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Remarks of
John P. LaWare
Board of Governors of the Federal Reserve System
The Association of Bank Holding Companies

Washington, D.C.
November 18, 1988

I am pleased to be here today to share with
you my reaction to entering the public sector after spending many
years in private industry.

I hope to show you the kind of

adjustment this transition requires by discussing how my
perspective on some of the major issues currently facing the
banking industry has changed, given my new responsibilities.
As a commercial banker and chairman of your
association, I worked actively to foster a vigorous, strong, and
competitive banking industry.
these objectives.

Of course, I continue to support

However, as a member of the Federal Reserve

Board, I now find myself analyzing banking issues from a public
policy viewpoint which is somewhat different from the perspective
of a private sector C.E.O.

While my experience at the Fed is

limited to only a few months, I hope that the personal
observations I make this morning will stimulate your thinking
about the challenges ahead.

Expanded Banking Powers
Let me begin by discussing the subject of expanded
bank powers since this is viewed as a critical issue by both
regulators and bankers, and has received considerable media
coverage recently.

While Chairman of the Association of Bank

Holding Companies, I was a strong proponent of expanded banking

I argued that expanded powers were desirable because

they would enable banking organizations to diversify and compete
more effectively, tap new sources of income, and better serve the
needs of bank customers.

As a member of the Board, I continue to support
strongly the expansion of banking powers, and for many of the
same reasons.

However, it is obviously critical that any new

powers be managed and conducted in such a way as to avoid
exposing banks to unusual or excessive risks.

Before, when I was

Shawmut's Chairman, I could see to it that adequate controls were
in place to manage any new activities that the company undertook.
Now, while I may be in a stronger position to influence national
policies, I can only urge banks to be prudent.

Strong internal

systems and controls, a high level of staff expertise, and
effective risk management are especially critical if banks are to
conduct new activities, including expanded securities powers,
with reasonable safety.
I also believe that it matters where these activities
are conducted.

Banks, which enjoy access to the Federal safety

net, should be insulated from nonbanking risks, and the safety
net protections should not be extended to nonbank activities.


these points I agree with the Board's long-standing position that
new securities activities, as well as other types of nonbank
activities, should be conducted in holding company subsidiaries,
and that strong and effective fire walls should be established
between banks and their nonbank affiliates.
For its part, the Board continues to urge Congress
to grant banks broader securities powers in order to maintain an
internationally competitive banking system.

Banks must have the

ability to adapt to market and industry changes, develop new
products and services, and take advantage of new technology.


failure of Congress to repeal the Glass-Steagall Act's separation

of commercial and investment banking is a tragedy and inhibits
innovation and development of market solutions to customer needs.
The expanded powers bills should be resubmitted early
next year.

Hopefully, this time they will receive more favorable

treatment, although there will be a lot of competition for room
on the legislative agenda.

I should also note that, outside the

legislative process, some real progress was made to expand bank

The Board successfully defended legal challenges to its

decisions to allow bank holding companies to underwrite and deal
in commercial paper, mortgage-backed securities, consumer
receivable-backed securities, and municipal revenue bonds.


Board also recently approved a bank holding company request to
combine brokerage and investment advisory services.

That kind of

piece-meal reform may be better than no reform, but a
comprehensive legislative approach to new powers would be better.
I cannot emphasize too strongly that the success and
prudence with which banks conduct their present business will
affect their chances to receive new powers.

Public confidence in

the banking system is essential to its stability, and any loss of
confidence will undermine the support needed to achieve broader

As long-standing restraints on banking activities are

dismantled, it is critical that you continue to manage your
affairs in a way that maintains the public's trust.

Changing structure of the Banking Industry
While I was at Shawmut, I guided the company through
its emergence as a "superregional'' banking organization.
Board, I have a materially different role:

At the

Instead of managing a

company, I must now participate in the administration of the Bank
Holding Company Act and help formulate decisions on the
financial, managerial and competitive implications of proposed

At the policy level, I must decide such questions as,

"What level of concentration is best for the banking industry?**
And, "What implications do hostile takeovers have for industry
Changes in the U.S. banking industry are evident to
all of us.

Many of the barriers to interstate expansion have

fallen due to state action, and we are now approaching de facto
nationwide banking.

During the past decade, the number of

separate banking organizations, that is, the number of individual
bank holding companies and banks not affiliated with holding
companies, declined 17 percent.

At the same time the market

share of the 50 largest institutions increased by 8 percent.
This increased concentration primarily reflects the
development of regional compacts and the emergence of multistate
or "superregional" organizations.

Partly because the New York

banks were generally excluded from these compacts, their domestic
market share actually declined.

