View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

12:0Q P.M. CST (1 P.M. EST)
November 9, 1994

Remarks by
John P. LaWare
Member, Board of Governors
of the Federal Reserve System
at the
"What Is The Future of Banking?" Conference
co-sponsored by
Houston Baptist University
and the
Houston Branch of the Federal Reserve Bank of Dallas
Houston, Texas
November 9, 1994

Good afternoon and thank you for inviting me to be in Texas
today and to talk about the banking industry.

Being in Texas is

always special for me, whether in Dallas, Houston, Fort Worth,
San Antonio, or Bandara.

I mention Bandara because when I was in

O.C.S. at Lackland Air Force Base in 1952 we used to go to a dude
ranch in Bandara on weekends when we could get a pass.
a special place for me because of my happy

Texas is

memories of all of my

visits and sojourns, but also because of the people who have been
very kind to me:

Lewis Bond in Forth Worth, Bob McTeer,

president of the Dallas Fed, Bob Smith who runs the Fed office
here in Houston, Stewart Morris and his associates, and most
particularly my old friend and former partner in bank regulation,
Bob Clarke.

Bob's distinguished service to the nation as

Comptroller of the Currency epitomizes the best traditions of
public service.

It was a privilege to serve with him in

It is far less a privilege to follow him on any public

He is a gifted public speaker, bound to be well

informed on any subject to which he speaks, and he has that
additional advantage of an endless inventory of wonderful stories
with which to provide humorous leavening to any speech.

Bob, on

that score I won't even try to compete.
We are discussing today the future of banking in the United

In a sense that is too narrow a topic, because the

United States economy is an integral part of a global economy and
financial markets are increasingly globalized and independent of
time zones.

At any time of day or night Houston time, a

sophisticated financial market is open and available somewhere on

the globe, capable of handling almost any kind of transaction,
and communications technology permits instant contact and instant

But it is also fair to say that innovation in

financial product design and the speed with which transactions
can be completed also tends to escalate risk.

Any kind of a

meltdown in the settlement system for international transactions
could create systemic problems and risk a broad financial crisis.
Banks which are operating in these sophisticated markets
directly must learn to manage diverse elements of risk on a
daily, even hourly, basis and have in place the policies, systems
and controls to limit the effects of external events to an
aggregate level which capital and reserves can absorb without
institutional failure.
In addition, those bankers who participate indirectly must
understand every instrument they put on the balance sheet and all
the risks inherent in it.

They, too, should think about worst-

case scenarios and what they might mean to the viability of their
But, I will try now to put all of these admonitions and
alarms in the context of the vision I have for banking over the
next several years.

It is not a particularly rosy vision,

because the recent and current trends in legislation and
regulation tend to narrow increasingly the spectrum of
opportunity for banks.
Having said that, I hasten to add that commercial banks
today are in fine shape.

They weathered the worst storm and

absorbed the greatest losses during the period 1989-1992 since
the catastrophic period 1929 to 193 5.


Heroic measures to improve asset quality; deliberate and
radical reapportionment of balance sheets; and, with the help of
the capital markets, the addition of huge amounts of fresh equity
and debt capital have remade the asset and liability structure of
the industry.

At the same time, like other industries, banking

has taken drastic measures to improve productivity through
broader use of advanced technology and has enhanced earnings by
cutting costs.

Downsizing branch systems to eliminate operations

which are not cost effective is a standard approach.
profitable businesses have been sold or abandoned.


mergers like that of Chemical and Manufacturers in New York seek
to achieve real economies of scale through back-office

They also enable the combined institutions to

close redundant branches and reduce staff without losing

All of this has resulted in a vastly improved

earnings performance.
In the 1960s, large banks which could earn a return on
assets of only 70 basis points were the darlings of the analysts
and the role models for others.

