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THINGS TO COME: FINANCIAL INTEGRATION Remarks bv John P. LaWare to the National Economists Club Washington. D.C. October 31. 1989 Good afternoon. I am delighted to be here — in the midst of bands of professional economists — and not have to discuss the economy or monetary policy. That crystal ball is one into which I am still learning to look intelligently. What I want to do is gaze with yoxi into another crystal ball, the one that looks into the future of the banking system in the United States. Let's look together at the long-term issues with which bankers will be dealing and the implications of those issues for the future of the industry. I would argue that this Federal Reserve Board is not at all constrained by historical policies and inhibitions, but rather it is committed to the proposition that U.S. banks should be fully competitive, both domestically and internationally. Strong support for interstate banking; for the legislative initiative of Senator Proxmire in 1988 on Glass-Steagall reform; and the watershed so-called Section 20 decisions which allowed bank holding companies to set up affiliates to underwrite and deal in certain classes of 2 securities, are all clear evidence of this constructive stance. Indeed, we may seem too timid vet to bankers, but I would remind you that by statute we are simultaneously compelled to make safety and soundness a high priority. That priority dictates a measured pace of reform, with time to learn from experience, rather than a headlong rush, fraught with all of the inherent dangers of excessive speed. I assure you that our long-term goal, subject to the will of Congress, is to move to broader powers to assure the competitive position of United States banks both domestically and internationally. Now let's look at some of the issues we face: Capital will be a central issue for the foreseeable future. The thrift mess, the Texas snafu, and the LDC debt debacle all teach the same lesson. More capital! More capital would not have prevented any of those tragedies, but more capital would have made each one more manageable and would have significantly reduced the casualty lists and ultimately the cost to the taxpayer. As we move to reconstitute or assimilate the troubled institutions in the thrift industry, and rehabilitate the great Texas banking companies, and as banks absorb 3 additional provisions to bring third world debt reserves to mor* realistic levels, the demands of banking on the capital markets will be huge. At the same time we are moving toward risk-based capital standards and some banks will need more than just retained earnings to get them there. Will the markets be able to respond to that demand? Well, there is no question the capacity exists, but is there a will to do so. Securities markets tend to measure their appetites in terms of rates of return on investment. Will banks or holding companies having only .80 returns on assets and 12 percent returns on equity be able to compete for capital at an acceptable cost? Perhaps. But I suspect the prize will go to the swift and lean, those with a better than one percent return on assets and 15 percent or more on equity. On paper the differences between .8 and 1.0 and 12 and 15 percent look small, but when you are a manager trying to close that gap it looks as wide as the Chesapeake Bay. foresee a scramble for capital in the next few years which will force banks to rethink their strategies; to see if those strategies fit the changed world in which they will find themselves. New strategies to improve earning power and improve risk management will be searched for. Restructuring, downsizing, market targeting, narrower specialization and stringent cost controls will be common themes — all in the name of capital. And as bank powers are expanded, new elements of risk will be encountered — I 4 risk which must be matched against adequate levels of capital. All Winston Churchill could promise Britain in 1940 was blood, sweat, and tears. All I can promise bankers in 1989 is the need for more capital. Another issue, much in the news these days, is LBO and takeover financing accomplished with heavy ratios of debt. One emerging philosophy seems to be that investors using their own money are welcome to the junk bond market, and if they call it wrong they are simply wasting their own assets. But, there is growing concern whether it is appropriate for banks, using insurance-protected depositors' funds, to participate in these highly leveraged financings. In Congress the usual reaction to a perceived problem of this sort would be to regulate it or outlaw it. In my opinion, either course in this case would be a mistake since the real outcome would be to allocate credit, and credit allocation flies in the face of all that is holy in a free market economy. But, I do think there is a distinct element of risk in this kind of lending. The risk is in failing to make a proper appraisal of whether the cash flow coverage of debt service requirements is sufficient to absorb changes in interest rates, revenue flows or asset values which are part 5 of the forecast on which the loan is based, a stunning example is Campeau, where cash flows apparently failed to materialize as projected and a seemingly perfect deal quavered on the brink of disaster with very unsettling effects on financial markets. For banks the seductive elements in these highly leveraged situations are large fees, new lending opportunities and just the sheer excitement of being part of big deals. I have urged bankers to be more skeptical and to impose higher credit standards in these transactions lest Congress be goaded into action the bankers will regret. Bankers must make sure credit policies and procedures are sound; they must determine a prudent level of exposure to highly leveraged financing in their overall portfolios and stick to it. And they must make sure their directors know what policies they are following and what exposure limits have been established. In short, if highly leveraged financings are administered prudently, they are not likely to encounter objection or interference from Congress. But perceived imprudence will likely result in restrictive legislation which no-one wants. All of this apparently defensive commentary is intended to help preserve the creative initiative to produce new services and new ways to lend. Creativity is an important 6 part of competitiveness and competitiveness is the key to future banking success. While the other issues I want to touch on today are structural, the basic question remains; Are American banks competitive domestically and internationally with other financial institutions offering similar services? If not, are there changes in the structure of banking institutions which would contribute to greater competitiveness without compromising safety and soundness? Those are not puny issues which should be abandoned to casual solutions. When you stop to think about it, many of them threaten long-held principles and sacred practice. All of the answers are not clear, but here are some of the issues which those who operate banks, we who regulate and supervise banks, and Congress itself will be wrestling with in the immediate future. 