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FEDERAL RESERVE B AN K OF SAN FRAN CISCO
Office of the President

tJ
MAJOR




FORCES

FOR

CHANGE

IN

BANKING

Remarks of
John J. Balles, President
Federal

Reserve

C arter
Fall
San

Bank of San Francisco

H. Golembe
Executive

A ssociates
Seminar

Francisco, C alifornia

O ctober 15, 1975




Major Forces for Change in Banking
When Carter Golembe asked m to speak here tonight, he did not
e
suggest that I would be used as an object lesson to illustrate the
theme of the conference— the costs of regulation— although that thought
might have crossed his mind.

Rather, he suggested that I discuss, in

broad-brush fashion, some of the major forces that are now affecting
the banking industry, partly through Congressional and regulatory
decisions, and partly through underlying technological and economic
trends.

You are certainly just as familiar as I am with all these

developments.

But since changes are coming today so fast and furiously,

and since they are interrelated in so many ways, it would be useful
for us to red-flag some of the major developments— to show how, as
a group, they constitute a major set of forces for change.
Let me begin by quoting some rather unflattering remarks made
a few years back by a long-time observer of the industry.

"Banking

has had a pattern of traditional services, an imposed molecular struc­
ture, and a pedestrian operating technology, none of which it could
call its own.

It has not innovated its service products nor shown

much adaptive ingenuity in their promotion.

Its competitive aggress­

iveness has been schizophrenic, with large sectors of the industry
advocating or supporting publicly administered price ceilings for time
deposits, public prohibitions against the absorption of exchange,
and a variety of regulatory devices or postures that by sanction or
promise dilute competitive ingenuity."




2
The speaker was George Mitchell, the time was 1967— and despite
all the striking innovations of the intervening period, I rather imagine
that Governor Mitchell would take much the same line today.

The ri­

gidity that he describes is understandable, reflecting as it does the
extraordinary impact of the Great Depression and World War II on the
industry.

The Depression conditioned bank managements and regulators

to a fear of future commitments and a strong concern for liquidity.

The

war and its aftermath solved for a while the problem of liquidity, but
deadened the sense of initiative by providing managements with no more
challenge than managing a portfolio of government securities.

The

industry has developed a number of innovations in the last several de­
cades, of course, but many segments of the industry have remained burdened
by the dead hand of the past.
To help understand the resultant problems we should ask just what
is the business of banking?

Just what ought to be the functions and

powers of commercial banks in an era of sweeping changes in society?
I ’m not going to answer those questions in one brief after-dinner speech,
but I 'l l try to indicate some of the changes that will affect banking’s
basic intermediary function, in one way or another, in the coming
decades.

Banks produce a number of services— handling the nation’ s

basic means of payment, functioning as a source of credit, providing
customers with low-risk assets, providing accounting services, main­
taining investment portfolios for the public, and so on.

But other

financial and even nonfinancial institutions are operating today in
many of these same areas, and banking’ s future will be affected by
the responses of all of these institutions to the forces that are now




3

changing the industry’ s ground rules.

Let’ s consider the challenges

arising from four different directions— from computers, from bank
customers, from thrift institutions, and from nonfinancial institutions—
and consider also the challenge which banking itself poses to other
institutions, such as the securities industry.

With those factors

in mind, we can better understand the policy responses arising from
Congress and the regulatory agencies.
Technological Innovation
Technological innovation affects all financial institutions, but
one of its most significant impacts may be in the area of bank branching.
Banks in many cases have increased the size and penetration of their
market areas by branching, but at the cost of higher operating expenses
and diluted profits.

In the past 15 years, the number of banks in the

U.S. has increased by 7 percent but the number of branch offices has
jumped by 170 percent— permitting the number of persons per banking
office to decline from 7,500 to less than 5,000.
We now realize, however, that branching is not the only possible
method of supplying convenient banking services and of improving a
bank’ s effectiveness.

Customers no longer have to travel to a banking

office to make deposits, get cash or pay bills.

Direct deposit of

salaries and other income payments is a reality and is bound to increase.
Teller machines have been developed, at less cost than branches but with
comparable efficiency, to provide service to shopping areas and work­
places.

Moreover, point-of-sale terminals have been developed to provide

potentially spectacular operating savings.




4

Point-of-sale devices in shopping areas, factories, office
buildings and other workplaces, when shared, entail minimal costs to
financial institutions, being well within the reach of small as well
as large banks in a given market area.

Bank managers, in their market-

planning decisions, thus are no longer limited to a bricks-and-mortar
decision, but have an alternative way of reaching customers through
flexible and relatively inexpensive electronic devices.

