tell which firms are and are not
financial institutions.
I am particularly concerned with the risk implications of these
financial innovations, which will require careful regulatory and supervisory

There are abundant indications that financial institutions have

become more risky and vulnerable to external shocks.

First, the inflationary

environment and efforts to control it have tended to increase the riskiness
of bank and thrift assets because higher rates have added greatly to debt servicing

The sharply rising trend of bankruptcy filings, both personal and

business, reflects these strains as well as the difficulties of coping with
inflation and a sluggish economy.


Second, this same inflationary environment has also exposed our
depository institutions to sharp and unexpected changes in rates, making it
exceedingly difficult to predict the costs of funding their investment

The increased competition from foreign banks, other financial

and nonfinancial institutions, as well as the open market, also has goaded
banks into more aggressive behavior to maintain market share.


efforts to maintain an adequate funding base, as core deposits have eroded,
have brought fund raising and liability management to the fore.' The end
result has been to expand bank reliance on shorter-term interest-sensitive
managed liabilities, which increases both interest rate and liquidity risk.
The need to balance asset and liability maturities and costs to maintain
profitability surely represents one of the more difficult and complicated
management problems in banking today.
Third, the rapid expansion of large U.S. banks abroad and increased
reliance on foreign sources of funds and earnings clearly illustrates that
important components of the U.S. financial system are becoming more intertwined
with that of the rest of the world.

Exposure to political instability— such as

the recent financial problem related to the Iranian crisis and the current
problems in Poland— the effects of fluctuations in foreign economic conditions,
the financing problems of LDC's in an oil-short world, and more volatile exchange
rates are important factors suggesting that large U.S. banks have bepome in­
creasingly vulnerable to external shocks.
Finally, the capital positions of large banks and thrifts, in
particular, have declined, albeit for different reasons.

But clearly these

trends have been exacerbated by the fact that inflation has fueled everincreasing demands for borrowed funds and bank credit.

Accommodating these


demands has tended to accelerate the growth in bank assets relative to their
ability to generate capital internally or externally.

Adoption of the holding

company form of organization has facilitated this decline in capital through
double leverage, adding further to the exposure of banking organizations if
there is deterioration in asset quality— a risk that seems likely to continue
as we strive to break the inflationary spiral.
As I have noted, the blurring of the distinctions between banks and
thrifts has greatly-enhanced competition, especially in the consumer financial
services market.

Perhaps more important, over the longer run, are the structural

and competitive implications resulting from the growing involvement of non­
depository firms in this market.

Symptomatic are the money market mutual funds,

whose phenominal growth to over $110 billion has captured the attention of us all.
The funds offer ready access to accumulated balances through telephone transfers
or payable-through drafts that serve as checks, and they enable even the small
investor to earn something close to a market return on funds placed into a
fairly diversified, very short term fixed asset portfolio.

Because of the high

yields currently available on such instruments, the funds have been able
successfully to tap the time deposits of individuals and other relatively small
depositors that traditionally have been locally limited.

This breakdown of

consumer dependence on local institutions for savings and other financial
services may be one of the most important changes affecting the geographic
scope of competition for funds in the years to come.
There are other important examples of nondepository institution entry
into financial markets. Many large banks look with envy at the interstate office
network of Merrill Lynch, which offers a package of consumer financial services
in connection with its cash management plan having many attributes of an interest


bearing transaction account.

The plan includes the use of a Visa Card and

checks issued through an Ohio bank that permits a customer to draw down funds
invested in a money market mutual fund by creating what amounts to a daylight
over-draft of a margin account.
Another recent and potentially important development has been the
acquisition of "nonbank" banks by conglomerates and brokerage houses.


example, a finance company subsidiary of Gulf and Western recently acquired
a small California bank that had divested its commercial loan portfolio.


thus technically was no longer a bank for the purposes of the Bank Holding
Company Act, although in all other respects it remained a bank.

This acquisition

could serve as a model for further expansion for nonbanking conglomerates and
possibly also for bank holding companies attempting to avoid the restriction on
interstate bank acquisitions of the Douglas Amendment.

In a similar vein,

Shearson Loeb Rhodes has announced plans to acquire the Boston Safe Deposit
& Trust Company, a deposit-taking trust company that also is not in the
commercial loan business.

And Prudential Insurance Company last month reached

agreement to purchase the Bache Group, thus enabling the nation's largest
insurance company, whose investment portfolio acquisitions have shortened
significantly in recent years, to enter the brokerage business.
Bache has two money market mutual funds totaling $3 billion.


Thus, through such

an acquisition, an insurance conglomerate could become increasingly competitive
with banks, both in terms of competing for loan business and for investible funds.
In sum, the breadth of financial services beginning to be offered
by nondepository institutions now appears to include a full range of both
retail and wholesale business, including commercial finance, consumer and
real estate lending, leasing, investment, insurance— and even payment services.


The developments in the payments area are particularly interesting.
We have tended to be preoccupied with the pricing and other requirements
mandated by the Monetary Control Act, and may be overlooking the fact that
some of the major retailers— such as Wards, Penneys and Sears— have already
established their own proprietary nationwide EFT systems.

Sears has even

undertaken a pilot project with the Credit Union National Association to
accept credit union share drafts and process them electronically.
As I look forward into the decade, it seems clear to me that our
first priority for the financial industry, as for the economy as a whole, must
be to bring inflation within tolerable bounds, which in turn will offer the
prospect of a sustained lower level of interest rates.
a quick, easy or painless task.

But this will not be

Inflationary tendencies and expectations that

have been incorporated into the system over the past decade and more are likely
to be exceedingly difficult to reverse.

Thus, I certainly cannot give any

assurances that the near-term economic situation will be free from interest
rate pressures and the other forces that have recently been giving our depository
institutions so much difficulty.
In such an environment, the forces stimulating financial innovations
and new entry into financial markets seem bound to persist.

We are likely to

continue to be faced with serious adjustments problems to such a changing

And there will undoubtedly be proposals to resolve, or at least

to ease, these problems by extending the reach of regulation.

Each situation

must be judged on its own merits, of course, but we must all recognize that the
fungibility of funds means that regulatory constraints will likely serve to
intensify market oriented efforts to escape such regulations and increase the
potential rewards to those that are successful.


I, for one, am convinced that the depository institutions will
continue to be better, safer and more efficient providers of financial
intermediation services than nonfinancial institutions.

But in order to

maintain their position in the financial services industry, it will be
necessary to unwind those factors that inhibit the ability of the depositories
to compete and adapt to changing economic conditions.

This behooves us, in

both law and regulation, to have a broader focus in implementing our policies,
so that we take full account both of the immediate effects and the likely
avoidance and other unintended responses that can be set in motion by our

It may mean, for example, that we should rely more on the market

to help us regulate.

It may also require a more competitive spirit by

depository institutions themselves.

Regulation should not be viewed as a

permanent protection for the industry, because in the long run protective
regulation is very likely to be self-defeating.
We must accept the principle that competitive forces will eventually
prevail in the financial marketplace,
loopholes as they develop.

rather than simply react to close new

I view this as the only effective way that our

regulatory imperatives can be managed, and at the same time permit financial
institutions the necessary flexibility to meet new competitors and survive
in a rapidly changing environment.

This is our challenge for the 80's and

in it lies a fundamental key to maintaining a healthy, strong, efficient
financial system.