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BANK
REGULATION
\
AND BANK
V ____ PLANNING

REMARKS BY

John J. Balles
PRESIDENT
FEDERAL RESERVE BANK
OF SAN FRANCISCO

Chief Executive O fficers' Program
Am erican Bankers Association
Boca Raton, Florida
February 17, 1974







b /

I am pleased to be here in Florida and to be
able to participate in this program. The
ABA has organized an excellent agenda
that will certainly benefit your banks and,
through them, your com m unities.
My topic today concerns bank regulation.
Regulation in all its dim ensions is part of
the environment in which you operate, and
changes in regulation must be considered
in your planning. In part, my focus will be
on recent and proposed legislation and
regulation, especially those developments
which involve the Federal Reserve System.
I also propose to look at the changing prac­
tices and technology of the financial
system inasmuch as these changes gen­
erate pressures for new legislation. Major
regulatory changes are not accidents of the
legislative process; rather they reflect
more fundamental changes and needs in
the economy. Therefore, by looking at the
existing cost pressures and technological
developments in the financial system, you
can better assess the future regulatory
framework and its influence in your
planning.
Bank Holding Company Act

Let me begin by looking at some recent
legislation which is changing the character
of American banking. Specifically, I have in
mind the 1970 amendments to the Bank
H olding Com pany Act.
Since I have advanced the proposition that
legislation reflects changes in the financial
system, what were the econom ic forces at
work in this instance? The Bank Holding
Com pany Act passed in 1956 applied only
to corporations which controlled two or
more banks— one-bank holding com pa­
nies were exempt. The Act required multi­
bank holding companies to divest their
nonbank subsidiaries, but did not impose
similar requirements on the one-bank



companies. This exemption was important,
because it permitted important banking
innovations to be made.
In the 1960's, the financial environment
was affected by innovations in both tech­
nology and management practices. Banks
turned to liability management, whose
most obvious form is the certificate of
deposit. Twenty years ago bank com peti­
tion for deposits was relatively passive,
whereas now banks actively bid for them.
Banks also found that forming a holding
company brought important benefits. As
long as only one bank was involved, the
restrictions of the Bank Holding Com pany
Act did not apply. During the brief period
in the late 1960's when they were free of
regulation, these newly-formed one-bank
holding companies began to issue their
own commercial paper, in the manner of
large corporations. They began to expand
in other fields, some related to banking
and some not, and to expand these
non - banking activities across state
lines.
By the end of the 1960's, banks were ac­
tively developing new management tech­
niques, new financial instruments, and
new services. These spilled over the
boundaries of traditional banking through
the device of the one-bank holding com ­
pany. The legislative response to these
developments was the passage of the 1970
amendments to the Bank Holding Com ­
pany Act.
This legislation in a sense was restrictive,
but by form alizing new ground rules for
nonbank acquisitions, it opened up oppor­
tunities for the nation's banks. Congress
attempted to balance the benefits of in­
creased competition in new services
against the dangers of undue concentra­
tion of power.



This legislation has opened a new phase of
development in the nation's financial
system. Congress recognized the advan­
tages of controlled expansion to exploit
new technology and to increase com peti­
tion, and it did not attempt to turn back the
clock.
The Act assigns to the Federal Reserve
Board the responsibility for determining
permissible activities. To date, eleven non­
bank activities generally open for holding
company subsidiaries have been approved
by the Board, and other activities are under
consideration. The leading fields, in terms
of entry or acquisition applications, are
mortgage banking, consum er finance and
credit insurance. Other important fields
include the leasing of personal property,
investment advisory services and data pro­
cessing. At the same time, the Board has
specifically listed eight activities as not
permissible.
Approved activities must meet the stan­
dards set forth in Section 4(c)(8) of the Act:
The proposed activity must be so closely
related to banking as to be a proper inci­
dent thereto. Most of the activities ap­
proved in 1971 were closely related to tradi­
tional banking— mortgage banking,
consum er finance and so on. More re­
cently, approved activities have been less
obviously part of regular bank services, for
example courier services, and credit insur­
ance underwriting. The Board has felt
these activities provided benefits to the
public, either in greater convenience or
more competition. This approach recog­
nizes the changing nature of the banking
business.
The Board has denied activities on grounds
that they are not closely related to banking
or where there might be problems of
undue concentration of conflicts of in­



terest. For example, operation of a savings
and loan association by a bank holding
company is not on the permissible list, but
it is being reconsidered. Savings and loan
associations are closely related to tradi­
tional banking, but they also are com peti­
tors whose acquisition might create prob­
lems of undue concentration. At the
moment, this question has not been
settled.
Implications of Holding Companies

