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Remarks by
John P. LaWare
Member. Board of Governors of the
Federal Reserve System
at the
Ernst & Young Seminar
on
Current Matters in the Financial Services Industries
Washington. D.C.
October 3. 1990

Good afternoon ladies and gentlemen.

It is a privilege for

me to be with you to share with you my views on some of the
issues in banking today.

One of the central phenomena of the 1990’ is that the
s
United States increasingly finds itself a participant in a highly
competitive global economy.

United States political isolation

ended with World War I, and even the possibility of economic
isolation ended with World War II.

Indeed, the United States can

be said to have created the postwar reindustrialization of
Western Europe and Japan.

Today the economy of West Germany is

the keystone of European economic unification and Japan has
written a whole new chapter about industrial and financial
competitiveness.

2

A prominent feature of the new global economy is the
development of global capital markets.
and more swiftly today than ever.

Capital flows more freely

As a result, significant

changes in one of the major economies are soon reflected in
currency values, capital flows, and economic activity in the
others.

This new economic interdependence and the institutional
competitiveness it fosters are just two of the many factors which
suggest it is time to look at the United States financial system
with an eye to updating structure and regulation.

The last

fundamental revamping of the system came in the 1930's with
Glass-Steagall, deposit insurance, and regulation of the
securities markets.
<,

The issues raised in any such broad re-examination of the
financial system are complex and not generally well understood.
Unfortunately, any legislative solution considered will be
influenced by some in Congress who remain emotionally committed
to now discredited historic conclusions.

The most prominent of

these discredited conclusions is the one which blamed securities
activities of the banks for the market crash of 1929 and the
resultant Depression.

The error of that judgment led to the

Glass-Steagall Act and the separation from commercial banking of
the brokerage and underwriting of securities.

But Glass-Steagall

is only one of the issues with which we must deal.

3
American banking today is embattled both at home and abroad.
At home, traditional customer relationships have eroded as
foreign banks and the money markets have offered cheaper access
to working capital for U.S. firms, and U.S. firms faced with
narrower margins and greater financing needs have made decisions
according to price rather than historic relationships.

United States banks find themselves with higher capital
costs and higher funding costs than many of their competitors.
And, domestically, the spectrum of services banks may offer is so
narrow as to preclude the "one stop banking" approach that many
banks aspire to.

I am not going to recite all the numbers you have heard so
many times about how U.S. banks have slipped in terms of their
world position measured by the size of the balance sheet.
Frankly, I don't think that's a very good index.

The Japanese

banks, for example, which have had such dramatic growth in the
last few years, are very poor performers when measured in terms
of return on assets.

They struggle to get to 30 basis points.

And yet! How do we account for the disproportionate growth of
Japanese and European banks in the past 10-12 years?

Are they smarter?
innovative?

I hope not and think not.

Are they more

Well, I think the record would support an argument

that U.S. banks have been very innovative in lending, investment,

4
and cash management techniques.

In fact, U.S. banks have been

leaders in innovation, but with a rather narrower spectrum in
which to apply it.

There is also a case to be made that foreign competitors
operate under a more benign and easily understood burden of
regulation and compliance.

I can only tell you that we at the

Fed wince when, to implement legislation, we must impose an
additional compliance burden on banks.

These burdens are the

result of well-intended legislation often drafted without a full
appreciation of the cost to banks of additional reporting and
monitoring.

It is also fairly obvious to me that the American ethic of
short-term profits and matching short-term strategies puts
American banks and financial institutions at a great
disadvantage.

Foreign competitors take a longer view which is

apparently condoned and rewarded by their capital markets.
Forgoing short-term profits to gain market share by bidding deals
at skinny profit margins is considered smart in many countries.
In the United States such behavior is punished with lower stock
prices and higher interest costs for borrowed capital.

Well, I won't bore you with further description of a
situation of which you are all too well aware.

My purpose today

is to share with you my belief that it is time to eliminate some

5

of these competitive disadvantages.

The willingness of most

Members in Congress to deal with Glass-Steagall reform was
clearly demonstrated by the overwhelming Senate vote for Senator
Proxmire's bill in 1988.