For the first and second

quarters of 1994 the entire industry —
commercial banks —

that is, all insured

had a return on assets of 117 basis points

and many banks large and small had returns even better than that.
At the same time, asset quality has improved dramatically
and problem loans are down to $42 billion, their lowest level
since 1985.
At the same time, recent accounting mandates from the
Financial Accounting Standards Board in the form of FAS 115 make
it appropriate to mention that investment portfolio positions

have weakened.

In the fourth quarter of 1993, banks had

unrealized gains of $11.5 billion.

Changes in interest rates —

for which I admit the Fed bears some responsibility —
altered that figure materially.


Insured banks now show

unrealized losses in portfolio of $13.3 billion, a swing of
almost $25 billion in market value.

Of that $13.5 billion of

unrealized loss at the end of the second quarter, $5.9 billion
was in the "available for sale" category prescribed by FAS 115.
For reporting purposes after taxes, the effect on bank equity
accounts would be about $4 billion.
FAS 115 will certainly add volatility to bank balance sheets
for reporting purposes.

It remains to be seen whether attempts

to avoid or neutralize that volatility by bankers will result in
irrational portfolio management such as marking everything "to be
held to maturity" or conversely marking everything "available for
sale" but limiting maturities to 12 to 18 months.

Somehow, for

an industry heavily dependent on the confidence factor to obtain
proper funding, it seems counterintuitive to increase volatility
in financial reports when that volatility is wholly a result of
accounting practice rather than real events.
In the first half of this year, commercial and industrial
loans are up nearly $26 billion or 4.8 percent and loans to
individuals increased $19.5 billion, with nearly $17 billion of
that in the second quarter.
Equity capital increased $8 billion or 2.8 percent from
year-end 1993.

Equity for the industry stood at 7.84 percent of

total assets at the end of the second quarter and total riskbased capital at about 13.2 percent.


Four banks failed in the first half with aggregate total
assets of $230 million.

At June 30th, there were 338 problem

banks with $42 billion in assets, down from 1,016 banks at yearend 1991 with assets of $528 billion.
That is truly a remarkable recovery in a very short period
of time and has undoubtedly contributed to the vibrant current
rate of growth in the U.S. economy.
But what does the future hold for banking?

There are no

current indications that another asset quality crisis is

The capital markets and rating agencies have a

generally favorable attitude toward the industry.

The increasing

access of banks to secondary markets by securitizing assets has
enabled bankers to substantially lay off risks related to
carrying longer term fixed-rate loans.

And, this development has

given banks greater flexibility in managing balance-sheet items
against risk-based capital standards, while at the same time
increasing fee income by continuing to service the collection of
interest and principal on those loans.
Banks have proven over and over that they can adapt to
changing times and conditions.

But there is a limit, and I

believe we are fast approaching it.

The Financial Institutions

Reform, Recovery and Enforcement Act (FIRREA) and the Federal
Deposit Insurance Corporation Improvement Act (FDICIA) have
enormously increased the burden of federal regulation and

They are the products of over-reaction by Congress,

believing that more and more regulation and restriction on the
things which banks can do and how they do them will keep banks
from failing and protect the insurance funds.

Indeed, prompt


corrective action is a valuable tool which enables supervisors to
step in early in a deteriorating situation with the authority to
mandate steps to avoid failure.

But much of the rest of this

recent legislation will just result in expanding and complicating
bank reporting and compliance obligations with little potential
enhancement of safety and soundness.
Add to that recent efforts to expand the use of bank capital
and deposits to engineer social programs.

This is particularly

disturbing in the context of bank competitiveness with other
financial institutions.

In fact, the current proposals to revise

the enforcement of CRA constitute social engineering by
administrative fiat.

That seems to me to be highly questionable

from a public policy point of view.
The brouhaha about derivatives is only the most recent
example of this dangerous trend toward more and more regulation.
The prophets of doom who are calling for legislation act as
though derivatives were new phenomena invented by some evil
banker hellbent to take advantage of naive investors.

In fact,

many of these critics wouldn't know a derivative if they saw one.
Exhaustive disclosure and well-informed supervision can
insure prudent use of derivatives, even the super-sophisticated
ones of recent vintage.