This question

may be moot at present, in view of the Federal court ruling that
electronic terminals are equivalent to branches, and thus subject to
the 48-year-old McFadden Act limiting bank branching.

We may have

to await a Supreme Court decision on this matter or perhaps some
Congressional action— remember, Senator McIntyre has suggested that
Congress take a good hard look at the McFadden Act.

Meanwhile, the

technology remains available to support far-reaching institutional
changes in coming decades.
Customer Innovation
Consider next the impact of bank customers— especially through
the consumer movement— on the reshaping of the nation’ s financial
system.

Banks and other financial institutions have to contend with

more affluent and more knowledgeable customers who insist on a return
on their money, and who thus draw down their demand deposits to min­
imal working-capital needs.

Sophisticated consumers are now able to

obtain high returns from various market instruments— which the Treasury
and various Federal agencies are happy to supply in ample amounts—




5

and also from money-market funds.

Aggressive consumerists meanwhile

are pressing for the termination of bank-deposit interest ceilings,
which range from zero on demand deposits to 7^ percent on the longerterm certificates.

The response is evident in the recent actions of

the Senate Banking Committee, which essentially would permit payment
of interest on demand deposits at the end of next year and phase out
Reg Q ceilings on time-and-savings deposits in 5h years.
While consumers may be becoming less dependent on banks, the
trend-setting banks may be becoming more dependent on consumers.
Traditionally, the larger commercial banks have looked to businesses
as their prime customers, but these customers over time have found the
money and capital markets more attractive than the banks for the
placement of funds or as sources of funds.

A clientele which formerly

provided a solid loan and deposit base for the banks has demonstrated
less and less loyalty to its banking connections.

Corporations

increasingly pay for their banking services with fees rather than
with holdings of deposit balances, and they tend to concentrate their
loan demand in periods of credit restraint.

The choice for banks in

this situation is either to increase their dependence on interestsensitive funds in order to meet corporate demands, or to avoid the
pitfalls of liability management by cultivating a larger consumer
deposit and loan base.

f,This market is comparatively stable, statis­

tically predictable, comparatively insensitive to interest-rate
changes, and potentially profitable with the help of modem electronic




6

processing,1 in Governors Mitchell's apt description.
1

The question

then becomes, how will the consumer respond to the importunings of
the now-ardent banks?
Thrift Institution Innovation
The answer depends on the interaction between the rising com­
petitive challenge from thrift institutions and the far-ranging changes
(present and prospective) in the ground rules established by regulatory
authorities.

The institutional changes now underway are rapidly

blurring the distinction between demand accounts and time-and-savings
accounts— primarily of course through the development of NOW accounts,
but also through the development of telephonic and other convenient
methods of transferring funds out of savings accounts.

The public

increasingly holds its transaction balances and precautionary balances
in time-and-savings accounts, with commercial banks and thrift insti­
tutions competing directly for such balances.

They compete on the basis

of both interest rates and levels of service, so that an account at
any one of these institutions appears interchangeable to the depositor.
Consequently, we might expect the regulatory authorities to
attempt to enforce roughly similar ground rules for these competing
institutions; after all, that is one of the basic principles under­
lying the Hunt Commission’s recommendations.

Thus, we have several

Federal Reserve actions which would help bring the banks into line
with thrift-institution practices— the authorization for commercial
banks to offer passbook-savings accounts to corporate customers, and




7

the authorization for banks to offer a bill-paying service to savingsaccounts customers.

Moreover, we have the Senate Banking Committee’s

set of proposals, which would further blur the distinction between
the different types of institutions, such as by allowing the expansion
of all thrift institutions into the consumer-loan and NOW-account
fields.

The key question, as always, is whether the thrift industry

will be willing to give up its present tax arrangements and its present
interest advantage on consumer deposits in return for broadened lending
authority and third-party payments powers.
Technology has played an important part in the thrift-institution
drive for a larger share of the consumer market.

Electronic data-

processing technology and the structure of the related service industry
have given thrift institutions a capability to do for themselves, or
through non-bank contractors, certain vital processing operations
formerly done by banks.

I would draw your attention only to the latest

manifestation of the Hinky Dinky syndrome— the proposed Home Loan
Bank switch-and-settlement center which would interconnect several
California S&LT offering point-of-sale electronic funds transfers.
s
Such data-handling systems frequently attain volumes capable of reducing
dramatically the overall costs of deposit and money-transfer operations.
To the extent those economies are realized by thrift institutions,
their share of the consumer market should increase.
Nonfinancial Institution Innovation
But the challenge arises not just from the thrifts but from other
competitors as well.