In planning for your bank, consider
whether the bank holding company organi­
zation can be profitably utilized. The larger
bank holding companies have been ac­
tively expanding, but small banks should
not neglect the opportunities open under
this Act. Examine both local markets and
the skills present in your bank. For exam­
ple, mortgage banking and consum er fi­
nance are fields to which some banking
skills can be applied. Remember that in
many respects subsidiaries of a holding
company have more flexibility than a bank,
or a bank affiliate. The holding company
subsidiary is not subject to state banking
regulation. Moreover, it can expand across
state lines with greater certainty and
freedom of action than direct subsidiaries
of banks themselves.
If an opportunity exists, and your bank
does not jump at it, then don't be surprised
if other organizations move in. In unit
banking or limited branch banking states,
competition in consum er and mortgage
lending can arise from nonbank subsidiar­
ies, even though competition from new
banks is limited. The point is, look over the
list of approved activities for bank holding
com panies and see if they offer opportuni­
ties for you.
In terms of the specifics of expansion into
permissible fields, de novo entry is the




easiest way to secure regulatory approval.
Basically all that is required is publication
of a notice describing the proposed activity
and notification of the local Reserve Bank.
This approach has the disadvantage of re­
quiring you to build up a new organization,
but it may be possible to acquire people
with the appropriate skills. Regulatory ap­
proval of the alternative approach of ac­
quiring a going concern is less certain.
Generally approval can be expected if the
acquired firm and the bank are not direct
competitors, although large banks some­
times face questions about undue concen­
tration. Denials, when they occur, are usu­
ally the result of financial problems, such
as insufficient capital.
Acquisition of a firm in the same market as
the holding com pany's bank, however,
always faces the prospect of denial on
grounds of elimination of competition. To
obtain approval in these circumstances,
you must demonstrate that the acquisition
will result in some positive public benefit
or increased ability to compete with other
larger banking organizations in the same
market. Being a small bank will not prevent
a denial if the local market is small and
there are few com peting banks. In brief, de
novo entry faces lower regulatory barriers
than acquisition.
O ne final suggestion. Do not drop an ac­
tivity you think you could successfully offer
just because the activity is not on the ap­
proved list. If you think it fits the statutory
requirement of being closely related to
banking, apply to engage in the activity. I
know of an application submitted recently
by a small bank holding company in my
District and now pending before the
Board. The subsidiary bank had $30 million
in deposits, and the holding company ap­
plied to form a subsidiary which would act
as a dealer in municipal bonds serving




other small banks in its region. This pro­
vides a good example. If you have a prom­
ising idea, then discuss it with your District
Reserve Bank staff, and if it appears accept­
able, go ahead and apply. Why wait for the
big banks to act if you have a good
idea?
To summarize, the Bank Holding Com pany
Act offers an opportunity for banks to di­
versify and expand their activities. You
should not regard the Act as something just
for big banks. There are many banks which
can use the holding company as a means
for better utilizing their management and
their capital. Look into the opportunities
for expansion of services that are appro­
priate to your resources and skills.
Uniform Reserve Requirements

Now let me turn to a proposal for new leg­
islation, the recent Federal Reserve pro­
posal for uniform reserve requirements.
The proposal would apply Federal Reserve
regulations for reserve requirements to
demand deposits at nonmember banks,
and to the negotiable orders of withdrawal
(N O W accounts) offered in New England
by mutual savings banks. Savings and time
accounts of nonmember banks would not
be affected; they would continue to be set
by state regulation. The purposes of the
proposal are to strengthen monetary con­
trol and to reduce inequities between
member and nonmember banks.
This proposal, it should be emphasized,
does not mandate com pulsory System
membership. It is limited to those deposits
which effectively serve as money. Just as a
historical note, this objective was almost
achieved forty years ago. The 1933 legisla­
tion establishing the FD IC required non­
member insured banks to join the Federal
Reserve System, but this provision was
repealed in 1935.



