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For release on delivery 11:00 a.m. EST April 10, 1991 Testimony by John P . LaWare Member, Board of Governors of the Federal Reserve System before the Subcommittee on Consumer Affairs and Coinage of the Committee on Banking, Finance, and Urban Affairs U.S. House of Representatives April 10, 1991 - 1 - I am pleased to appear before this subcommittee on behalf of the Federal Reserve Board to discuss the potential impact on consumers of H.R. 1505, the Treasury's proposed Financial Institutions Safety and Consumer Choice Act of 1991. While I will be limiting my comments to issues most directly related to consumer benefits and risks, the subcommittee should know that a majority of the Board strongly supports the thrust of this bill. We believe that H.R. 1505 constructively addresses evolving difficulties with the safety net, and offers important and constructive measures to strengthen bank supervision, and to modify the operating framework that limits the ability of U.S. banks to compete effectively on both cost and service grounds. But this subcommittee in particular should know that the Board's support for the bill is not keyed solely to any benefits that might accrue to banks. The objective of public policy is not to enhance the profits of one group of businesses relative to another. The Board generally supports this bill because it would result in better and cheaper services to consumers and other users of financial services, while at the same time it restricts the further extension of the federal safety ne t . - 2 - Additional Consumer Services and Protections For example, the bill would permit financial services holding companies with exceptionally wellcapitalized bank subsidiaries to provide, through separately capitalized affiliates, money market mutual funds, other securities investments, and insurance services. Like H.R. 192, the bill introduced by Congressman Barnard, H.R. 1505 recognizes that allowing banking organizations to provide a full range of financial services will not only help to improve the condition of our banks, but also improve service to the consumer. The Board believes that consumers would benefit from the convenience and competition that would result from having a wider range of financial services products easily accessible from banking organizations. Banking organizations would only be successful in marketing new financial products if they were able to offer greater convenience and better rates and prices to the public. The Administration's proposal would regulate and supervise the expanded activities through functional regulation that would provide consumers the same protection they enjoy when dealing with an independent provider of financial services. For example, consumers buying securities from bank affiliates would be protected by the same regulatory and statutory standards and the same regulator — the SEC — as when the securities are purchased from independent broker/dealers. Additional protections for - 3 - consumers already exist in laws prohibiting most tie-in sales that require consumers to buy another product in order to obtain access to bank credit or other essential bank services. Even if there were no statutory constraints, the large number of competing banks and other providers of financial products would severely limit the ability of banks successfully to require any tie-ins in most markets. H.R. 1505 would permit the sale on bank premises of mutual fund shares, certain investment securities, and insurance products, with appropriate disclosures designed to inform the consumer that these products are not covered by the federal safety net. Such a delivery system would allow maximum synergy between the bank and its affiliates, providing benefit and convenience to both the buyer and seller. Whether purchased on bank premises or elsewhere, the bill would require that customers purchasing nondeposit products from banks and bank affiliates be alerted to the lack of federal insurance by signing documents indicating in plain words that the products were not federally insured. Consumer confusion about such claims has been a continuing problem, and the bill addresses it directly. Interstate Branching The Treasury's proposed bill would repeal the Douglas Amendment to the Bank Holding Company Act, to permit banking companies to operate subsidiary banks in all states, and would amend the McFadden Act, to permit banks to operate - 4 - branches of their banks in all states. Branching within a state after the first interstate branch is opened would be subject to the same state restrictions placed on locally headquartered banks. A majority of the Board strongly supports the proposal to permit full interstate banking by any vehicle that a banking organization chooses. We are encouraged to see that this proposal already has support within the full committee: Congressman Wylie's bill, H.R. 15, Congressman Schumer's H.R. 624, and Congressman Neal's H.R. 1480, all would also allow interstate branching. Only Hawaii and Montana have not yet passed legislation to permit interstate banking in some form, reciprocal, regional, or without limit. Virtually all, however, require the interstate presence to be in the form of separate subsidiary banks of the parent holding company, each with its own board, management organization, and capital. A majority of the Board believes that cost-savings could occur in some banking organizations just from the conversion of existing bank subsidiaries to branches of the lead bank. Through competition, such cost reduction would be reflected in more and lower-priced consumer services. The lower cost of branching across state lines would also induce more banks to engage in interstate banking, further enhancing competition and consumer choice. - 5 - Over the years, there has been opposition by some consumer and other groups to interstate branching. It is important