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Testimony of Governor Laurence H. Meyer
Mergers and acquisitions in banking and other financial services
Before the Committee on Banking and Financial Services, U.S. House of
Representatives
April 29, 1998
I am pleased to appear before this Committee on behalf of the Federal Reserve Board to
discuss issues related to mergers among U.S. banking organizations and other financial
services firms. The last two decades have seen a steady and sometimes breathtaking
consolidation of our banking system, a process that will likely continue for quite some time.
This ongoing consolidation is in many ways a natural response to our rapidly changing
banking environment. However, the very large mergers and acquisitions of recent years, and
those approved or announced in the last few weeks, have raised a number of public policy
questions and concerns in the minds of many observers.
As the Committee knows well, this is not the first time the Board has testified on the subject
of bank mergers. The Board continues to believe that the primary objectives of public policy
in this area should be to ensure a safe and sound banking system, preserve the benefits of
competition for consumers of financial services, meet the convenience and needs of local
communities, and allow U.S. financial services firms to evolve with the needs of the
marketplace. My statement today will discuss how, within the context of existing law, the
Federal Reserve is pursuing these goals, and will review the potential economic effects of
bank mergers. I will also argue that the consolidation of the U.S. financial services industry
reinforces the need for legislation to modernize our banking and financial systems.
One of the reasons we are here today is the recent announcements of several large and
interesting mergers. My statement purposely does not include any substantive discussion of
specific mergers and acquisitions that have been proposed recently. Several of the recently
announced proposals will require that a company obtain the Board's approval under the
Bank Holding Company Act. Each proposal subject to the Bank Holding Company Act will
be thoroughly reviewed by the Board on a case-by-case basis in conformance with current
law and under the Board's well-established policies and procedures. It's important to note,
however, that the Bank Holding Company Act does not give the Board unfettered discretion
in acting on such proposals. Instead, the Bank Holding Company Act specifies the factors
that the Board must review in these cases, and the Board's power to approve or deny a
proposal is significantly limited by these factors.
These factors include the competitive effects of the proposal, the financial and managerial
resources and future prospects of the companies and banks involved in the proposal, and the
effects of the proposal on the convenience and needs of the community to be served,
including the performance record of the depository institutions involved under the
Community Reinvestment Act. In addition, the Board may enforce compliance with the
requirements of the Bank Holding Company Act and must be assured of access to

information needed to enforce compliance. The Bank Holding Company Act also
establishes nationwide and individual state deposit limits for interstate bank acquisitions and
consolidated home country supervision standards for foreign banks. In proposals involving
the acquisition of a nonbanking company, the Board must consider whether performance of
the activity by a bank holding company affiliate can reasonably be expected to produce
benefits to the public, such as greater convenience, increased competition, or gains in
efficiency that outweigh possible adverse effects, such as undue concentration of resources,
decreased or unfair competition, conflicts of interests or unsound banking practices.
The Board is not granted authority under the Bank Holding Company Act to disapprove a
proposal that meets all of these statutory factors. Thus the Board could not deny a proposal
because, for example, the Board does not like this particular combination of firms or
because it believes that a different combination of companies would be more profitable,
efficient or desirable. The Board must consider the proposal that is presented to the Board
and whether the particular companies involved in the application before the Board meet the
statutory factors. Similarly, the Board cannot deny a proposal simply because the companies
involved are large, unless the effect of the proposal may be to substantially lessen
competition in violation of the standards in the federal antitrust laws or to contravene one of
the other factors in the Bank Holding Company Act. Later in my statement, I will discuss
the methodology the Board uses in assessing each of these aspects of a proposed merger. As
an initial matter, I can assure you on behalf of the Board that none of the applicants or
potential applicants has been given any prior indication of the Board's views on their
proposals or whether their proposals will be approved or disapproved by the Board.
I. Trends in Mergers and Banking Structure
It is useful to begin a discussion of the public policy and other implications of bank mergers
with a brief description of recent trends in merger activity and overall U.S. banking
structure. The statistical tables at the end of my statement provide some detail that may be of
interest to the Committee.
Bank Mergers: There have been over 7,000 bank mergers since 1980. The pace accelerated
from 190 mergers with $10.2 billion in acquired assets in 1980, to 649 with $123.3 billion in
acquired assets in 1987. In the 1990s, the pace of both the number and dollar volume of
bank mergers has remained high. Through March of this year, the rapid pace of merger
activity has continued. For example, if only the five largest mergers or acquisitions
approved or announced since December are completed, a total of over $500 billion in
banking assets would have been acquired.
The incidence of "mega-mergers," or mergers among very large banking organizations, is a
truly remarkable aspect of current bank merger activity. But, it is useful to recall that very
large mergers began to occur with growing frequency after 1980. In 1980, there were no
mergers or acquisitions of commercial banking organizations where both parties had over
$1.0 billion in total assets (table 2). The years 1987 through 1996 brought growing numbers
of such acquisitions and, reflecting changes in state and federal laws, an increasing number
of these involved interstate acquisitions by bank holding companies. The largest mergers in
U.S. banking history took place or were approved during the 1990s--including ChaseChemical, Wells Fargo-First Interstate, NationsBank-Barnett, and First Union-CoreStates.
And while these mergers set size precedents, the recently proposed mergers of Citicorp and
Travelers, and NationsBank and BankAmerica, if consummated, would set a new standard
for sheer size in U.S. banking organizations.