The reason for the uniform reserve pro­
posal lies in trends in the banking system.
Thirty or forty years ago, this legislation
would not have been needed. But the pro­
portion of demand deposits held by non­
member banks has increased to the point
where the effectiveness of monetary policy
is being affected. Since 1960, approxi­
mately 750 banks have left the System and
about 960 out of 2700 newly chartered
banks have joined. But only 92 were state
banks— 867 were national banks for whom
membership is mandatory. Thus, 1,742 of
the new state banks became nonmembers.
In the same period, the demand deposits
held by nonmember banks grew by 164
percent, while those held by members in­
creased only 61 percent. In 1960 non­
member banks controlled 17 percent of
demand deposits, but by the end of 1973,
their share was approximately 25 percent.
Add to this situation the prospect of more
savings institutions offering accounts with
third party payment features. These ac­
counts serve as an effective substitute for
demand deposits at commercial banks, and
they represent deposits outside the direct
monetary control of the Federal Reserve.
Again trends in the financial system point
to the need for new legislation. Unlike
banking of the 1930s and '40s, when excess
reserves were a sign of prudent manage­
ment, contemporary bankers count the
costs of their reserve requirements and
manage their reserves as carefully as other
assets. For smaller banks, cost considera­
tions do not favor Federal Reserve mem­
bership. I do not think cost trends will be
reversed, and therefore, the prospect is for
a continued increase in nonmembers'
share of demand deposits.
The advantage of state nonmember status
rests upon the fact that state reserve re­
quirements are effectively lower than



System requirements. States permit re­
serves to be held as deposits at correspon­
dent banks, and in some cases, with regard
to time deposits, in earning assets such as
U.S. government securities. The balances
held as correspondent deposits serve two
purposes: they meet reserve requirements
and they compensate the correspondent
bank forvarious services provided to the
nonmember banks. Member reserves
serve only the first purpose, and additional
assets must be allocated as correspondent
balances. Cost differences explain the
trend away from membership.
The growing share of deposits in non­
member banks weakens monetary control
because deposits in correspondent banks,
unlike deposits at a Federal Reserve Bank,
can support lending by the correspondent
bank as well as serving as legal reserves for
the state banks. Therefore, reserves
flowing into nonmember banks, under
present arrangements, can support more
deposits and lending than they would if
they went initially to member banks. The
Federal Reserve through its open-market
operations changes the reserve base of the
banking system, but the effect of any openmarket transaction depends upon the pro­
portion of the proceeds appearing as non­
member deposits. This proportion is not
predictable and at times it has been quite
large. Under such conditions, monetary
control becomes more difficult. The ob­
vious way to remove this source of uncer­
tainty is to have uniform reserve require­
ments on all types of demand deposits.
Adoption of uniform reserves for demand
accounts and N O W accounts would im­
prove monetary control by strengthening
the link between the supply of reserves
controlled by the Federal Reserve and the
nation's money supply. In the absence of
uniform reserve requirements, the man­



agement problems of the Federal Reserve
can only increase to the detriment of the
whole economy.
That is why the Federal Reserve has asked
Congress to impose uniform reserve re­
quirements. This is not an attempt to un­
dermine the dual banking system, or to
bring about com pulsory Federal Reserve
membership. In fact, the legislation is de­
signed specifically to achieve the maximum
benefits in terms of improved monetary
control with minimum disruption of the
state banking system.
Easing the Burden

In particular, several features of the pro­
posal are designed to ease the burdens on
nonmember banks:
— Savings and time accounts would not be
subject to the uniform reserves. State
rules would continue to apply. On eco­
nomic grounds, demand deposits are
the prime target of control, not time
accounts. This same consideration ex­
cludes controls over the bulk of the ac­
counts in savings and loan associations
and mutual savings banks.
— The first $2 million of net demand de­
posits would be exempted from Federal
Reserve control. With the exclusion of
time accounts, this would mean most
banks below $4 million in deposits
would not be affected by the uniform
reserve proposal. This exemption
amounts to about 38 percent of present
nonmember banks, although only a
nominal part of total demand deposits.
In addition, there is a large group of
banks for whom their existing vault cash
is sufficient to meet System require­
ments. When you allow for all these
banks, only about 3,500 of some 8,700



