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BANK REGULATION
AND THE
PUBLIC INTEREST

Remarks of

John J. Balles
President
Federal Reserve Bank
of San Francisco

George S. E ccles Lecture
Tenth Annual Intermountain Banking Seminar
Utah Bankers Association/Utah State University
Logan, Utah
November 1, 1979







Simplification and reduction—and in some
cases, removal—of regulatory burdens on
banks is essential for the long-term health of
the nation's financial institutions and of the
overall economy, says Mr. Balles. The Federal
Reserve is well aware of the problems
created by a constantly changing and ever­
growing set of regulations burdening the
financial system. To cope with those
difficulties, the Fed has begun to review every
one of its regulations with a view toward
simplifying or deleting wherever possible—in
effect, zero-based regulating. But
simplification of regulations can go only so far.
What the banking industry must do is to
convince Congress of the need to avoid
regulatory overkill.




I feel honored by the invitation to give this
year's Eccles Lecture, not least because it
gives me the opportunity to pay tribute to
the remarkable man after whom the series
is named. The breadth of George Eccles'
interests is well known to all of us. Along with
his late brother Marriner, George has played a
key role for many decades in stimulating the
growth of the Intermountain West —in
banking and finance, and in many other
fields. And judging from his wide experience,
I'm sure that George could discuss the topic
of today's conference with more skill than the
rest of us put together.
My theme today concerns the ways that the
regulatory agencies and the people they
regulate can best satisfy the public interest—
how we can all work together to make
regulatory actions conform to broad national
goals at the least possible cost. Some of you
may have seen the cartoon which shows two
shepherds standing at the foot of Mount
Sinai, watching a distinguished-looking
gentleman carry some stone tablets down the
mountainside. One man turns to the other
and comments, "More damn rules and
regulations!" That attitude, although perhaps
overly critical in that particular context, still
represents a healthy approach to the present
debate, because it highlights the costs as well
as the benefits of regulation.
The costs may be difficult to quantify, but
there's no doubt that they are substantial.
Many analysts argue that business firms as a
whole incur expenses of roughly $100 billion
a year in complying with government di­
rectives. These indirect costs, of course, far
exceed the direct costs of about $5 billion
needed annually for staffing and operating all
the financial and nonfinancial regulatory
agencies—and all such costs should be kept




in mind in any discussion of the future of
regulation.
Let me declare my personal convictions at the
outset. From my long experience as both a
commercial banker and a central banker, I
believe that the simplification and reduction—
and in some cases, removal—of regulatory
burdens on banks is essential for the long­
term health of our financial institutions and of
the overall economy.
Origins of Regulation
No one disagrees that banking is heavily
regulated—perhaps one of the most heavily
regulated industries in the country. In earlier
decades, this stemmed largely from public
and legislative concern with the safety and
soundness of the banking system and the
protection of depositors—particularly after
waves of bank failures, such as in the 1930's.
After all, banks are at the center of the
nation's monetary and credit mechanism.
They have a fiduciary responsibility for funds
deposited with them, which are insured only
in part. The supply of credit flowing through
the banking system is essential for the growth
and stability of the national economy. We
have seen how failures of particular banks can
have major ripple effects, affecting the state
of confidence and the viability of the banking
system, and hence the state of the entire
economy. All of these considerations suggest
the need to protect the financial cornerstone
of the national economy.
Thus, one important body of restrictive
legislation or regulations on banking originated
from economic and financial crises, along with
some accompanying abuses and unsound
practices in banking. Especially important in
this regard were the Banking Acts of 1933
and 1935 which, among other things,