that their concerns be discussed. The first concern is that interstate branching would result in undue concentration — loan rates and lower deposit rates — and ultimately higher as large out-of-state banks drive smaller in-state banks out of business. In state market evidence simply does not support that contention. All of the evidence -- we know of no studies reaching the opposite conclusion -- is that small banks generally survive out-of-market bank entry by large banks and are subsequently more profitable than the entrant. Similar evidence indicates that, whether de novo or by acquisition, new large bank entrants to local markets are able to expand market share by only modest amounts, if at all. In the 1970s, for example, when state-wide branching was authorized in New York State, a number of large New York City banks sought an upstate presence by acquiring small banks in these markets. By 1983, the acquired banks had gained on average less than one percentage point in market share, with the largest gain less than three percentage points. The acquired banks or branches continue to have small market shares or they have been sold to local banks, as the New York City banks have exited the market. In addition to their difficulties in winning customers away from existing banks, entrants by acquisition - 6 - often are soon confronted with competition from a de novo bank organized by local citizens, at times led by the former managers of the bank acquired. The potential for entry — both de novo and by acquisitions by other banks outside the market — plus evidence of continued small bank success, substantially lessens the potential that consumer harm will result from interstate branching. It is well to remember that in the decade just passed, while about 5,300 banks were absorbed by merger, about 2,700 new banks were chartered, and while 6,700 branches were closed, 16,500 new ones were opened. Local banking markets in the United States are incredibly dynamic and sensitive to consumer demand, and interstate banking seems likely to make it only more so. Another concern of some is that new entrants will vacuum up local deposits and channel them to out-of-market loans, or that managers brought into local markets will be insensitive to, or have no authority to adjust to, local demands. However, it is important to recall that a bank must fulfill its Community Reinvestment Act responsibilities in all the markets in which it operates. Moreover, the ease of entry, just discussed, should soften such concerns that out-of-market entrants will ignore local customers. If a local branch does not meet the demands of the community, it will not succeed and it will attract a rival. who owns a bank or branch — Regardless of local or out-of-market capital - 7 - -- market realities drive the bank to seek local loans both to attract and maintain deposits and to earn a profit. Finally, large banks have higher loan-to-deposit ratios than small banks, an important factor for evaluating the benefit of interstate branching. This could imply that large banks entering new markets would make both more in market loans and out-of-market loans. Many assume that most of the loans would, in fact, be made outside the community. However, as I noted, banks must both meet their CRA requirements and service their customers in order to remain competitive in the market. It should also be kept in mind that small banks also export funds: they are relatively large lenders to other banks through the federal funds and correspondent deposit markets, and purchase relatively more Treasury and out-of-market state and local bonds than large banks. In sum, the evidence suggests that interstate banking will not lead to the displacement of community banks by large regional or money market rivals, nor will it in the aggregate be a substantial source of additional earnings to out-of-market banks seeking new profits. What interstate banking promises is wider consumer choices at better prices, and, for our banking system, increased competitive efficiency, the elimination of unnecessary costs associated with the delivery of banking services, and risk reduction through diversification. By the record, most community - 8 - banks are already providing services to their customers so efficiently that they have little to fear from out-of-market rivals. Those that are not should worry because interstate banking will — and should — mean their displacement by a more efficient competitor. CRA Issues If large regional, or even national, branch networks develop, the Board and the other regulators will have to assure themselves that their CRA examination processes continue to work within the new structure. Obviously, some adjustments will be necessary because the present geographic focus of CRA examination reports and ratings will have to be adapted to banks with broader geographical scope. However, it is worth noting that we already review the performance of banks with large intrastate branching systems by examining a sample of branches. We believe this procedure would be appropriate for larger systems as well. Under the Treasury proposal, nothing in the process of bank acquisitions or branching would be different for organizations owning banks whose capital is not significantly above the international capital standards. Such entities would continue to be subject to the current full application process for acquisition of banks and the addition of branches, including review of public criticism of their CRA performance. And, a bank — regardless of its - capital — 9 - would be subject to a full application process, including CRA review, when it opened its initial branch in any new state. Holding companies whose subsidiary banks meet unusually high capital standards, could under H.R. 1505, acquire additional banks, after 1994 in any state, with only a 45-day prior notice under a scaled back or expedited review process. These high-capital