nonmember banks would have to keep
deposits at the Federal Reserve Banks.
— As compensation for increased costs,
nonmember banks would have access to
the discount window on similar, though
not identical, terms as member banks.
— Finally, there would be a four-year tran­
sition period before full reserve require­
ments would come into effect.
The proposed legislation contains other
features, but the net effect is to exempt the
smaller nonmember banks. It is not in­
tended to erode the incentives to hold
state charters. There would be no major
change in the existing supervisory powers
of state or other regulatory bodies. The
Federal Reserve would be concerned only
with insuring that proper reserves are held,
and it would not exercise any other super­
visory functions over member banks.
Most of the nation's banks recognize the
need for effective monetary control, and
accordingly they should support this pro­
posal. Uniform reserves applied in the way
specified by the legislation would repre­
sent a major gain for monetary policy.
There also are considerations of equity.
The proposal would remove some of the
competitive disadvantages that the smaller
national banks bear compared to similar
nonmember banks, as to the effective cost
of reserve requirements. The opposite side
of the trend to more nonmember banks is a
trend to a large-bank national banking
system. A proper dual banking system
should more closely balance the relative
attractions of national charters for small
banks. At the moment, the benefits as they
involve reserves favor state charters for
small banks.




Finally, you should all consider the longrun benefits of establishing the principle
that all accounts which serve as money
should be subject to the same reserve re­
quirements. If NO W accounts or their
equivalent accounts spread throughout the
savings and loan industry, these institu­
tions would have considerable competitive
advantages over commercial banks—
nonmember banks as well as members—
under present rules. Savings institutions
would have lower liquidity requirements,
and they would be able to pay interest on
the equivalent of demand account. C o n ­
sider the competitive consequences of
such an arrangement. Competitive equality
and more effective monetary control both
point to the need for uniform reserve re­
quirements.
Hunt Commission Proposals

The President's Com m ission on Financial
Structure and Regulation, better known as
the Hunt Com m ission, released its report
in late 1972. It proposed a package of legis­
lation which would bring about a farreaching rationalization of the nation's fi­
nancial system. Its general aim was to in­
crease the flexibility of the financial sys­
tem, provide more competition among the
nation's financial institutions, and impose
less regulation. The Com m ission regarded
its recommendations as an inter-related
package. Losses from one proposal might
be offset by gains in another, but overall
the benefits would be positive when
judged by the whole package. The major
proposals were:
1) to phase out interest ceilings on time
and savings accounts;
2) to permit thrift institutions to offer
third-party payment services;
3) to require that all institutions offering




checking accounts become members
of the Federal Reserve System ;
4) to grant expanded lending and invest­
ment powers to thrift institutions and
banks; and
5) to provide more uniform tax treat­
ment of various lending institutions.
As the situation now stands, it appears
likely that the Hunt Com m ission's pro­
posals will not be adopted as a package.
The Administration submitted its own pro­
posals in the Financial Institutions Act of
1973 last summer. W hile these follow the
Hunt Com m ission in part, they add some
new features. Nonetheless, an element
common to both is the prospective grant of
more power to thrift institutions while
removing some of the present regulatory
and tax advantages these institutions
enjoy. However, the savings and loan in­
dustry appears to be unwilling to give up its
present tax arrangements and its present
interest advantage on savings accounts in
return for broadened lending and invest­
ment authority and third-party payments
powers. Moreover, Congress itself has
shown little inclination to move in the
direction recommended by the Hunt
Com m ission. Instead of broadening the
lending and investment powers of the na­
tion's financial institutions, Congress
seems inclined to impose more rigid port­
folio specifications, including com pulsory
allocation of funds to specific sectors, for
example, by the allocation of a fixed percen­
tage of assets to residential mortgages.
In the absence of a unified package of insti­
tutional reforms, we are likely to see a
piecemeal approach which could be detri­
mental to some, if not all, financial institu­
tions. It appears that everyone is in
favor of the market mechanism as a




foundation for the financial system
in the abstract; but the ultimate effects
of increased reliance on the market
are sufficiently uncertain that few
are willing to rationalize the existing
welter of obscure costs and benefits, in­
cluding subsidies, which are implicit in dif­
ferential reserve, tax and other regulatory
treatment.
Outlook for New Legislation