established the statutory basis for the
regulation of interest payments on bank
deposits, provided for the separation of
commercial banking and investment banking,
established the Federal Deposit Insurance
Corporation, and mandated numerous
reforms in banking practices and bank
supervision.
Even in the absence of a widespread
economic crisis, abuses by a small group of
banks, or even a single bank, can lead to
successful demands in the Congress for
further regulation of the entire industry. As a
very recent example, I am informed that the
Financial Institutions Regulatory and Interest
Rate Control Act of 1978 is often referred to
by bankers as the "Bert Lance" bill. Similarly,
the emergence of consumer-protection
legislation in the banking field was based on
abuses which were perceived to exist by the
Congress. Some of those abuses might have
been handled more productively by vigorous
enforcement of existing laws rather than by
additions to an already large body of
regulations.
As to a third area, it appears to many
observers that key elements in restrictive
banking legislation and regulations have arisen
or have been retained because of successful
demands by certain segments of the banking
industry itself. Generally, these regulations
have had the effect of restricting competition.
Leading examples are restrictions on price
competition, as in the case of legislation
authorizing Regulation Q, which prohibits
payment of interest on demand deposits and
limits the payment of interest on savings and
time deposits; and restrictions on market
areas of competition, as is the case with
limitations or prohibitions on branch banking
and interstate banking. The latter group of




restrictions would include the 1927 McFadden
Act, which limits national banks to the
branching powers accorded to statechartered banks under state law; laws of a
number of states which limit or sometimes
prohibit branch banking; and the Douglas
Amendment to the 1956 Bank Holding
Company Act, which prohibits a bank holding
company from acquiring or creating subsidiary
banks outside the home state, except where
state law expressly permits such entry.
The rationale offered for measures restricting
the scope of competition has usually run
along one or more of the following lines:
preventing undue concentration of economic
power; preserving the vitality of local
independent banking; guarding against
overbanking and destructive competition;
or preserving states' rights under the dual
banking system. In terms of broad social and
economic policy, such considerations are
pertinent. At the same time, judgments need
to be made and periodically reassessed as to
whether the specific measures adopted that
restrict competition are in fact justified by the
national interest, in terms of costs versus
benefits.
In the view of some observers, the net effect
of industry-supported measures which place
limits on competition in banking may have
been largely to protect some individual
competitors, rather than to protect and
promote net public benefits. It should be
noted, in fairness, that many fields of U.S.
business have also been marked by similar
intra-industry differences and disputes on the
limits to competition.
As a personal observation, I am always
surprised, and sometimes distressed, at the
number of banks of all sizes which oppose




the liberalization of regulatory measures.
Several instances from the past several years
come readily to mind, in terms of vehement
objections expressed to me personally from
banks in the Twelfth Federal Reserve District.
For example, bankers have objected to me
about several liberalizations of Regulation Q,
and more recently the actions to liberalize the
provisions governing the international banking
operations of Edge Act Corporations.
Types of Regulatory Burden
In summarizing the origin of much of the
regulatory burden imposed on banking over
the past half-century or so, it seems to me
that it falls into several classes. First, there
were actions limiting the scope of compe­
tition that either originated from, or were
strongly supported by, a large segment of the
banking industry. Unless or until this support
changes, the outlook is not especially bright
for relief, particularly since legislative action
would be necessary. I am reminded of that
famous line from Pogo: "We have met the
enemy and they is us!" My own personal
views are that the country and the banking
industry would be well served by a phasing
out of Regulation Q and a gradual evo­
lutionary relaxation of present barriers to the
geographical scope of competition in banking.
A second category of the bank regulatory
burden originated in the banking "rescue and
reform" measures of the 1930's, under the
impact of the Great Depression. No doubt
many of those measures were of lasting value
and should be retained, such as Federal
deposit insurance and improved standards for
bank examination. But at the same time, my
personal views are that a searching review
should nevertheless be made of such
legislation, to eliminate unnecessary
restrictions that have become outmoded after




the passage of 45 years. Some observers
question whether complete separation of
commercial and investment banking still
serves the country well. As a specific case in
point, the studies made of the possibility of
permitting banks to underwrite and deal in
municipal revenue bonds, as they can already
do in the case of general-obligation bonds of
municipalities, have convinced me that a
change would be to the net benefit of state
and local governments. Specifically, if banks
could compete in this area, it should mean
expanded competition for revenue bonds
and a lowering of the net interest cost. In this
case, fierce opposition from the investment
banking industry has thus far prevented
enabling legislation from being passed.
A final category of banking regulation, of
more recent origin and dealing with consumer
protection, will also be difficult to modify or
simplify. In recent years, Congress has
imposed new responsibilities on the Federal
Reserve and other bank regulatory agencies,
through the passage of legislation which has
focused increasing attention on constituencies
other than the banking community. In 1968,
the Truth in Lending Act ushered in a decade
of extensive new legislation and rule-making
responsibility in the consumer-protection and
anti-discrimination areas. Such legislative
mandates have created problems for regu­
lators and regulated, and thus have led to
loud cries for reform. As a preview of my
personal views, I recognize that there were
enough genuine abuses to warrant some
corrective action. At the same time, I fear that
in many cases, and considering the whole
gamut of consumer-protection laws and
regulations in the credit area, we may have
gotten into an "overkill" mode. Because
of the inherent cost and complexity of
regulatory compliance, the net effect may