But legislation to regulate and restrict

the use of derivatives, undertaken unilaterally here in the
United States, could well result in our market for these
important financial instruments being exported to London,
Frankfurt, Tokyo, Hong Kong or Singapore.

This would be a

significant lessening of the importance of U.S. financial markets


which are perhaps our most important competitive advantage in the
global economy.
Returning to our basic question:
like in the year 2000?

What will banking look

Well, here are some guesses.

And please

keep in mind that the thoughts I have already shared with you and
those I am about to enunciate are mine alone and do not
necessarily represent the position of the Federal Reserve or the
views of my colleagues on the Board.
First —


I believe that the balance of this

decade will see a continuation of the strong trend toward

This will be driven by the desire of many banks

to increase their geographic reach and diversification.

But it

will also be driven by the need for greater efficiency.


market mergers offer immediate opportunities to eliminate
inefficient branches and reduce staff.

This can be just as true

for two $100 million banks in the same market as for two $50
billion banks like Chemical and Manufacturers.
Second —

Interstate branching will dramatically change the

way some banking organizations look, but I doubt very much that
it will significantly change the basic structure of banking in
the United States.

I think we will always have seven or eight

thousand commercial banks.

Perhaps fifteen or twenty of them

will aspire to an essentially national network of banks and

But there will also be large super-regional banks

which choose to remain in a regional posture because a franchise
with a more homogeneous market may be easier to manage.


regionals or sub-regionals will operate in two or three states,


usually contiguous.

And the great majority of banks will be

You know Tip O'Neill once said "all politics is local."
Well, I contend that all banking is local.

Some banks will try

to be local, using branches and encouraging branch management to
be actively engaged in the community.

That may be local enough

for some customers, but there will always be those who want to
deal with folks they know —

bank managers and directors whom

they know and who clearly are identified with what is good for
the community.

There are still a lot of people who like to be

able to talk to the president of the bank and get quick answers
based as much on the character of the customer as on his balance

For those reasons, community banking will continue to

thrive even in the age of full interstate


If I were

active in bank management today, I would love to run a bank in a
small town that was in competition with the branch of a moneymarket bank headquartered 1,000 miles away.

I'd beat their socks

Third —

Banks will continue to see their share of market

for commercial and industrial loans erode.

Investment bankers,

finance companies and insurance companies have taken dead aim at
this market.

They have the advantage of less regulation of that

business than banks have.

That translates into lower costs and

more leeway to be creative in the kinds of financing and other
services they can provide.

At the other end of the market

spectrum, banks are going to have ever-tougher competition for
consumers' patronage.

Mutual funds offer better returns for

deposit-like funds with enough of a differential to override


concerns about deposit insurance.

In the credit-card field, an

area where banks once had a near lock, AT&T, General Motors and
GE, to name a few, will make big inroads over time on this highly
profitable business.

Banks won't be eliminated as competitors,

but competition will be tougher and margins thinner.
Fourth —

Here I

return to optimism:

I believe that

Members of Congress who recognize the importance of banks to the
economic health of the nation will begin to realize that a more
integrated financial system with comprehensive supervision but
much less restrictive formal regulation is desirable if we are to
maintain our leadership in global financial markets and provide
support for a burgeoning economy at home.

Before the end of the

decade I expect Congress will consider in detail, and enact,
broad reform measures to permit the integration under common
ownership of commercial banks, investment banks and insurance

This has been a recognized format in Europe for some

time and is now permitted in Canada.
that direction.

Japan is also moving in

A key issue in the debate that will surround

that revolution will be whether or not to maintain the present
legal barrier between commerce and banking, thereby continuing to
prohibit commercial enterprises from owning banks.

But perhaps

that is a topic for another conference.
Thank you for listening to my concerns and my interpretation
of what images appear in my crystal ball.
If there is time, I will be delighted to answer questions or
engage in debate.