National Banking Structure: The high level of merger activity since 1980, along with a large
number of bank failures, is reflected in a steady decline in the number of U.S. banking
organizations from 1980 through 1997 (table 3). In 1980, there were over 12,000 banking
organizations, defined as bank holding companies plus independent banks; banks numbered
nearly 14,500. By 1997, the number of organizations had fallen to about 7,100 and the
number of banks to just over 9,000. The number of organizations had declined over 40
percent and the number of banks by over one-third.
The trends I have just described must be placed in perspective, because taken by themselves
they hide some of the key dynamics of the banking industry. Table 4 shows some other
important characteristics of U.S. banking. While there were about 1,450 commercial bank
failures and over 7,000 bank acquisitions between 1980 and 1997, some 3,600 new banks
were formed. Similarly, while over 18,000 bank branches were closed, the same period saw
the opening of nearly 35,000 new branches. Perhaps even more importantly, the total
number of banking offices, shown in table 3, increased sharply from about 53,000 in 1980 to
over 71,000 in 1997, a 35 percent rise, and the population per banking office declined. This
includes former thrift offices that were acquired by banking organizations. Fewer banking
organizations clearly has not meant fewer banking offices serving the public.
These trends have been accompanied by a substantial increase in the share of total banking
assets controlled by the largest banking organizations. For example, the proportion of
domestic banking assets accounted for by the 100 largest banking organizations went from
just over one-half in 1980, to nearly three-quarters in 1997 (table 5). The increase in
nationwide concentration reflects, to a large degree, a response by the larger banking
organizations to the removal of state and federal restrictions on geographic expansion both
within and across states. The industry is moving from many separate state banking
structures toward a nationwide banking structure that would have existed already had legal
restrictions not stood in the way. The increased opportunities for interstate banking are
allowing many banking organizations to reach for the twin goals of geographic risk
diversification and new sources of "core" deposits.
As I will discuss shortly, it may well be that the retail banking industry is moving toward a
structure more like that of some other local market industries such as clothing and
department store retailing. As in banking, clothing and department store customers tend to
rely on stores located near their home or workplace. These stores may be entirely local or
may be part of regional or national organizations. Thus, it should perhaps not be surprising
that banks, now freed of barriers to geographic expansion, are taking advantage of the
opportunity to operate throughout the country as have firms in other retail industries.
But, it would be a mistake to think that adjustment to a new statutory environment--and the
increased opportunities for geographic diversification--were the only reasons for the current
volume of bank merger activity. Each merger is somewhat unique, and likely reflects more
than one motivation. For example, a recent study of scale economies in banking suggests
that efficiencies associated with larger size are likely to be exhausted after about $10-$25
billion in assets. In addition, some lines of business, such as securities underwriting and
market-making, require quite large levels of activity to be viable.
Increased competitive pressures caused by rapid technological change and the resulting
blurring of distinctions between banks and other types of financial firms, lower barriers to
entry due to deregulation, and increased globalization also contribute to merger activity.

Global competition appears to be especially important for banks that specialize in corporate
customers and wholesale services, especially among the very largest institutions. Today, for
example, almost 40 percent of the U.S. domestic commercial and industrial bank loan
market is accounted for by foreign-owned banks.
More generally, greater competition has forced inefficient banks to become more efficient,
accept lower profits, close up shop, or--in order to exit a market in which they cannot
survive--merge with another bank. Other possible motives for mergers include the simple
desire to achieve market power, or the desire by management to build empires and enhance
compensation. Some mergers probably occur as an effort to prevent the acquiring bank from
itself being acquired, or, alternatively, to enhance a bank's attractiveness to other buyers.
Many of these factors are also motivating mergers between bank and nonbank financial
firms. However, in these cases, a key causal factor is the on-going blurring of distinctions
between what were, not very long ago, quite different financial services. Today, as the
Board has testified on many occasions, it is increasingly difficult to differentiate between
many products and services offered by commercial banks, investment banks, and insurance
companies. Thus, we should not find it surprising that firms in each of these industries
should seek partners in the others.
Local Market Banking Structure: Given the Board's statutory responsibility to apply the
antitrust laws so as to ensure competitive banking markets, it is critical to understand that
nationwide concentration statistics are generally not the appropriate metric for assessing the
competitive effects of mergers. Moreover, the extent to which mergers can increase national
concentration is limited by the provisions in the Riegle-Neal Act of 1994 that amended the
Bank Holding Company Act and established national (10 percent) and state-by-state (30
percent) deposit concentration limits for interstate bank acquisitions. States may establish a
higher or lower limit, and initial entry into a state by acquisition is not subject to the RiegleNeal statewide 30 percent limit.
Beyond this, the Board has a statutory responsibility to apply the antitrust laws so as to
ensure competitive local banking markets. Evidence indicates that in the vast majority of
cases the relevant concern for competition analysis is competition in local banking markets.
While one can identify specific local markets that have experienced increases in
concentration, from 1980 through 1997, in both urban and rural markets, the average
percentage of bank deposits accounted for by the three largest firms has remained steady or
actually declined slightly, even as nationwide concentration has increased substantially
(table 6). Essentially similar trends are apparent when local market bank concentration is
measured by the Herfindahl-Hirschman Index (HHI) the sum of the squares of the market
shares. Because of the importance of local banking markets, I would like to provide
somewhat more detail on the implications of bank mergers for local market concentration.
Metropolitan Statistical Areas (MSAs) and non-MSA counties are often used as proxies for
urban and rural banking markets. The average three-firm deposit concentration ratio for
urban markets decreased by three percentage points between 1980 and 1997 (table 6).
Average concentration in rural counties declined by 1.7 percentage points. Similarly, the
average bank deposit-based HHI for both urban and rural markets fell between 1980 and
1997 (table 7). When thrift deposits are given a 50 percent weight in these calculations,
average HHIs are sharply lower than the bank-only HHIs in a given year, but the HHIs trend
slightly upward since 1984. On balance, the three-firm concentration ratios and the HHI data