Data-processing and communications firms, credit-

8

card companies, and national and regional retailers are also becoming
involved in the payments system— an area once dominated exclusively
by commercial banks, the Treasury and the Federal Reserve.

These newer

enterprises see the change-over in payments technology as an opportunity
to enter the payments business without the operating handicap of
having to use paper checks processed through commercial-bank channels.
Indeed, as Governor Mitchell argues, while the banks and thrifts
zealously try to limit each other's competitive effectiveness by
statutory or regulatory action, they overlook the very strong challenge
being launched by unregulated enterprises.

The sheer volume of money

transfers— over 100 million daily, by check alone— has overtaxed the
banks1 conventional labor-intensive technology, and has thus created
an opportunity for more innovative firms to move in.
All of this is made possible by the break-up of the operating
steps of moving money from payor to payee— an evolutionary process
resulting from the introduction of the credit card and the removal of
check processing from a backroom operation to a centralized operation.
Nowadays, funds transfer, data handling, data transmission and the
extension of short-term credit all can be segregated operationally.
Moreover, all steps can be performed outside of the banking system—
except for funds transfer, and even that can be simplified.

The field

offers many profitable opportunities for entrepreneurial talent, and
that talent is just as likely to be found outside the banking industry
as inside.




9

Securities Market Opportunity
Remember, though, that the growing challenge to the banks inside
their own bailiwick is balanced somewhat by the growing challenge of the
banks to other financial institutions.

In recent years, we have seen

the expanding power of bank holding companies in a number of non-bank
areas.

Now, with the upcoming hearings of the Securities Subcommittee

of the Senate Banking Committee, we're likely to hear a great deal
about the growing strength of the banks in the securities industry.
Banks already underwrite Treasury securities and general-obligation
municipals, and through their trust departments, they are the nation’ s
largest investor in corporate stocks.

They have become important

suppliers of longer-term (as well as shorter-term) capital to business
through expanded term-loan activity— and of course they are heavy
lenders to the brokerage industry itself.

The banks1 powers may in­

crease by default if Wall Street continues to be beset by sluggish
trading volume and by the wild price competition triggered by the
shift to fully negotiated commission rates.

It may be too early to

bury the Glass-Steagall Act, but if Wall Street proves unable to meet
the nation’s very heavy capital needs, the banks perforce may have
to fill the gap.
But in this as in other areas, the banking industry will be
affected by the changing groundrules brought into being by changing
economic circumstances.

Thus we have the new guidelines proposed

not only by the bank regulatory authorities but also by the SEC in
its role as protector of investors in bank holding companies.




Under

10

these guidelines, large banks would have to furnish such new information
as their loan-loss experience, income statements for foreign branches,
maturity breakdowns for various loans, and detailed interest-rate data
for security holdings.

The guidelines represent a difficult compromise

between investors1 rights and bank customers1 rights.

In developing

them, we have had to weigh carefully the type and form of disclosure
imposed on banks, so that we don’ t undermine the banks’ willingness
to assume risk— and also don’ t erode the confidence of depositors,
which after all is a key determinant of the banks’ ability to attract
the funds needed to finance future lending activities.
Concluding Remarks
What conclusions can we draw from this discussion?

Above all,

bankers should remember that we live in Earthquake Country, affected
not only by shifting regulations but also by the shifting of the very
ground beneath the industry’ s feet.

Technological change is a con­

stantly disturbing element, posing a major change to such established
practices as bank branching.

The demands of a more affluent and more

sophisticated consumer are another seismic force.

Thrift institutions

and (increasingly) nonfinancial institutions, by their rapid adaptation
to this new environment, provide a serious challenge in many aspects
of the banking business.

But banks themselves have the power to

expand— for instance, in the securities industry— by proper adaptation
to institutional and technological change.
To deal with these far-reaching developments, I would like to
suggest several principles, in line with the proposals made several




11

years ago to the Hunt Commission by a Special ABA Committee which
I chaired.

Basically, our committee argued that 1) maximum reliance

should be placed upon free-market forces to assure an innovative
financial system; 2) regulatory processes should be reviewed continually
to ensure that each regulation is justified and that its administration
is not unnessarily restrictive; 3) public-policy measures for financing
the nation's social priorities should provide incentives to all lenders,
and should not subsidize only certain specialized institutions; and
4) the ground rules for competition among financial institutions should
be equitable, with no substantial differences limiting the ability
of these institutions to compete with one another.
I submit that these principles have held up well, and that they
provide a basis for developing an industry-wide position on the issues
first crystallized by the Hunt Commission.

But it seems essential

that bankers close their ranks and work to develop a unified position
on these crucial issues.

If they don’ t, they will only lose their

markets, in piecemeal fashion, to other institutions.




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