banks could also branch within any state, subsequent to opening their first branch in that state, without any prior notice, although, of course, they would be subject to state regulations on branching. Some community groups may be concerned that these expedited procedures would not permit them to raise CRA protests at all for some branches, and that there would be inadequate time for them to do so for some bank acquisitions. We believe, however, that procedures now in use and the bill itself should soften these concerns. For example, a bank with unusually high capital must still have at least a satisfactory CRA rating to open an in-state branch without notice or review. For the acquisition of banks by holding companies with well capitalized bank subsidiaries, the benefits of the acquisition to the local community, including analysis of the bank's performance record under the Community Reinvestment Act, must be explicitly considered by the regulators in the convenience and needs test that would - 10 - still accompany the expedited review during the 45-day prior notice interval. Even with this shortened period, interested parties would be provided an opportunity to comment. Importantly, the agencies have taken a more aggressive role in the CRA examination process to encourage members of the public to submit comments on the bank's CRA performance to the bank at any time. These comments are then reviewed by the examiners as part of the examination process and reflected in the CRA rating given to the bank. Thus, files and ratings, as well as investigations of complaints, should now be more up-todate and therefore more consistent with expedited review. This current procedure should be particularly helpful to community groups in having their concerns investigated. There is always a tension between the banks' desires to have the government review their expansion plans expeditiously and community interests that CRA performance be weighed in the process. The more rapid review in H.R. 1505 is designed to make the maintenance of high capital more attractive, and this goal must be balanced against the greater time pressure put on potential protestants. We believe that public disclosure of CRA ratings and public comments received on a continuing basis will tend to offset, in part, this timing adjustment for community groups. - 11 - Deposit Insurance Reform There is concern about the Administration's proposals (1) to limit deposit insurance to $100,000 per person per institution (plus another $100,000 per person per institution for retirement funds), and (2) to study the feasibility of limiting insurance to one $100,000 coverage per person across all institutions. The Board too has some doubts about the administrative cost, potential intrusiveness, and feasibility of the latter proposal, but prefers to await the results of the proposed study before taking a position. But, the majority of the Board supports the $100,000 per person per institution limit for each of two classes of accounts and believes it is not an issue that should affect the average consumer. Based on a 1989 survey, sponsored by the Federal Reserve and several other agencies, no more than 3-1/2 percent of all households have deposits of more than $100,000 at any one insured depository institution. However, the Treasury bill specifically permits each individual to benefit from $100,000 of deposit insurance at each institution. And almost 60 percent of the households with aggregate deposits in excess of $100,000 at one institution are composed of a husband and wife whose combined deposits could be fully insured at their depository institution by splitting their deposits into two accounts at that institution, each of no more than $100,000. This - calculation — 12 - which reduces the proportion of all households with uninsured balances under the Treasury bill from 3-1/2 to 1-1/2 percent -- even ignores the additional insurance each spouse could obtain from retirement accounts under the Administration's proposal. Moreover, the median household net worth for the 1-1/2 percent of households whose deposits at one institution would exceed the $100,000 insurance limit for each spouse is almost $2 million, suggesting little need for the protection of a safety net. The comparable net worth of the households holding fully insured deposits is under $60,000. Extending insurance to all consumer deposits to protect the 1-1/2 percent of all households that would have any uninsured balance under the proposal -- and to uninsured deposits of small- and medium-size businesses and nonprofit institutions — is, of course, possible, but would, we believe, be highly undesirable without significant and substantial increases in the minimum capital ratios of banks. Such an approach would attract even more large- balance accounts, further increase the moral hazard risk induced in the banking system, and expand further the potential for taxpayer liability, raising consumer costs in the process. Indeed, the higher bank insurance premiums already levied to avoid taxpayer costs for the current bank insurance problems are reducina bank profits and probably the yield available to consumers on insured-bank deposits, - 13 - as well as raising their bank loan rates. Increased costs are usually passed through, at least in part, to the customers of any business. Smaller banks, consumer groups, and others have pointed out that, despite these arguments, risk-averse depositors with balances in excess of deposit insurance limits may be inclined to shift their funds out of smaller banks. Such shifts could be a significant share of total deposits in some communities, leaving insufficient funds to meet local credit demands. Although transfers might be to other small banks in the community to keep deposits at each institution within insurance limits, the concern is that the shifts will be to market instruments — like Treasury securities or money market