turn out to be counter-productive by raising
the cost and reducing the availability of credit
to consumers. This is a question of costs
versus benefits, which surely deserves a
searching review. Efforts now underway in
the Congress, for example, to simplify Truth
in Lending legislation, represent a needed
start, and more such action may be desirable.
Avoiding Reg Q Restrictions
Let's consider next those restrictive
regulations which were initially conceived to
preserve market positions of financial
institutions or to limit competitors' incursions
into their territory—but which in fact have
been self-defeating. A prime example, of
course, is provided by the Regulation Q-type
ceilings on interest rates paid by banks and
thrift institutions. With the aid of inflation and
a changing financial environment, the
"creative destruction" of the marketplace
undermined this restrictive regulation, long
before the legislative process recognized the
market reality. In this connection, it's hard to
conceive that money-market mutual funds
would even exist, much less hold $35 billion
in assets, if depository institutions had been
free to pay market interest rates during the
past decade.
As you may have noticed, the legal process
has begun to catch up in this field, although
through the legislative rather than the judicial
approach. Last April, a U.S. Court of Appeals
panel decided against certain financial
innovations which avoid the legal prohibition
of interest payments on demand deposits.
The court ruled adversely on the automatic
fund transfers'between savings and checking
accounts offered by commercial banks, the
remote-service units in shopping centers and
elsewhere operated by savings-and-loan
associations, and the check-like share drafts




on savings accounts offered by credit unions.
The panel argued that "three separate and
distinct types of financial institutions" created
by Congress to serve separate needs now
are offering "virtually identical services
to the public, all without the benefit of
Congressional consideration and statutory
enactment."
Several weeks ago, the Supreme Court
refused to hear the case on appeal, and the
action shifted back to Congress, just as the
appeals court proposed last spring. From all
indications, Congress will act to legalize these
financial innovations before the January 1
deadline imposed by the court, and we may
begin to see a rough correspondence emerge
between the legal and economic realities.
Meanwhile, Reg Q rate ceilings continue
under heavy attack, although they are
unlikely to be phased out completely for a
few years yet.
Avoiding McFadden Act Restrictions
Let's turn to the still evolving, and thus more
interesting, subject of the geographic barriers
to competition typified by the McFadden Act.
For several decades, market forces have
brought those barriers under heavy attack.
Today, holding-company subsidiaries (with
Federal Reserve approval) can engage in a
number of specified bank-related activities
without any geographic restrictions.
Commercial banks can transfer funds and
carry out government-securities transactions
through the Federal Reserve's wire-transfer
facilities, and they also can buy and sell
excess reserves in that key national market,
the Federal-funds market. Large banks can
send the lending officers of their national
divisions across the country to seek new
customers, and in addition, establish
representative offices or loan-production




offices in major financial centers to develop
local business in those areas. Edge Act
corporations can now set up branches in
different states, after gaining the Fed's
approval. And of course, credit cards can
provide a form of interstate banking for
consumers throughout the nation.
Holding companies provide a major example
of the market's reaction to the McFadden
Act; indeed, they now represent the
dominant organizational form in banking.
There are now more than 2,000 such
organizations, and they control more than 70
percent of domestic bank deposits. The
Federal Reserve processes about 1,000 cases
each year involving holding-company
applications to purchase existing banks, to
form new banks, or to engage in one of the
13 permissible "nonbanking" activities
approved by the Board.
The holding-company movement represents
a response by the industry to the evolving
framework of laws and regulations that
constrain and restrict bankers' actions.
During the 1960's, for example, the
holding-company form of organization
allowed banks to tap nondeposit sources of
funds—mainly commercial paper and longerterm debt markets—at rates not subject to
Regulation Q ceilings. These nondeposit
sources of funds became very important to
banks during those high-rate periods when Q
ceilings were still binding on all time deposits.
Again, borrowed funds raised by the holdingcompany parent have been downstreamed
to bank subsidiaries in the form of debt or
equity. This procedure has tended to increase
the leverage of the overall organization, while
maintaining or increasing the equity of the
bank subsidiary.