In my opinion, that legislation would

have passed the House in similar fashion if it had ever reached
the floor.
disguise.

But, failure to act then may have been a blessing in
Recently the Congress has become concerned about the

competitive position of our banking system.

I believe that

concern has so far survived the shock and dismay surrounding the
S&L mess and when Congress revisits banking legislation, it will
be on a much broader front than just securities powers.

By the end of this year Treasury will be putting the
finishing touches on its FIRREA-mandated study of deposit
insurance.

That study will contain recommendations for revisions

to the system designed to protect the integrity of the insurance
fund.

Deposit insurance, originally designed to avoid financial

panics and runs on solvent banks, has worked too w e l l .

In the

past the threat of a run motivated bankers to stick to safe and
sound practices.

Experience has shown that deposit insurance has

almost totally eliminated consumer runs.

Encouraged by

security

from runs, some bankers moved into riskier assets, attracted by
higher returns.

Certainly that pattern emerged time and again in

failed S&Ls and in many failed commercial banks as well.

6
The difficult part of deposit insurance reform will be to
strike the right balance.

Any re-introduction of market

discipline by exposing depositors to more risk will have an
offsetting effect of somewhat less stability for the system.

And

perhaps most difficult of all will be any effort to make
significant visible changes in a system which, after 55 years, is
deeply imbedded in our commercial culture.

Deposit insurance is, of course, the centerpiece of the socalled federal safety net mechanism.

The pivotal issue in

consideration of new powers and the future structure of the
banking system will be whether to extend the protection of the
safety net to new financial activities of banks.

Depending on

how that issue is resolved, the future structure of the banking
system will be determined.
v

The safety net is essentially of three parts.
deposit insurance.

-

The first is

The second is emergency liquidity assistance

provided through the discount window at Federal Reserve Banks.
Liquidity assistance was, as you know, an important reason for
creating the Federal Reserve in the first place.

The third

element of the safety net is access to the payments system
through clearing and settlement services of the Fed.

An argument frequently used against spreading the net any
wider, that is to say granting additional powers to federally

7

insured banks, is that the safety net provides a subsidy to
banks.

The assumption is that banks can fund themselves at lower

cost than other financial institutions because the insurance of
deposits and access to emergency liquidity insulate them from
failure.

But whatever advantage is gained in funding cost is at least
partially offset by the opportunity cost of the sterilized
noninterest-bearing reserves member banks must keep at the Fed,
the cost of services provided to depositors by banks acting as
paying and collecting agents, and the substantial cost of
reporting and compliance imposed by regulation.

Unfortunately, we do not have a precise quantitative
analysis of this much discussed subsidy, and the numbers would
vary widely from bank to bank depending on the deposit m ix and
the purchased funds markets which a particular institution might
use.

In any case, access to the window may be the most important

element of the safety net, particularly in this era of widely
fluctuating markets and volatile interest rates.

It may be fair to assume that any proposal to change the
basic structure of deposit insurance would be doomed to an early
political demise.

In my opinion, the public would see any

reduction in coverage as a significant take-away — particularly
against the backdrop of the S&L catastrophe.

I think the public

8

clamor would force Congress to stay with the present coverage.
In that case "reform" is likely to be legislation to protect or
insulate the safety net from poor management decisions or asset
deterioration caused by external factors rather than alteration
of the basic format of insurance coverage.

There are several ways to protect the safety net.

— First, good supervision by the regulatory agencies - a
—
factor that was conspicuously absent in the case of the thrifts.
This would include thorough asset quality examinations at least
once a year and more often in the case of banks with problems.

— Second, higher capital requirements for banks which want
to expand rapidly, enter new businesses ge novo or pursue
aggressive acquisition programs.

Capital, after all, is the best

protection for depositors and other creditors against loss.
Indeed, higher capital requirements may prove to be appropriate
even for banks pursuing "business as usual" strategies.

— Third, statutory authority for supervisors to intervene
in a troubled bank before it becomes brain dead or capital
insolvent.

Why let the patient die before you make a house call?

Preventive medicine can often avoid the need for radical surgery
and save on funeral expenses.

For example, the authority to

demand restoration of satisfactory capital when levels drop below

9
minimums or to replace management and directors when compliance
is not forthcoming.