strongly suggest that, despite the fact that there were over 7,000 bank mergers between 1980
and 1996, local banking market concentration has remained about the same.
Why haven't all of these mergers increased average local market concentration? There are a
number of reasons. First, many mergers are between firms operating primarily in different
local banking markets. While these mergers may increase national or state concentration,
they do not tend to increase concentration in local banking markets and thus do not reduce
competition.
Second, as I have already pointed out, there is new entry into banking markets. In most
markets, new banks can be formed fairly easily, and some key regulatory barriers, such as
restrictions on interstate banking, have been all but eliminated.
Third, the evidence overwhelmingly shows that banks from outside a market usually do not
increase their market share after entering a new market by acquisition. Studies indicate that,
when a local bank is acquired by a large out-of-market bank, there is normally some loss of
market share. The new owners are not able to retain all of the customers of the acquired
bank. Anecdotal evidence suggests that some other banks in the market mount aggressive
campaigns to lure away customers of the bank being acquired.
Fourth, it is important to emphasize that small banks have been and continue to be able to
retain their market share and profitability in competition with larger banks. Our staff has
done repeated studies of small banks; all these studies indicate that small banks continue to
perform as well as, or better than, their large counterparts, even in the banking markets
dominated by the major banks. This may be due, in part, to more personalized service. But
whatever the reason, based on this experience, we expect that there will continue to be a
large number of banks remaining in the future.
Despite a continued high level of merger activity, studies based on historical experience
suggest that in about a decade there may be about 3,000 to 4,000 banking organizations,
down from about 7,000 today. Although the top 10 or so banking organizations will almost
certainly account for a larger share of banking assets than they do today, the basic size
distribution of the industry will probably remain about the same. That is, there will be a few
very large organizations and an increasing number of smaller organizations as we move
down the size scale. It seems reasonable to expect that a large number of small, locally
oriented banking organizations will remain. Moreover, size does not appear to be an
important determining factor even for international competition. Only very recently have
U.S. banks begun to appear, once again, among the world's twenty largest in terms of assets.
Yet those U.S. banks that compete in world markets are consistently among the most
profitable and best capitalized in the world, as well as being ranked as the most innovative.
Finally, administration of the antitrust laws has almost surely played a role in restricting
local market concentration. At a minimum, banking organizations have been deterred from
proposing seriously anticompetitive mergers. And in some cases, to obtain merger approval,
applicants have divested banking assets and deposits in certain local markets where the
merger would have otherwise resulted in excessive concentration.
Overall, then, the picture that emerges is that of a dynamic U.S. banking structure adjusting
to the removal of longstanding legal restrictions on geographic expansion, technological
change, and greatly increased domestic and international competition. Even as the number

of banking organizations has declined, the number of banking offices has continued to
increase in response to the demands of consumers, and measures of local banking
concentration have remained quite stable. In such an environment, it is potentially very
misleading to make broad generalizations without looking more deeply into what lies below
the surface. In part for the same reasons that make generalizations difficult, the Federal
Reserve devotes considerable care and substantial resources to analyzing individual merger
applications.
II. Federal Reserve Methodology for Analyzing Proposed Bank Mergers
This section of my statement discusses in some detail the Board's policies and procedures
for evaluating proposed bank mergers and acquisitions.
Competitive Criteria Reviewed in Mergers: While competition in the banking industry is,
and likely will remain robust despite bank merger activity, some individual bank mergers
affect individual local markets. When considering the competitive effects of a proposed
bank acquisition, the Board is required to apply the competitive standards contained in the
Sherman and Clayton Antitrust Acts.
The Board's analysis of competition begins with defining the geographic areas that are likely
to be affected by a merger. Evidence suggests that small businesses and households tend to
obtain their financial services in their local area. With this basic local market orientation of
households and small businesses in mind, the staff calculates bank market shares and a local
market index of concentration, the HHI, which is widely accepted as a sensitive measure of
market concentration. The resulting market share and both the level and change in the HHI
are also key elements of the Department of Justice merger guidelines. The Board relies on
these guidelines as a preliminary screen of proposed mergers. If the resulting market share
and the level and change in the HHI are within Justice Department guidelines, there is a
presumption that the merger is acceptable on competitive grounds, but if they are not, a
more thorough economic analysis is required. These guidelines are not applied
mechanistically, because there are other factors that may influence competition. These
factors may vary from case to case and market to market. Some of these factors are
described below.
z

z

z

z

Potential competition, or the possibility that other firms may enter the market, may be
regarded as a significant procompetitive factor.
Thrift institution deposits are now typically accorded 50 percent weight in calculating
market shares and HHIs. A higher percentage may be applied if thrifts in the relevant
market look very much like banks, as indicated by the substantial exercise of their
transactions account, commercial lending, and consumer lending powers.
Competition from other depository and nonbank financial institutions may also be
given weight beyond that already given within the framework of the merger
guidelines. Added weight is appropriate if such entities are particularly important in
providing substitutes for the basic banking services used by most households and
small businesses.
If the bank being acquired is not a reasonably active competitor in a market, its
market share might be given a smaller weight in the analysis of competition than
otherwise.

z

z

z

z

z

If the firm to be acquired is located in a declining market, this may be viewed as
mitigating adverse structural effects.
Competitive issues may be reduced in importance if the bank to be acquired has failed
or is about to fail. In such a case, it may be desirable to allow some adverse
competitive effects if this means that banking services will continue to be available to
local customers rather than be severely restricted or perhaps eliminated.
A very high level of the HHI could raise questions about the competitive effects of a
merger even if the change in the HHI is less than the Justice Department criterion.
Economies of scale are considered to be a positive factor in appropriate cases unless
the economies could be achieved in a less anticompetitive manner.
Finally, other factors unique to a market or firm would be considered if they are
relevant to the analysis of competition.

When a merger cannot be justified using any of the criteria I have just outlined, some
applications are approved only after the applicant proposes divestiture of offices to remedy
competition problems.
Safety and Soundness Criteria: In acting upon merger applications, the Board is required to
consider financial and managerial resources and the future prospects of the firm. In doing
so, the Board's goal is to promote and protect the safety and soundness of the banking
system, and to encourage prudent acquisition behavior. Indeed, except in very special
circumstances, usually involving failing banks, the Board will not approve a merger or
acquisition unless the resulting organization is expected to be strong and viable.
The Board expects that holding company parents will be a source of strength to their bank
subsidiaries. In doing so, the Board generally requires that the holding company applicant
and its subsidiaries be in at least satisfactory overall condition, and that any weaknesses be
addressed prior to Board action on a proposal. The holding company applicant must be able
to demonstrate the ability to make the proposed acquisition without unduly diverting
financial and managerial resources from the needs of its existing subsidiary banks.
These general principles apply regardless of the size or type of acquisition--banking or
nonbanking. The financial and managerial analysis of an application includes an evaluation
of the existing organization, including bank and nonbank subsidiaries, the parent company,
and the consolidated organization, as well as an evaluation of the entity to be acquired. Also
included in this analysis are the financial and accounting effects of the transaction, that is,
the purchase price, the funding and sources thereof, and any purchase accounting
adjustments. Numerous factors are analyzed for strengths and weaknesses, including
earnings, asset quality, cash flow, capital, risk management, internal controls, and
compliance with law and regulation.
Community Reinvestment Act Criteria: The Community Reinvestment Act (CRA) requires
that supervisory agencies assess each insured depository institution's record of safely and
soundly meeting the credit needs of its entire community, including low- and moderateincome neighborhoods. The CRA performance of banking organizations that seek the
Board's approval to acquire a bank or thrift is an important part of the "convenience and