Holding companies, through nonbanking
activities, meanwhile have been able to avoid
geographic and other barriers when
competing with retail firms and nonbank
financial institutions. These nonbanking
activities account for less than 4 percent of
holding-company assets, but they are
important enough to arouse considerable
opposition from affected economic interests.
A prime example is a piece of legislation that
was recently approved by a House Banking
Subcommittee, called the Bank Holding
Company Amendments Act, which would
restrict activities of such companies in various
ways. The fact that this piece of legislation
was even introduced suggests that holding
companies cannot expect completely free
sailing in the years ahead.
McFadden Act restrictions meanwhile have
hampered American banks in their growing
competition with foreign banks. Traditionally,
in state banking law, a "foreign" bank is
considered an out-of-state bank, whether
foreign or domestic. But many U.S. banks find
it ironic that they are considered even more
foreign than (say) Japanese or British banks.
Thus, if the owners of a New York bank
decide to sell out, because of financial
troubles or other reasons, they can sell to a
Japanese or British institution but not to a
California one. And with state boundaries
defining the size of markets, antitrust laws
frequently stop banks within the same state
from acquiring one another. Banking, alone
among major industries, thus is constrained by
the lines drawn on a map by surveyers a
century or two ago, rather than by the needs
of today's customers.
I don't want to prejudge the Administration's
forthcoming report on the McFadden Act,




but I certainly believe that the regulatory
environment will continue to evolve, as we
try to balance today's economic and
technological realities against the tradition of
small-bank safeguards within the state/
national dual-banking system. There are
various forms in which new legislative
authority might evolve. For example, we
might see interstate branching within
metropolitan areas, perhaps limited initially to
EFT terminals. Again, we might see out-ofstate bank holding companies acquiring failing
banks, or out-of-state banks (say, in California
and New York) establishing branches or
holding companies on a reciprocal basis.
Further down the road, the banking industry
could develop into a several-tiered structure,
made up of several dozen multinational banks
in one group, several hundred regional banks
in a second group, and thousands of small
banks serving local markets in a third group.
In a word, further evolution seems certain in
our banking system.
Living with Consumer Legislation
Let's consider now another type of
regulation—one which does not divide the
industry as much as the McFadden and other
restrictions that I've already discussed. I'm
speaking of consumer regulation, an area
where bankers generally stand united against
Congressionally-imposed requirements and
restrictions. Indeed, in trying to cure the real
or perceived inequities created by the
marketplace, Congress has created a massive
and complex body of regulations for the
Federal Reserve and the other banking
agencies to administer.
This regulatory burden has developed in three
different stages, the first of which covered
roughly the period 1968-74, and dealt largely
with the problem of disclosure. In that period,




Congress passed the first of the many laws
that rewrote the rules governing the
relationships between banks and their
household borrowers. This group of laws
included the Truth in Lending Act of 1968,
the Fair Housing Act of 1968, the Consumer
Credit Protection Act of 1968, the Fair Credit
Reporting Act of 1971, and the Real Estate
Settlement Procedures Act of 1974. In most
cases, the Congress delegated to the Federal
banking agencies the responsibility for
enforcement, giving them a new and very
unfamiliar role—the protector of consumer
rights.
In a second period between 1974 and 1977,
Congress added a different kind of law to the
books. Through legislation such as the Equal
Credit Opportunity Act of 1974, the Home
Mortgage Disclosure Act of 1975, and the
Community Reinvestment Act of 1977,
Congress applied the Civil Rights Act of the
1960's to credit transactions. In effect, it
outlawed rules of thumb which classify
borrowers into groups based upon certain
demographic characteristics for purposes of
assessing creditworthiness. (An example
would be the old rule which counted only
half of the wife's income in lending decisions.)
All credit decisions now must be researched
and documented on an individual basis,
thereby substantially increasing the cost of
extending credit. Moreover, Congress during
this period made it clear that it expected the
banking agencies to play a more visible
enforcement role than they had previously.
Following an amendment to the Federal Trade
Commission Act, each of the agencies
established formal complaint-handling
procedures. The Federal Reserve Board of
Governors set up a unit, now called the
Division of Consumer Affairs, to handle
complaints and to formulate policies on