mutual funds — or to larger out- of-community banks where the deposits in excess of insurance limits might still be protected by the too-large-to-fail doctrine. The local credit implications of these arguments are difficult to evaluate. As I noted, the shifts may be in-market with large balances broken into multiple accounts at several local banks, each of less than $100,000. In addition, community banks tend to be the best capitalized, least risky entities, and as a result are perhaps less subject to deposit withdrawals. Indeed, our review of the data did not suggest any special deposit weakness at smaller banks during the period of publicity about bank soundness. - 14 - Nonetheless, while any local credit market impacts are probably modest, one cannot rule out entirely that deposit insurance limits, as called for by H.R. 1505, could cause some balances to shift, possibly to larger entities or out of the banking system. I will return to the longer-term resolution of these concerns in a moment. The Treasury proposal does call for an exception to the least-cost resolution of a failing bank, which usually implies fully paying depositors only up to the insurance limit. If the Treasury and the Federal Reserve agree that the failure of an insured entity could have systemic risk implications — that is, that its failure with losses to depositors could cause failures to occur at a large number of other entities, or could cause disruption in financial markets generally — the government could then provide special assistance to protect all of its depositors and to maintain the existence of the bank. While this provision of the bill could be used to offset potential regional systemic problems from the possible failure of a number of small or medium-size banks, it is clear that this provision focuses on larger institutions. No one is comfortable with special treatment for larger banks, and the Treasury proposal does substantially tighten up existing practice. On its face, too-large-too- fail is unfair; it tends to induce moral hazard risks at large banks; it may, in certain circumstances, cause a shift - 15 - of large account balances from small to large banks. Nonetheless, there are circumstances in which there is a need to support large banks in order to avoid disruption to the economy as a whole. It is for this reason that we reluctantly support this provision and hope that it will have to be used only on very rare occasions. Indeed, H.R. 1505 envisions circumstances in which large banks could fail without undue disruption to financial markets and the economy. Thus, it would be a mistake for the depositors of large banks to assume that all their deposits were protected at all times. Moreover, the Board believes that other provisions of H.R. 1505 would address both the perceived risk of uninsured depositors at small banks and the future necessity to implement the too-big-to-fail doctrine. The best protection for depositors and the insurance fund is to have strong and safe banks. The Board believes the bill's emphasis on capital and prompt corrective action policies — as well as the profit opportunities from expanded activities and the greater diversification of risks through interstate branching — will reduce risk in the banking system and soon make the practical implication of deposit insurance limits a much less important consumer issue. Stronger banks also mean a safer Bank Insurance Fund and less need for potential taxpayer assistance. Prompt corrective action, expanded activities, and interstate branching are consumer benefits - — 16 - directly through more convenient choice and indirectly through a stronger system. Other Issues Mr. Chairman, your invitation to testify also requested Board comment on the adequacy of firewalls and commercial ownership of banks. I shall address these issues briefly . H.R. 1505 imposes no cross-marketing firewalls among affiliates of holding companies in order to permit a high degree of synergy among the components of the organization. As I have previously noted, it does require disclosure of the insurance status of deposits and other financial products in order to inform consumers. Moreover, it provides the agencies with the authority to limit possible conflicts of interest in order to constrain the risk to the safety net. H.R. 1505 also provides authority for the supervisors to take actions to limit risks that affiliates may create for the insured bank and imposes rules that limit the transfer of funds from the bank to its affiliates. Some tightening of these latter proposals, including some additional specificity regarding the types of transactions the agency may address, would be desirable, but generally their thrust is consistent with the Board's preferences. The bill would permit the purchase of financial services holding companies — with their bank subsidiaries - — 17 - by commercial and industrial enterprises. Before the Congress takes what will amount to an irreversible step in this area, the Board believes that the issue of commerce and banking should be carefully studied and should await the absorption of the large number of other reforms contained in the bill. I have not commented on all provisions of the Treasury bill or the other reform proposals that may have consumer implications. Nor have I addressed the specific consumer provisions in H.R. 6, introduced by Chairman Gonzalez. The Board will be happy to provide its views and assistance on these issues if requested at some later time. Conclusion In summary, the Administration's proposals would widen and strengthen the ability of U.S. banks to serve the public more effectively, which is why the Board supports their thrust. The possible adjustments to the CRA process that may be necessary for nationwide branch banks and for accelerated acquisitions by the strongest institutions seem to the Board to be manageable.
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