needs" criteria that must be considered by the Board.
In making its judgment, the Board pays particular attention to CRA examination findings. In
recent years, these examinations have focused more on hard measures of performance,
rather than just efforts, and they provide a key source of information about the institution's
record. The law now requires that these examinations reflect a state-by-state and MSA-byMSA evaluation, and this will be particularly helpful in judging the performance of large
organizations. In addition, the public may comment during the processing of the application,
and this is often an important additional source of insight. Besides analyzing these
comments, our staff prepares extensive documentation concerning the institutions involved,
including analysis of projected branch closings, the record of service as reflected in Home
Mortgage Disclosure Act data, and other material.
The Board expects banking organizations that apply for mergers and acquisitions to have
policies and procedures that are working well to address their CRA responsibilities. This is
commonly understood by prospective applicants, and large organizations have typically
committed substantial resources toward building an acceptable record. Nevertheless, we
scrutinize all the data available to us very carefully, as reflected in the Board's orders which
often focus in large part on CRA and related matters. In short, ensuring that CRA records
are consistent with approval is a very significant part of the Board's consideration of these
cases.
III. The Supervision of Large, Complex Banking Organizations
It is clear that mergers of very large financial institutions and future, unknown combinations
of large U.S. banking and financial institutions raise questions about how such giant
organizations can or will be supervised. To be sure, supervising large or diversified
institutions presents challenges to the Federal Reserve in its oversight of bank holding
companies. More coordination, for instance, has been and will be needed throughout the
Federal Reserve System to ensure that such diverse, nationwide institutions receive effective
and efficient oversight. In some cases, we must also do more to coordinate with other
supervisory authorities, both banking and nonbanking, domestically and abroad. These are
not unexpected challenges and, indeed, were recognized with the advent of full interstate
banking and the continued trend of consolidation within the U.S. and international banking
systems. We have, for example, had in place for some time formal efforts to coordinate state
and federal supervisory activities in order to provide more effective oversight of statechartered banks with interstate activities, and to do so with minimum burden to the
supervised institutions.
The emergence of very large, nationwide and multi-product financial firms also requires that
we review and revise our staffing requirements to ensure that personnel are properly located
and sufficiently trained. Developing and maintaining sufficient numbers of examiners and
supervisory personnel with expertise in understanding and evaluating derivatives, trading,
and other capital market activities, for example, has been and remains a challenge. These
activities can be complex and are becoming ever more important elements of large U.S.
banking organizations. Individuals familiar with them are in wide demand.
To the extent possible, the Federal Reserve will continue to rely on the supervisory and
regulatory activities of other agencies, as we do now with the evolving, yet more
traditionally structured, bank holding companies of today. But, the rapidly changing nature
of the U.S. banking and financial system requires that administrative and managerial

considerations receive prompt and perhaps heightened attention. The Board believes that
both the existing supervisory structure and the provisions of H.R. 10 would accommodate an
adequate supervisory and regulatory process in the environment that is taking shape.
As this Committee knows, the supervisory practices of the Federal Reserve, and of the other
U.S. banking agencies as well, have evolved in recent years toward a "risk focused"
approach: one that emphasizes the importance of an institution's risk management policies
and procedures, its risk measurement and information systems, and its internal controls.
While reviewing asset quality clearly remains important, less emphasis than before is placed
on the current condition of an institution's balance sheet, particularly in the case of large,
internationally active organizations. It places increased reliance and supervisory focus on
the role of senior management and boards of directors--that is, on the adequacy of corporate
governance and the management and control process. Indeed, that is properly where the
primary responsibility and focus must reside. Moreover, for many of the new instruments,
such as derivatives, we have increasingly relied on market discipline and disclosure, and
have been impressed with their effectiveness. This approach has become necessary, we
believe, in response to technological and financial innovations and to the growing
complexity, transaction volume, and increased pace in world financial markets today.
As the Federal Reserve has found in revamping its own supervisory policies and practices,
many of the fundamental principles of sound risk management that apply to traditional
activities of banks also apply to those of securities firms and to the activities of many other
financial and nonfinancial firms. Joint statements on sound practices issued in recent years
by the Basle Committee on Bank Supervision and the International Organization of
Securities Commissions help to underscore that point. Similarly, many of the oversight and
capital adequacy concerns of the Federal Reserve and other bank regulators are shared by
regulators of other financial institutions. Through efforts of the Joint Forum on Financial
Conglomerates, which includes regulators for banking, securities, and insurance industries
worldwide, we are working to develop frameworks for adequate supervision and regulation
of complex internationally active financial institutions. By emphasizing critical aspects of
risk management through our supervisory process and working with other agencies as well,
the Federal Reserve is and can remain sufficiently positioned, we believe, to provide
continued "umbrella" oversight to the consolidated activities of banking organizations.
Importantly, H.R. 10 recognizes the need for consolidated supervision in effectively
supervising financial conglomerates. H.R. 10 also recognizes the effectiveness of the
holding company framework in helping to insulate depository institutions and the federal
safety net from the risks of new activities, and that the holding company framework better
accommodates effective functional regulation of activities that are already heavily regulated.
H.R. 10 preserves the Board's authority, as the consolidated supervisor, to obtain
information from and to examine financial holding companies and their subsidiaries, and to
establish capital standards on financial holding companies as appropriate. The bill also
retains the Board's authority to take administrative actions to preserve the safety and
soundness of depository institutions in a financial conglomerate and to enforce compliance
with the Bank Holding Company Act.
H.R. 10 does place some limitations on the Board's current authority under the Bank
Holding Company Act. These changes, often grouped under the term "Fed light," are
primarily in two areas. The first changes recognize that insurance companies and securities