regulatory enforcement, and the Comptroller
and FDIC established similar programs.
More recently, the regulatory agencies have
vastly expanded their compliance programs
while attempting to deal with the new
responsibilities created by the latest spate of
legislation. The Community Reinvestment Act
of 1977 and the Financial Institutions
Regulatory Act of 1978 portend expanded
and intensified enforcement efforts. But
enforcement has become systematized under
the special consumer-compliance programs
initiated in late 1976. Since then, the agencies
have undertaken specialized training programs
for examiners and have moved aggressively
to improve compliance among banks,
beginning with a series of major consumercompliance examinations. All of these
activities require expanded staffs; for
example, the Federal Reserve Bank of San
Francisco has doubled the size of its
Consumer Affairs Unit in the past several
years, mainly to develop advisory services for
banks and to conduct in-depth examinations
under the Fair Housing and Community
Reinvestment Acts.
Congress and the regulatory agencies have
received many complaints, especially from
small banks or branches of state-wide
institutions, stating that they have difficulty
understanding and complying with the
constant flow of consumer legislation. The
problem may be difficult for the personnel of
large institutions, but it could become almost
insurmountable for, say, the loan officer of
a small institution. His regular duties may
include making instalment loans, buying
dealer paper, overseeing credit-card




operations, making home-mortgage loans,
extending construction credit and arranging
for credit insurance. When he then has to
take on the added responsibility of dealing
with consumer-credit regulations, his task
becomes difficult indeed.
The Federal Reserve is well aware of the
problems created by a constantly changing
and ever-growing set of Federal regulations
burdening the financial system. To cope with
those difficulties, we have begun to review
every Federal Reserve regulation with a view
toward simplifying or deleting wherever
possible—in effect, zero-based regulating. But
simplification of regulations can go only so far.
What the banking industry must do is to
convince Congress of the need to avoid
regulatory overkill. As I noted at the outset,
banks incur immense costs in complying with
government directives, and it is virtually
certain that these costs will have to be passed
along to the users of bank credit. Thus it
would behoove Congress to do everything
possible to reduce the costs which consumers
now have to pay because of the burden of
regulation, and to avoid the danger of a
lessened availability of credit to consumers
because of the heavy burden involved in
handling such business.
Concluding Remarks
By way of summation, let me cite several
principles which were proposed in 1971 to
the Presidential Commission on Financial
Structure and Regulation (The hlunt
Commission) by an American Bankers
Association Special Committee, of which I
was chairman. Basically, our committee
argued that:




"1. Maximum reliance should be placed upon
free market forces in order to assure an
innovative financial system which is
responsive to the public interest.
"2. Consistent with the need for safety,
regulation of financial institutions should be
subject to continuing review to make certain
that the regulation is justified in terms of basic
purpose and that its administration is not
unnecessarily restrictive.
"3. To best finance the nation's social
priorities, public policies should be directed
toward mobilizing the resources of all financial
institutions through measures which provide
incentives to all lenders, rather than relying
exclusively on subsidies to specialized
institutions.
"4. As a corollary, the ground rules for
competition among financial institutions must
be equitable. Substantial differences in
regulations affecting the relative ability of
these institutions to compete with one
another must be avoided if the nation is to
move toward a truly responsive system of
financial institutions."
I submit that these principles have held up
well, and that they provide a basis for
keeping the regulatory process in
conformance with the public interest. We
regulate in order to maintain a sound financial
system as the foundation stone of a strong
national economy. We recognize, however,
that competitive change is a necessary
element of future economic growth, and that
change can sometimes be hampered by
outmoded regulations. Thus, we can and
must examine the wisdom of our regulations
in a continuing review process. The
cooperation of the private and public sectors
is essential for keeping this process going, in
order to fulfill the broad public interest.