The large regionals, by

contrast, have grown rapidly — mostly through mergers and

Prior to 1981, no merger had been approved between

banks where both had deposits in excess of $1 billion.
then, at least 87 such banks have combined.


These changes in the

size and geographic coverage of our banks will present both
bankers and regulators with new challenges.

For the most part

these large mergers have been successful, and have improved
efficiency and market share, but geographic reach, market

diversification, and culture blending present new and more
sophisticated management challenges.
Supervisory considerations are especially important in
the case of hostile takeovers.

Such takeovers are new in banking

and raise a variety of policy questions for the Board.


reviewing applications involving hostile takeovers, the Federal
Reserve has avoided taking sides; rather, the Board has focused
on the managerial, financial, regulatory, and competitive factors
it is authorized to take into account under the Bank Holding
Company Act.

We must, however, address any safety and soundness

or other supervisory issues that accompany hostile takeovers.
For one example, we will discourage payment of excessive
dividends as part of takeover defense strategies.


seeking to be the aggressor in hostile takeovers should be
exceptionally well-capitalized to compensate for the potentially
greater risks and expenses they may face.

It is also important

that the time and money spent initiating or defending against
such takeovers not weaken the banks involved or distract
management from its basic operating responsibilities.

While the

Federal Reserve will avoid taking sides in hostile takeovers,
supervisory policies must be developed to discourage actions that
would weaken or undermine the condition of subsidiary banks or
the ability of a holding company to support its banks.
A final aspect of the changing banking structure worth
mentioning is the increasing presence of foreign competition in
U.S. markets.

During the past decade, foreign-controlled

institutions have increased their share of domestic banking
assets from 6 percent to 20 percent.

And in the commercial loan

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market, their share during this period has more than doubled.
They nav, control more than one-half of business lending in New
York; 42 percent in California; and more than 25 percent in
As a banker, I worried about the additional competition
these foreign banks would present — although I never doubted the
ability of U.S. banks to compete successfully given a level
playing field.

As a regulator, 1 can still see the challenge

posed by foreign competition, but I am also obliged to consider
the benefits that U.S. businesses and consumers derive from the
services foreign banks offer.

While our national policies

supporting open markets in the United States have served us well,
I feel strongly that U.S. banking organizations should receive
equal treatment abroad.

I plan to work actively to achieve that

In this connection, the concept of national treatment is

especially important as the European Community moves to
deregulate its markets.

Implementation and Refinements to Risk-Based Capital Guidelines
As financial markets cross national boundaries,
cooperation between banking supervisors of different nations
becomes increasingly important.

In this area, authorities have

made important progress, as indicated by the adoption of
international risk-based capital standards.

These common

standards should strengthen the international banking system and
lessen competitive inequities among banks of different countries.
In addition to these immediate gains, the Basle Capital
Accord also represents an encouraging step toward greater

international cooperation.

The interdependence of financial

markets and the global networks of the world's major banks
require banking authorities to communicate more than ever and to
develop consistent supervisory rules.

I personally believe that

the development of these capital standards sets a good example
for further cooperation.
Although the first phase of the risk-based capital
guidelines will be implemented this coming year, much work
remains to be done.

We still need to develop improved procedures

to measure interest rate and foreign exchange risk and to assess
the adequacy of loan loss reserves.

And, once we gain some

experience with the risk-based standard, we may need to consider
refinements in our framework for matching capital standards to
various levels of risk.

These efforts require further

international negotiations.

However, the crucial role of capital

in providing a cushion enabling financial institutions to absorb
losses from unforeseen events and risks requires that the effort
be made.

Source of strength

In its long campaign to ensure adequate capital ratios
for banks, the Federal Reserve has held that a holding company
should serve as a source of strength to its subsidiary banks.
believe that policy, which I accepted and supported during my
tenure at Shawrout, is very important.

The policy requires a

holding company to use its resources, including its ability to
raise capital, to assist its subsidiary banks during periods of


financial stress.

The Board regards that "source of strength"

policy as a critically important supervisory tool.
The policy also has implications for expanded bank
powers that many bankers do not fully recognize.

Congress has

repeatedly indicated its preference that banking organizations
exercise any new powers through nonbank affiliates of bank
holding companies.

However, if bank holding companies do not

continue to act as sources of strength to their banks, or if they
act as

sources of weakness, it is probable that Congressional

support for expanded powers would wane.

The Board, and I believe

the Congress, will continue to hold that banks play a very
special role in our financial and payments system.