brokers and dealers are already extensively regulated. Accordingly, H.R. 10 includes
sensible provisions that enhance functional regulation, require the Board to use examination
reports of other functional regulators, improve coordination and information sharing among
supervisors, and resolve potential conflicts between regulatory schemes. The bill would
retain the Board's authority to take administrative actions, including examining a
functionally regulated affiliate, where the Board has reasonable cause to believe that an
affiliate is engaged in activities that pose a material risk to an affiliated depository
institution. These provisions in H.R. 10, we believe, strengthen the overall supervisory
framework of the new financial services companies permitted under H.R. 10.
H.R. 10 also reduces somewhat the Board's authority in supervising companies that own
only uninsured wholesale financial institutions. These provisions are based on the premise
that reduced supervision of the holding company is appropriate when none of the depository
institution subsidiaries of the holding company are federally insured. Importantly, the
Board's supervisory authority is only adjusted, and is not eliminated over this type of
holding company, and the Board has full authority to examine and supervise the wholesale
financial institution itself in the same manner as any other bank with access to the Board's
discount window and payment system.
There are other important provisions of H.R. 10 that affect supervision. For example, H.R.
10 expressly grants the Board authority to establish prudential controls on transactions and
relationships between a depository institution and any affiliate (other than a subsidiary of a
depository institution) where the prudential control may be in the public interest to avoid
significant risk to the depository institution, to enhance financial stability, to enhance
customer privacy, to avoid conflicts of interest or to promote national treatment among
foreign and domestic institutions. The Board believes that this is a key provision that would
enhance the separation afforded by the holding company structure and better limit the
expansion of the federal safety net to new nonbank affiliates.
It is the strong belief that the benefits of the federal safety net and the obligation of the
taxpayer should not be extended to new activities that motivates the Board to oppose
expanding the new affiliation authority to subsidiaries of depository institutions. Problems
experienced at an affiliate of a depository institution are more readily addressed by
prudential controls than problems that arise at a subsidiary of the depository institution.
A holding company subsidiary is not part of a depository institution. A subsidiary of a
depository institution, on the other hand, has always been considered to be a department of
the bank and, more importantly, under generally accepted accounting principles is
consolidated into the financial statements of the parent depository institution. This may
seem like a technical point, but it is a very significant difference. No matter what accounting
regime may be included in H.R. 10, generally accepted accounting principles will govern all
public reports of depository institutions that seek funding in the market. Under GAAP, the
financial statements and the capital of a parent depository institution must fully reflect the
financial condition, capital and losses of its subsidiaries.
Prudential controls, even if supplemented by capital deductions for purposes of regulatory
reporting requirements, are not sufficient to limit the impact of losses at a subsidiary
because the capital of the depository institution parent is directly exposed to, and must
reflect the losses experienced by its subsidiaries. Thus, losses experienced by a subsidiary
directly jeopardize the financial condition of the parent depository institution.

Moreover, subsidiaries of depository institutions directly benefit from and place at risk the
federal deposit insurance funds and the guarantee of the taxpayer. The Board believes that it
would be a mistake to consider that a subsidiary of a depository institution can be effectively
insulated from its parent depository institution in the same way that an affiliate can be
separated from the depository institution. For these reasons, the Board strongly opposes
provisions that would broaden the authority of subsidiaries of depository institutions.
Aside from the issue that bank operating subsidiaries raise with respect to expansion of the
nation's sovereign credit, and on which the Board feels strongly, an issue is emerging with
respect to our ability to supervise the complex institutions which would arise if the current
trend in bank mergers and acquisitions continues, and the operating subsidiary authority is
expanded. In particular, if in the future the central bank did not have the understanding and
adequate supervisory authority to engage giant financial institutions during a systemic crisis,
the Federal Reserve would be seriously impaired in its ability to meet its statutory
responsibility to maintain the stability of the financial system. Put differently, while the
economic desirability and efficiency of large financial institutions is primarily up to their
shareholders and customers, the effect of such institutions on systemic stability is very much
a public policy concern. And when it comes to controlling systemic risk, the central bank
must be able to play a substantive role.
More generally, a critical question raised by the creation of very large and diverse banking
organizations relates to the potential effect of future banking problems on systemic risk and
the federal safety net. Research supports the view that more geographically diversified firms
exhibit, other things equal, less risk. Geographically diversified firms are less dependent
upon the economic fortunes of any one locality, region, industry, or group of industries. In
addition, such firms are not dependent upon a limited area for their core deposits, thereby
helping to ensure a more stable source of funds. But, the issue of systemic risk clearly
highlights the importance of developing and maintaining adequate laws, regulations, and
supervisory structures that are sufficiently compatible with the banking and financial system
we have. It seems important to emphasize, at this point, that "bail-outs" and concepts of "too
big to fail" can be easily misunderstood and misconstrued.
The point, it seems, relates to one's view of bank failures and bail-outs. Whom should the
safety net protect? Certainly not shareholders or responsible directors or senior
managements. These individuals should clearly lose their investments or jobs when banks
fail. And, over time, pieces of any organization, no matter how large, can be sold and the
total firm reduced in size. The public policy objectives are to protect the financial system
and insured depositors, and to resolve banking problems in an orderly way. Moreover, with
passage of the FDIC Improvement Act of 1991, the Federal Reserve and the FDIC are
strictly limited in their abilities to provide liquidity or financial assistance to weak banks and
potential acquirers, no matter what their size. By enacting this legislation, the Congress
made clear its intent to ensure that discount window lending extends only to solvent
institutions or to weak banks only for relatively short periods of time. For its part, the FDIC
must resolve bank failures using the "least cost" approach. And, the circumstances under
which the least cost approach can be relaxed are rather severe. In sum, we believe the
structure currently in place in the United States to address weak or failing banking
institutions provides an adequate balance of discipline and flexibility to resolve future
problems.
IV. Potential Implications of Bank Mergers