Strong medicine?

You bet!

But what is the alternative?

Can we afford even the remote possibility of another calamity?

I

think not!

I am persuaded that only if it is satisfied that we can
avoid an S&L kind of mess will Congress move in the direction of
further deregulation and structural reform.

And, I believe that

such deregulation and restructuring will still be done with
protection of the safety net in mind.

In that case, Congress is

likely to turn to the financial services holding company as a
preferred structural solution.

The holding company concept is

seductive in that it permits the isolation of the insured
deposit-taking bank from risks inherent in any new powers and
facilitates functional regulation of new businesses.

One urgent question is:

Can U.S. financial institutions

forced into a holding company structure, with all of the
attendant inefficiencies of funding and management, compete
effectively with European banks which will probably continue to
develop as so-called universal banks.

Also, Japanese banks are

likely to be given securities, brokerage, and trust powers in the
near future as part of a revamping of their system currently
being studied by the Bank of Japan and the Ministry of Finance.

10

But, it is not yet clear whether they will adopt a universal bank
model to assure competitiveness in Europe or a holding company
model similar to ours.

In the United States, competitiveness arguments taken alone
favor the universal bank, but defense of our unique federal
safety net will clearly favor the financial services holding
company.

One compromise might be to permit the formation of u n ­

insured bank subsidiaries of holding companies.

These un-insured

banks could operate as universal banks either domestically or
internationally with independent funding or funding from the
parent, and regulation could be minimal.

Capital in sufficient

quantity to be competitive might be difficult to raise.

On the

other hand, the broader opportunity available to such an entity
might make the investment very attractive.

Another compromise which might be considered would allow new
powers — securities, for example — to be carried on in a
subsidiary of the bank but with the stipulation that the sub be
capitalized as though it were free-standing and its capital could
not be counted with the parent bank's capital in calculating
capital adequacy of the bank for regulatory purposes.

This

approach would address some of the competitive weaknesses of the
holding company alternative and at the same time substantially
insulate the insured institution from any additional risks
involved in the subsidiary's operation.

Further insulation could

11

be achieved by limiting intercompany transactions between the
bank and its subsidiary to those sanctioned under Sections 23A
and 23B of the Federal Reserve Act.

An issue closely related to structure is the jssue of
commerce and banking.

Whether Congress adopts the holding

company structure or the universal bank alternative or some other
structure, the question of ownership will arise.

The United

States has long held that commerce and banking should be
separate; that commercial enterprises should not own and operate
banks and banks should not substantially own or manage commercial
entities.

But should a steel company or an automobile

manufacturer be allowed to own a bank or financial services
holding company?

Is there in that relationship an inherent

threat to the country or the financial system?

By the same

token, would it be wrong in some moral or economic sense for a
large bank or bank holding company to also own a life insurance
company, an investment banking company, a computer company and a
real estate development company as long as the insured deposittaking entity was insulated from whatever additional risks might
exist in those other businesses?

This issue of commerce and banking will also arise because
of the recent history of the thrift industry where the ownership
of thrift institutions by insurance companies and industrial and
commercial enterprises is well established.

For example, Ford

12

owns the nation's third largest thrift.

Thrifts and banks are

operationally more like each other every day, although the
capital sections of their balance sheets may be somewhat
different.

I should hasten to add at this point that we can find no
correlation between nonfinancial ownership of S&Ls and failure
rates.

Why then do we accept the relationship for thrifts and

not for banks?

It is high time we re-examined this ancient

issue; and all of us, whichever side we are on, should be vocal
participants in the debate.

It may well be that pragmatic considerations will override
philosophy if we find that ownership by a commercial enterprise
would significantly improve access of banks to capital.
should not rush this one.

But, we

Congress needs to be sure it

understands all of the implications before it acts.

CRA performance of banks has become an increasingly
contentious factor in the approval of applications made by banks
and holding companies, adding measurably to the time to process
applications and to the cost of compliance.

Recent amendments to

the Home Mortgage Disclosure Act impose a data collection,
collation, and publication burden on banks and regulators which
will result in the generation annually of about one million seven

13

hundred thousand pages of charts, tables, and statistics.