Despite the uncertainties in this situation, I
would like to assess the prospects for new
legislation and regulations. I think that the
Federal Reserve System's request for uni­
form reserve requirements will be seri­
ously considered by Congress, and its
chances for adoption will improve with
time. This reasoning is related to another
expectation, namely that thrift institutions
eventually will offer a wide range of thirdparty payment services. Like those cur­
rently provided by nonmember banks,
such services could have a significant
monetary impact. This consideration again
underscores the need for uniform reserve
requirements on institutions offering com ­
parable payment services.
Com m unication systems are beginning to
make point-of-sale terminals economically
feasible. When such a system is tied to the
retail level, considerations of economics
and competition (including the probable
stance of the Justice Department) will point
to the participation of as many institutions
as possible— S & L's as well as commercial
banks. If you don't think electronic sys­
tems of some kind are com ing, look
around today. You will see 24-hour na­
tional authorization systems com ing on­
line for bank credit cards, and remote
banking facilities appearing and being
tested by savings and loan associations.
Some of you may have noticed reports of
successful experiments by a Nebraska sav-




ings and loan with remote terminals at
supermarkets.
The Federal Home Loan Bank Board now
permits Federal S&L's to install remote
terminals in merchant locations within
their market areas without specific Board
approval. The Home Loan Bank Board also
is considering allowing automated tellers
and cash dispensing machines to be in­
stalled without requiring an application,
which seems to me to be a good substitute
for actual branching. The extension by
regulatory authority for S&L's to credit
merchant accounts directly also may be
imminent.
In short, it is conceivable that the S&L's
may bypass the checking account entirely
and jump directly into third-party clearing.
This would enable these nonbank financial
institutions to compete in the trade area of
smaller commercial banks, and to offer
deposit and withdrawal services by means
of electronic transfers comparable to the
bank services offered through the medium
of checks. Moreover, their cost of electronic-transfer services would be signifi­
cantly less than the cost of check proces­
sing.
The Federal Reserve System has proposed
amendments to its Regulation j to set up
rules for automatic or paperless transfer of
funds. Under these proposals, member
banks could send and receive electronic
funds transfer transactions having many of
the characteristics of checks. Such "debit
transfers” could be transmitted nation­
wide by the electronic telecommunication
system operated by the Federal Reserve.
Settlement usually would occur on the
same day the debit was transmitted. Pre­
authorization would be required for these
debits, and in this sense the "debit trans­
fers" are similar to the transactions now



processed by automated clearing-houses
in California.
In these areas, the paperless deposit of
paychecks is a reality, and banks are
looking into procedures for eliminating all
or part of the paper involved in processing
such recurring payments as utility and de­
partment store bills. This system would
offer important advantages to member
banks. As for nonmember-bank access to
these transfer facilities, it may be wise to
have them go through their correspon­
dents or be subject to higher fees than
members.
The various pieces needed for a full elec­
tronic payments system exist. It only re­
mains for them to be put together as an
econom ic proposition. When that system
is operational, regulations will be changed
to reflect it. I think third-party payment
privileges, regardless of what they are
called, will be given to thrift institutions
and that uniform reserve requirements of
some kind will go along with them.
On the lending side, it is also probable that
thrift institutions will be given more pow­
ers, particularly in the consum er-lending
area, but for the moment, any expansion
will be hedged by concern about pro­
tecting housing finance. As part of this
hedging tendency, interest-rate ceilings
will be retained for the moment, but in
time I think they will disappear. Their dis­
appearance will be hastened by the appear­
ance of new market instruments which in­
creasingly will be consumer-oriented, such
as small denomination savings bonds is­
sued by nonfinancial corporations. These
developments seem certain to result in less
reliance by the thrift institutions (and the
banks) upon traditional passbook savings
accounts, and more reliance upon such
instruments as mortgage-backed bonds,



which can be authorized under existing
Home Loan Bank Board authority.
Thus, the aim of the Hunt Com m ission—
greater flexibility for the nation's financial
system— will be achieved only slowly and
partially by developm ents in the market
and at the regulatory level. Rigid rules do
harm, because they reflect past social
priorities which may not be the same as
today's and tomorrow's priorities, and thus
they impede adjustment to new needs.
Conclusion

In conclusion, pressures for change exist
and legislation will reflect these pressures.
As bankers, you should recognize them
and try to plan for them. It is difficult to fit
in these longer-term forecasting problems
when short-term problems seem over­
whelm ing. Yet early recognition of the
trends in the financial system will give you
time to plan ahead to exploit the oppor­
tunity to offer new services by new
methods. Look to the options open under
the Bank H olding Com pany Act and be
prepared for more vigorous competition
from thrift institutions.
These changes will bring new legislation
and problem s of adapting, but they also
will bring new opportunities. I think there
will always be a role for the small bank to
serve its community. American technology
has always been flexible enough to serve
the small firm, and with this help, you can
count on the small bank playing a role in
the com ing payments system.