The rapid rate of bank mergers has raised a number of questions regarding the potential
effects of banking consolidation on those consumers whose demands for banking services
are primarily local in nature and on the performance of the merged banks.
Effects of Mergers on Locally Limited Customers: Historically, banking in the United States
has had a distinctly local flavor with many communities served by locally owned
institutions. The prospect of loss of these local ties is troubling to many. Moreover, this is
occurring at the same time as banks are unbundling and explicitly pricing individual services
that were not previously priced separately. The combination of new fees and the specter of
more impersonal service has, quite understandably, raised widespread concerns.
We do not wish to minimize these concerns. However, there are two reasons to hope the
impact will be modest: (1) many mergers have not been between banks operating primarily
in the same local banking markets; and (2) the effects of intramarket mergers can be, and
thus far have been, limited by both market forces and antitrust constraints on such mergers.
As a consequence, customers should still enjoy the benefits of competition.
Competition
Even in those places where in-market mergers have occurred, evidence to date suggests that
the effect on competition has on average not been substantial. This, of course, does not
mean that users of bank services will never be harmed by mergers. No policy can guarantee
that result. But, the trends in local market concentration I discussed earlier indicate that
market forces and the Board's application of antitrust standards to within-market merger
applications generally have preserved competition. In addition, the Board's policies have
almost certainly discouraged some potential bank mergers before an application was ever
filed. Moreover, many urban markets could see a relatively large number of in-market
mergers before antitrust guidelines would be violated.
Branch Closings
In-market bank mergers often lead to some branch closings, raising concerns that consumer
convenience may be harmed. Indeed, the possibility of branch closings is often one of the
more controversial aspects of a proposed merger. Branch closings and their impact on the
convenience and needs of the local community are, of course, one of the key factors
reviewed in a bank's CRA examination, and thus are carefully considered by the Board in
our evaluation of a proposed merger. In particular, we review very carefully the impact on
low- and moderate-income communities. In addition, Board staff have recently been
examining the effect of bank mergers on office closings more generally, and I would like to
summarize some of the key preliminary findings.
Board staff investigated relationships between bank mergers and changes in the number of
banking offices, looking separately at rural and urban markets. This research indicates that
mergers between institutions operating in the same local market have tended to be
associated with reductions in the number of banking offices in neighborhoods served by the
bank being acquired. The strongest relationships are observed in neighborhoods where the
merging institutions both had offices. However, these effects were partially offset by office
openings by competitors, either de novo or through the acquisition of divested offices of the
merged firms. Moreover, looking at the nationwide data, the observed relationships between
mergers and office closings do not appear to be systematically different between low- and
moderate-income areas and other localities.

These results suggest that the issue of office closings is more complex than is frequently
portrayed. Offices in markets served by both of the merging firms tend to be reduced,
perhaps in an effort by the merged firms to achieve operational efficiencies. Low- and
moderate-income neighborhoods do not appear to be disproportionately affected by such
closings. Importantly, new entrants tend to partially offset the merger-induced reduction in
banking offices, suggesting that, as new profit opportunities arise, other firms will come in.
Moreover, the exploitation of such opportunities is much easier today than even two years
ago before the full implementation of interstate banking. Put differently, if consumers
demand locational convenience, banks of all sizes will need to, and are now able to, respond
if they expect to remain viable competitors for retail customers.
Small Business Lending
An often-expressed concern with bank mergers, and especially with mergers involving very
large banks, is that small business lending will be impaired. This concern springs in part
from some research which indicates that, on average, large banks devote relatively modest
portions of their portfolios to small business loans, and that consolidations involving large
banking organizations tend to result in reduced small business lending.
Such results, however, likely provide a misleading picture of the effects of mergers on small
business lending. A deeper evaluation suggests that it is far from clear that small business
lending is, on net and after a transition period, harmed in any significant way. For example,
a study which examined the reactions of other banks in markets where mergers occurred
found that increases in the supply of small business lending by these other banks tend to
offset much, if not all, of any initial negative effects of mergers on small business lending.
Indeed, when mergers of large banks are announced, it is quite common to read press reports
of other in-market banks' expectations of taking business away from the newly formed
entity.
New profit opportunities in small business lending may also encourage the creation of other
new banks. In fact, it is not uncommon for some of the loan officers of an acquired bank to
leave and form their own bank. Further studies suggest that new banks, regardless of why
they were formed, tend to lend larger portions of their assets to small businesses than do
even other small banks of comparable size.
Over the long term, at least two factors are likely to improve the prospects for small
business finance. First, rapid technological changes applied to the process of loan evaluation
will, in all probability, continue to lower the cost of assessing the creditworthiness of small
businesses. Indeed, we see this process at work today in the increasing use of credit scoring
techniques in evaluating the extension of relatively small loans to small businesses.
Significantly, credit scoring technology has the potential to allow banks located outside
local markets to compete against within-market institutions for small business lending. A
second important factor is the role of nonbank lenders in small business finance. Such
lenders have traditionally played an important role in small business finance, and in the
future, such firms are likely to be an increasingly important source of funds for small
businesses.
Community Lending
As yet, there are no studies of the effects of mergers on community lending comparable to
the studies done for small business lending. However, I suspect that mergers--large or small-do not have negative effects on community lending. Given prior commitments often made