For this

reason, the Federal Reserve will continue to work to encourage
holding companies to serve as sources of managerial and financial
strength to their subsidiary banks under all circumstances in
order to ensure the integrity of the system.

Condition of Savings and Loan Industry
The problems facing the S&L industry are particularly
difficult and complex challenges for public policy-makers.
Clearly, the magnitude of the problem will require a significant
commitment of resources.

Currently, nearly one-third of all

thrifts are insolvent by any standard, and many continue to lose
money at a rapid rate.
There were many developments that contributed to
current conditions in the S&L industry, including interest rate
deregulation, shortsighted asset/liability strategies by
unqualified managements, excessive growth, imprudent lending, and

speculative investment activities.

Regardless of the causes, the

problems in the industry have important implications for the
banking system. In the short run, they affect the interest costs
of banks as weak S&Ls are forced to raise deposit rates to
attract funds.

In the longer run, their problems could affect

public perceptions about the strength and stability of the whole
financial system and raise questions about how that system should
be structured.
That last issue, in turn, raises a number of difficult

Is there a need for reforming deposit insurance?

Should reform include risk-based premiums?

Should we encourage

banks and nonfinancial firms to acquire thrifts both troubled and
healthy as a way to recapitalize the industry?

There is even the

question of whether there is a need for a separate thrift
As we reconsider the nature of our financial system, it
may be appropriate to consider the structure of the regulatory
agencies and the deposit insurance funds.

Without making any

judgments on the outcome, any restructuring should permit the
system to remain innovative and competitive on both a national
and international basis.

U.S. financial institutions must have

sufficient powers to adapt to and, indeed, to be leaders in the
continuing evolution of financial markets.

We must be careful,

though, to ensure that new powers do not further threaten the
strength of the deposit insurance programs or undermine the
integrity of the banking system.

As the lender of last resort,

the Federal Reserve has a clear concern for the strength of the

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banking and financial system and must remain intimately involved
in understanding and addressing its problems as they arise.

Other supervisory Issues
As a former banker and Boston Reserve Bank director, I
am very sensitive to the whole range of issues and practices that
have supervisory implications for banks.

One area that is of

concern to me is the risk associated with asset securitization

It is particularly critical that banks fully

understand these risks at a time when more and more banks are
moving to securitization as a device to regulate balance sheet
size, reduce interest rate risk, and increase servicing income,
while at the same time adjusting capital ratios.
Unfortunately, in many cases the securitized assets are
the highest quality assets in order to be readily acceptable in
the marketplace.

As a result, the overall guality of the

remaining assets may suffer.

If carried to an extreme, this

practice could undermine the validity of the risk-based capital
In addition, some asset sales are structured in such a
manner that the buyers are subject to little credit risk.
Rather, the risk is retained either by the issuer or by a third
party which issues a letter of credit or some other form of
financial support in order to obtain an investment grade credit
rating on the bonds.

If banks retain these risks, or if they

allow the average quality of their assets to decline, they must
recognize that higher levels of capital may be needed to

Clearly, banks roust have policies and procedures

that limit their contingent liabilities under these programs and
systems in place which enable them to monitor the nature and
degree of risk associated with asset securitization activities.
The growing volume of leveraged buyouts being financed
by banks is another activity that begs for attention.


credit decisions are properly for banks to make — not the

However, it is important that lending practices do

not raise the risk profile of banking organizations or weaken the
financial system.

Bank supervisors must be satisfied that banks

have proper safeguards in place to control risks stemming from
LBOs and other lending programs.

And lead banks have a heavy

responsibility not to be a pied piper to other banks to whom they
offer participations.
Real estate is yet another area that bears watching.
In recent years, banks have substantially increased their
exposure to this sector.

At the end of 1987, banks with assets

exceeding $5 billion held 25 percent of their loan portfolios in
real estate loans compared with only 14 percent at year-end 1978,
and their real estate loans exceeded $225 billion.


importantly, the composition of their real estate portfolio has

In the earlier period, higher risk real estate loans

for construction and for domestic, nonfarm, non-residential
purposes represented 32 percent of the average real estate

By the end of 1987, these loans were more than 50

percent of the average real estate portfolio.

Obviously, banks

will be directly affected by any downturn in the real estate

And the boom in equity credit lines adds a new dimension

to real estate exposure, even if only indirectly.

Closing Remarks
In closing, I hope I have shown that there is no
shortage of issues on my plate.

Although I realize I have only

raised — not answered — these questions, I hope that the
thoughts I have shared will be helpful.

They come from a

newly-minted bank regulator with a long background in commercial

I look forward to working with you as we face the

challenges ahead and hope that my experience on your side of the
table will improve my performance on this side.