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. This issue will inevitably emerge as part of the debate over further expansion of bank powers. The recent experience with the thrifts and sensitivity to the exposure 7 of taxpayers may dictate that, to the extent additional powers mean additional risk, the exercise of those powers must be outside of the comfort of the federal safety net. In that case Congress is likely to turn to the financial services holding company structural concept. In such a holding company, additional powers would be granted to separate subsidiaries and the insured deposit-taking subsidiary would be insulated from the risks of its affiliates by appropriate prohibitions or limitations on inter-company financing or transfers of capital. to use the vernacular. Firewalls Functional regulation of nonbanking activities would assure expert oversight for each activity and integrated marketing of related financial services would significantly enhance competitiveness. An inevitable question arising from consideration of such a structure is the ownership of the holding company itself. Could an insurance company own such a holding company? Actually, for many insurance companies the only item missing today from their subsidiary lists is a commercial bank. a company? Could an automobile manufacturer own such Well, Ford and G.M. and Chrysler are operators of huge finance companies and G.M. has a large insurance operation as well. Is there an inherent threat to the country if one of them or all of them were to own a bank? And what about G.E. or Sears or Gulf & Western and so on? By the same token, would it be wrong in some moral or 8 economic sense for Citicorp's shareholders to also own a life insurance company, an investment banking company, a computer company and a real estate development company as long as Citibank itself 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. nation. Ford owns the second largest thrift in the Thrifts and banks are operationally more like each other every day, although the capital sections of their balance sheets may be somewhat different. Why then do we accept the relationship in one case and not in the other? 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 in the resolution of this issue, particularly if we find that ownership by a commercial enterprise would significantly improve access of banks to capital markets. But, we should not rush this one. We need to be sure we understand all of the implications before we act. 9 Uncharacteristically, I am not sure where I am personally on that issue. My tilt at the moment is toward change, but it is too early on for final judgments. Interstate banking on a nationwide basis is rushing at us like a fast freight train, and whatever your individual feelings are about that development, the trend is not going to be reversed. By the mid-1990s we will have facto nationwide interstate banking without the de jure blessing of Congress or repeal of the McFadden Act. But, absent clarifying federal legislation, we may be creating a whole army of Frankenstein monsters 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 faces with banks in ten different states. — First, he is forced into a holding company or multi-holding company organizational structure because 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 approach the same transaction. 10 — To the extent that there are state-chartered banks in each state, there will be ten different examination standards to be managed to and ten different examinations to be endured. — Advertising, marketing, pricing, etc. may be subject to ten different standards or sets of regulations and limitations. — And, if the company is in more than one Federal Reserve District, where is its friendly, helpful, fatherly central banker? Is he in Richmond, Philadelphia, New York, or Cleveland? — Given those operating constraints, can bankers really achieve the operating efficiencies they bragged about to the security analysts when they were trying to explain how they were going to eliminate the dilution they saddled themselves with to make the acquisition? Efficiency is forced to take a backseat to jurisdiction. I predict that both federalists and states-righters will be calling for reform to accommodate these changes by the mid-1990s. And one approach 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 11 entirely. In order to deal with redundancy, repeal of McFadden would be proposed and nationwide branching permitted making much more efficient operation possible. Obviously many assumed values would change if all that came to pass. Treasured axioms such as: beautiful, big is bad." at all costs." "small is "States rights must be preserved "Local banks with local management and local directors are the only way to assure proper attention to the needs of the community." Or, "the bigger the bank, the more unmanageable it becomes." Some of those axioms are established elements of our economic culture, but in the interest of adapting to the changing needs of the economy and the requirements of competitiveness we may have to discard them as we have done others in the past. For example: It took us 125 years and two aborted prior attempts in order to establish a central bank — the Federal Reserve. By doing so we rejected the once popular argument that a central bank gave bankers too much power over the economy. 12 We chartered national banks and created a national currency system to provide a sounder base for financing the Civil War and to help stabilize the banking system. To meet the financial exigencies of the depression we stopped redeeming paper currency with gold and ceased gold coinage. We accepted control over securities markets and banks by the federal government in the 1930s in order to restore confidence in financial institutions in return for federal insurance of deposits. All of those were painful, even heart-rending, changes. But today we accept those changes and generally agree either that they were an improvement or at least that they were necessary given the call of the times. Change is always threatening and almost always uncomfortable, but like death and taxes it is also inevitable. The issues I have presented for your consideration today are only a few of the more obvious ones we will be dealing with in the near future. I hope we can approach the development of these issues with our focus on what is good for the United States. Too often in the past there has been division on great issues along parochial proprietary lines and Congress has thrown up its hands and 13 gone its own way. That is always a risky outcome. might have said, "Let's come reason together." As LBJ If we do, I am confident we can achieve results good for the country and good for banking.
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