by acquirers, mergers may even have a positive effect, and the merger application process
provides an opportunity for discussion of community needs. In addition, if there are
profitable opportunities--as I believe there are in community lending--it seems reasonable to
expect that those same market forces that provide for small business loans (and new bank
offices) would also operate in the market for community lending after mergers. Moreover,
large institutions have the experience, expertise, and resources that enable them to be quite
active and innovative in the community development process. Larger institutions are often at
the forefront of efforts to develop affordable home mortgage programs, small business and
microenterprise financing programs, and they provide considerable resources to support
both local and national nonprofit intermediaries that focus on lower income areas. In
addition, the core of a bank's CRA evaluation is the adequacy of its community-based
lending programs, the record of which is reviewed frequently and especially whenever a
bank is involved in a merger.
Bank Fees
The level and variety of bank fees is another concern frequently voiced over bank mergers.
We are not aware of any studies that have looked specifically at the effects of mergers on
the level of fees that banks charge their customers. There have been a few findings,
however, that have some relevance to the question of how mergers might affect fees. There
is evidence that larger banks charge higher fees than smaller banks, but a study that
investigated this issue in more detail found that this differential appeared to be due to the
disproportionate presence of larger banks in large urban areas, where costs tend to be higher.
There is substantial evidence that banks that are part of multi-state organizations tend to
charge higher fees in general than do banks that are not, and this difference cannot be
explained by locational factors.
Effects of Mergers on Bank Performance: Federal Reserve System staff and others have
conducted numerous studies over many years on the effects of bank mergers and
acquisitions on bank performance. Some of these studies have focused on the effect of
mergers on bank profits and prices, while others have looked at the potential for cost savings
and efficiencies derived from mergers.
Of those studies concerned with profits and prices, some have examined the effects of
mergers directly, although most studies have approached this issue more indirectly by
considering how bank profits and prices differ across banking markets. Each type of study is
relevant to an assessment of the impact of bank mergers on performance.
Studies of differences in bank profitability across markets with varying degrees of
concentration represent the oldest type of study relevant to the issue. Typically, such studies
have found that banks operating in more concentrated markets exhibit somewhat higher
profits than do banks in less concentrated markets. These higher profits may reflect the
lesser degree of competition in more concentrated markets.
Other studies have looked across banking markets for differences in the prices that banks
charge or pay their loan and deposit customers. For the most part, such studies have found
that banks located in relatively concentrated markets tend to charge higher rates for certain
types of loans, particularly small business loans, and tend to offer lower interest rates on
certain types of deposits, particularly transactions accounts, than do banks in less
concentrated markets. In general, these studies support the need to maintain antitrust
constraints if locally limited bank customers are to continue to receive competitively priced

banking services.
A related issue is whether mergers lead to greater bank efficiency and thus a healthier, more
competitive banking firm. Studies that are relevant to the effect of mergers on bank
efficiency may be divided into those that do and those that do not look directly at the effects
of mergers.
A large number of studies have sought to determine whether larger banking organizations
exhibit lower average costs than do small organizations. Although most earlier studies found
weak evidence of scale economies, recent research using data from the 1990s finds that cost
advantages of large firms exist for banks up to about $10-$25 billion in assets. In one study,
significant scale economies existed within each of several size classes of banks, from less
than $50 million in assets to more than $10 billion. Thus, simply by achieving larger size,
many bank mergers may have the potential to yield greater efficiency.
In addition to scale economies, there is some evidence that, after mergers, banks may
reallocate their internal resources to more profitable activities than smaller banks. As I
indicated earlier, there is also some evidence that geographic diversification by banks is
associated with a reduced level of risk, and thus there is the potential for improved safety
and soundness.
Another strand of research has attempted to discover whether there are important differences
in the efficiency with which banks use inputs to produce a given level of services. These
studies, which essentially focus on the efficiency effects of management skills, suggest that
some banks, both large and small, are just a lot better than others at using their inputs, such
as labor and capital, in a productive way. In addition, they suggest the potential for
substantial efficiency gains from mergers if management would move toward best industry
practices, although this could presumably be achieved without a merger.
In the past several years, numerous researchers have sought to determine whether past
mergers have resulted in cost savings. If so, this could be good for bank customers as well.
Many such studies examine expenses before and after the merger and, in some cases,
compare them to the same changes observed concurrently in banks that did not participate in
mergers. Other research has examined how the stock market reacted to merger
announcements. Most of these studies have not found evidence of efficiency gains from
mergers. Evidence on the relative efficiency of acquiring and acquired firms is mixed. Let
me emphasize that most of these studies are based on many mergers and thus provide the
basis for statistically valid generalizations.
A fairly recent set of case studies, by Board staff, examined nine bank mergers that were
selected for study because they were of the type that seemed most likely to yield efficiency
gains. These involved large banks generally with substantial market overlap, and most
occurred during the early 1990s, a time when efficiency was receiving a lot of attention in
banking. The studies found clear evidence of efficiency gains in only four of the nine
mergers but significant cost cutting in all nine. Finally, on the issue of efficiency, in the
evolving world of high technology and global markets for corporate banking, there is greater
emphasis on efficiency in order to survive. This factor has probably played a role in the
efficiency gains realized in some of the individual recent large mergers.
V. The Affiliation of Banks and Nonbanks and the Need for Legislative Reform

The Bank Holding Company Act also applies to the acquisition of nonbanking companies
by bank holding companies. These provisions have been the focus of much speculation in
recent weeks, so I think it is important to take a moment to discuss what these provisions
say. As an initial matter, the Bank Holding Company Act contemplates that companies that
are not now bank holding companies and that have made investments that are not
permissible for bank holding companies will decide to acquire a bank and thereby become a
bank holding company. To address this situation, the Bank Holding Company Act
specifically provides that a company may retain, for a period of two years, any investment
that the company has on the day before it becomes a bank holding company. The Bank
Holding Company Act states that the Board may extend this two-year period for up to three
one-year periods if, at the time of each extension, the Board finds that an extension "would
not be detrimental to the public interest."
This provision was more commonly relied on in the past, when larger numbers of companies
were registering as bank holding companies subsequent to passage of the 1970 amendments
to the Bank Holding Company Act. Nonetheless, it is still the law today.
Nonbanking provisions of the Bank Holding Company Act highlight one of the key reasons
why H.R. 10 is important legislation. As recently announced proposals are demonstrating,
the marketplace believes that consumers and shareholders would benefit from the
combination of firms that provide financial services beyond those permitted under the
current Bank Holding Company Act. Indeed, the Board has long supported legislative
change that would allow all types of financial service providers to exist under one roof
within the holding company framework.
To be sure, current law permits a wide range of mergers among financial service providers.
The combining of securities and brokerage firms with banks is a prime example. In this
regard, it is noteworthy that since early last year bank holding companies have either
purchased or announced their intention to purchase at least twenty four securities firms.
The fact remains, however, that current law does not permit the combination of all types of
financial services providers, and even those deals that have already been announced cannot
reach their full potential without legislation that broadens the ability of depository
institutions to affiliate with insurance companies, securities firms and other financial
services suppliers. Thus, the Board remains a strong supporter of financial modernization
legislation, and urges the Congress to pass H.R. 10.
H.R. 10 effectively addresses the need for financial modernization by allowing the
affiliation of depository institutions, insurance companies, securities firms and other
financial services providers. Critically, H.R. 10 allows broader affiliations within a
framework that provides the best insulation of insured depository institutions from the risks
of broader affiliations, restrains the expansion of the federal safety net to these new
affiliates, and assures a level playing field for companies affiliated with depository
institutions and companies that are independent of depository institutions.
As I discussed at some length earlier in my statement, H.R. 10 also includes key measures
that provide for meaningful, but controlled umbrella supervision of financial holding
companies, and that preserve and enhance the functional regulation of insurance companies,
securities firms, depository institutions and other regulated companies within the financial
holding company. In addition, H.R. 10 includes provisions designed to enhance consumer