I

mention this just to illustrate the magnitude of the burden.

In the context of these remarks this afternoon, I would
suggest that any comprehensive reform of the financial system
might well include a real look at the possibility of simplifying
and lightening the compliance and reporting burden on financial
institutions.

Simplification alone, without changing regulatory

reguirements, could save the industry and the government
substantial costs.

Turning to another issue, interstate banking on a nationwide
basis is rushing at us, and whatever our individual feelings are
about that development, the trend is not going to be reversed.
By the mid-1990's we will have de facto nationwide interstate
banking without the £le jure blessing of Congress or repeal of the
McFadden Act.

But, absent clarifying federal legislation, we utay

be creating a whole army of severely handicapped institutions in
the form of multi-state bank holding companies.

Consider for a moment some of the nightmare problems the
manager of a bank holding company would face if he or she had
banks in ten different states.

First, an interstate operation is forced into a holding
company or multi-holding company organizational structure because

14
the McFadden Act effectively precludes branching across state
lines.

— That means ten different management teams; at least ten
boards of directors; and compliance with applicable state banking
regulations which may dictate ten different ways to handle and
price the same transaction.

— To the extent that there are state-chartered banks in
each state, there will be ten different examination standards to
be complied with, and ten different examinations to be endured.

— Advertising, marketing, pricing, etc. might be subject to
ten different standards or sets of regulations and limitations.

— And, if the operation is in more than one Federal Reserve
District, where is that friendly, helpful, fatherly central
banker?

Is he or she in Boston, New York, Atlanta, Dallas, or

San Francisco?

And

— Given those constraints, can the multi-state holding
company really achieve the operating efficiencies that were
promised to analysts and investors as justification for the high
price paid to put the company together in the first place.

15

I predict that whether bankers are federalists or statesrighters they will all be calling for reform to achieve more
efficient interstate operations by the mid-1990's.

One approach

which will probably be proposed will be legislation to create a
whole new class of federally chartered financial institutions *
—
multi-state banks or holding companies which would be federally
regulated, overriding state authority entirely.
In order to deal with redundancy, repeal of McFadden will be
considered to permit nationwide branching in order to make
operations more efficient.

The states rights debate around that

issue will be a hot one.

Finally, an issue which has not had enough serious attention
is the structure of federal regulation.

We have the Office of

Thrift Supervision, the Federal Deposit Insurance Corporation,
the Office of the Comptroller of the Currency, the National
Credit Union Administration, and the Federal Reserve — all
operating in addition to banking regulators in each state.

No

matter how diligently the agencies strive through mechanisms like
the Exam Council to coordinate policies and procedures, there are
inevitable differences and inconsistencies which create confusion
and error on the part of regulated companies.

It is particularly

troublesome in multi-bank holding companies with a mixture of
national, state member, and state nonmember banks.

16

The Fed regulates bank holding companies and state-chartered
member banks.

The OCC, national banks; the FDIC, state-chartered

nonmember banks; the OTS, federally chartered thrift
institutions; and the NCUA, credit unions.

Simple logic tells you that there must be a better way, but
I would hesitate to speculate in this area.

There may be too

many turf considerations ever to reach a sensible solution.

But

a system where there was one insurer for all deposit takers, one
regulator for federally chartered institutions, and one for
state-chartered federally insured institutions sounds simpler and
more logical to me.

I think all of these issues will be considered by the
Congress in the next 12 to 18 months.

The debate and ensuing

legislation may be as important to the future of banking and of
the country as the National Banking Act of 1863, the Federal
Reserve Act of 1913, and the several pieces of banking
legislation in the mid-1930's.

It will be a big debate.

Let us

not hesitate to participate, keeping in mind that what is right
for the United States as a whole should override any and all
parochial interests which various groups might have.

These issues are important to the banking system and to the
future of the United States.

The efficient operation of domestic

financial markets is vital to the health of the economy.

And a

17
strong , fully competitive banking system is vital to U.S.
participation in world markets.

We need to adapt our system to

the new realities of a global economy, and we need to do it now.

Thank you for inviting me to be with you.
delighted to try to answer your questions.

I would be