protection and to improve disclosure of the distinction between insured deposits and
uninsured investment products.
H.R. 10 provides effective limits on the mixing of banking and commerce, all of which
should be retained. Indeed, we would prefer smaller limits for now. The mixing of
commerce and banking has the potential of spreading the federal safety net subsidy over a
wide range of activities, and of undermining the safety and soundness of insured banks.
With the prospect of financial services holding companies with greater than $1 trillion in
assets on the horizon, the Board continues to urge caution in addressing the removal of the
current legal barriers between commerce and banking. Restricting large financial
conglomerates to generating only five percent of their revenues from nonfinancial
businesses would still allow such conglomerates the possibility to purchase any one of all
but the top 250 nonfinancial companies from the current universe of nonfinancial firms. A
large financial conglomerate could own literally hundreds of nonfinancial entities without
hitting the percentage restrictions incorporated in H.R. 10 because such restrictions are
simply not very meaningful in a world of giant financial institutions. Thus, it is critical that
H.R. 10 retain its ongoing $500 million cap on the dollar amount of revenues that can be
generated by nonfinancial businesses. The Board strongly believes that now is not the time
to modify such a fundamental structural rule as the separation of banking and commerce.
There will be ample opportunity to revisit this issue in the future once the market has
adjusted to financial modernization legislation and there has been some assessment of its
value.
VI. Conclusion
The recent wave of large bank mergers and merger announcements reflects to a large degree
a natural response to new opportunities for geographic expansion and diversification as legal
restrictions are removed. The industry is moving away from a legally fragmented banking
structure toward a nationwide banking structure. The search for cost economies, pressures
brought by increased domestic and international competition, and efforts to respond to the
on-going blurring of distinctions between different types of financial services are other
important motivating factors for the current merger movement.
The increased pace of bank mergers since the early 1980s has greatly reduced the number of
U.S. banking organizations, and resulted in a substantially higher nationwide concentration
of banking assets. However, concentration in local banking markets, which is normally
considered most important for the analysis of possible competitive effects, has remained
virtually unchanged. In addition, there continues to be substantial new bank entry. In short,
the U.S. banking structure is highly dynamic, and sweeping generalizations are extremely
difficult to make.
The dynamic nature of U.S. banking means that analysis of the potential competitive, safety
and soundness, convenience and needs, and CRA effects of individual bank merger
proposals must be done on a case-by-case, market-by-market basis. The Federal Reserve
devotes considerable resources to this end, and has well-developed policies and procedures
within the context of existing law. However, the rapid pace of change in the American
banking and financial systems, and particularly the large size of some institutions, create a
number of major challenges. These challenges are particularly complex in the supervisory
area. In recent years, the Federal Reserve has moved to put increased focus on an
institution's risk management and corporate governance practices, as well as discipline
imposed by counterparts themselves, and has sought to move supervisory practice forward

in the international arena. While we believe that the current mechanisms for addressing
weak or failing banking organizations of any size are adequate, this is clearly an area that
will receive continued intense attention.
To date, the available evidence suggests that recent mergers have not resulted in substantial
adverse effects on the vast majority of consumers of banking services. It is certainly possible
that some customers have been disadvantaged by some mergers. And, mergers can no doubt
be very disruptive to bank employees as functions are consolidated and reorganized. But
research on the effects of mergers on branch closings and small business loans suggests that,
while mergers may initially result in some branch closings and possibly some reduction in
small business loans, market responses tend to offset much, and sometimes all of these
effects.
It seems clear that substantial harm to consumers would occur if mergers were allowed to
decrease competitive pressures significantly. However, market developments and the
removal of geographic restrictions on bank entry into new markets have significantly
lessened the chances for anticompetitive effects. In addition, the antitrust standards enforced
by the bank regulatory agencies and the Department of Justice have helped to ensure the
maintenance of competition.
The evidence on whether bank mergers result in performance and efficiency gains is mixed.
Greater geographic diversification appears to result in improved performance, including the
potential for greater safety and soundness. And, recent evidence on economies of scale
indicates that such economies may be achieved up to banks of moderate, but certainly not
giant size. Some mergers lead to improved efficiency, but others do not. Research does
suggest that the potential for substantial efficiency gains is there if well-managed firms take
over, and change the management practices of inefficient banks. Given the continuing
pressures for cost minimization in banking, it seems plausible to argue that some of this
potential will be realized in the future.
The ongoing and rapid pace of change in the banking and financial services industry
reinforces the need for financial modernization legislation. The Board believes that H.R. 10
provides a sound framework for achieving such modernization and urges the Congress to
move expeditiously on this matter.
Tables
Table 1 - Bank Mergers and Acquisitions, 1980-1997
Table 2 - Number of Large Mergers, 1980-1997
Table 3 - Number of Banks, Banking Organizations, and Offices, 1980-1997
Table 4 - Entry and Exit in Banking, 1980-1997
Table 5 - Shares of Domestic Commercial Banking Assets Held by Largest Banking
Organizations, 1980-1997
Table 6 - Average Three-firm Deposit Concentration Ratio (in percent) based on Insured
Commercial Banking Organizations, 1976-1997
Table 7 - Average Herfindahl-Hirschman Indexes (HHI) of Metropolitan Statistical Areas
and Rural (Non-MSA) Counties, 1976-1997
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1998 Testimony
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