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6:00 P.M. E.D.T.

Remarks by

Lyle E. Gramiey

Member, Board of Governors of the Federal Reserve System

at the

47th Annual Session


The Stonier Graduate School of Banking

New Brunswick, New Jersey
June 11, 1981

I want to discuss with you briefly this evening some
of the problems and challenges that the commercial banking in­
dustry is presently facing and will continue to face in the years

Developments in financial markets are affecting in major
ways the conduct of day-to-day bank operations,

the nature of

competition between banks and other financial institutions,


sources of funds to borrowers, and the terms and conditions on
which a wide range of financial services are provided to the public.

These developments may be contributing to a sense of
frustration among commercial bankers.

One of my friends in the

industry recently said to me, "Why should I keep my bar.v charter?
Wouldn't I be better off without it?"

Current trends in financial markets are, I believe,
seen in somewhat better perspective by looking back at what has
been happening to banking over the past three decades, and by
considering how commercial banks have fared in a financial world
in which innovation has been the order of the day.




Thirty years ago, commercial banks hung out a shingle
that said, "We accept deposits," and took whatever deposit flows

There was precious little competition between commercial

banks and thrift institutions, and almost none at all between bank
deposits and market securities.

Markets for credit were relatively

compartmentalized by type of credit instrument and geographic
location of lender and borrower.

When a borrower's traditional

source of credit dried up, he had few alternatives to turn to.

The rise in interest rates that commenced in 1951, and
has continued ever since, caused individuals and businesses to
begin searching for better ways to protect financial asset hold­
ings against loss of real purchasing power.

As time went on.

they became more and more sophisticated in financial asset manage­
ment and increasingly sensitive to differential rates of return
on financial assets.

Banks and other financial institutions responded to
these developments by creating new financial instruments and
opening new markets--often as a means of getting around deposit
rate ceilings or other regulatory constraints.

The relaxation

of regulations itself contributed to the innovational process.
So, too, did the application in financial markets of technological




advances in the fields of computers and communication, which
gave rise to automated accounting systems, computer-based cash
management models, and wire transfers of funds.

The new instruments and markets that have been created
are so familiar to all of you that I need not name them.

Let me

simply remind you that some of the new financial assets are close
substitutes for money;

others are not.

others by nonbank depository institutions;

Some are issued by banks;
others by nondepository

financial institutions, and still others by nonfinancial firms.
The financial investor now has an enormous menu of assets to choose
from and a large and growing array of chefs to prepare the
financial repast.

At banks, management of liabilities took its place
alongside investment portfolio and commercial lending policies as
a critically important element of à bank's overall financial

Liability management increased enormously the capacity

of individual institutions to control their size and to extend
credit to potential borrowers.

It also changed drastically the

source of liquidity to individual depository institutions, which
previously had been liquid debt instruments issued by someone else-often the Treasury.

Now, the principle source of liquidity is the

ability of a bank to sell its own debt instruments in the market.

Increasingly, banks and thrift institutions have become
more alike, and there has also been a gradual blurring of the
distinctions between financial and nonfinancial corporations as
the latter entered the financial service industry.


expansion in the number of effective suppliers has increased
competitive pressures even in the more isolated markets.

Competition has also intensified across national

Foreign banks have entered the U.S. in volume, and

U.S. banks have made similar inroads abroad.

Capital has begun

to flow much more freely in international markets--to both public
and private borrowers--with the result that the geographic location
of real economic activity and the financial transactions related to
it have become less closely associated.

And as the share of

exports and imports has risen in GNP, U.S. banks have become more
heavily engaged in the financing of international trade.

Interest rates have become more volatile in recent
years, and this, too, has spawned new practices and markets.
Banks and other lenders have sought to protect themselves from
interest rate risk exposure by moving heavily to floatingrate loans.

Futures markets for financial instruments are

proliferating rapidly.




The innovational process that began thirty years ago
is still sweeping through financial markets.

It cannot be halted.

I would hazard a guess that the structure of financial markets,
practices, and institutions will change as much in the next three
decades as it has in the past thirty years.

Technological change

will continue to provide new applications in the financial field.

the effects of past innovations are still far from
For example, electronic transfer of funds has reached

only a small fraction of its potential.

EFT will surely play

a substantially larger role in payments transfers in years to come.
More importantly,

the increased competition that banks are facing

from the incursion into banking by nondepository financial
institutions, and even by nonfinancial corporations,

still has

some distance to go, if developments of the past few months are
any indication.

Brokerage houses are establishing links with banks that
offer opportunities to attract funds that have not yet been fully


it would take very little for some of our

large, nationwide retailers to become merchant-financial

For example, one large retail firm has a nation­

wide EFT system, a stock S&L subsidiary in California, a credit
card with over 20 million customers, an on-line POS system,




arrangements for clearing and settling third party payments, a
full-line insurance subsidiary, a nationwide network of over a
thousand offices, and ready access to the commercial paper market.
If interstate branching were permitted for S&L's, that firm would
have an opportunity to increase the financial counterpart of its
operation enormously.

In fact, the recently announced proposal

of the FHLBB to permit interstate deployment of EFT terminals
would give its S&L subsidiary 1,000 EFT locations and the ability
to conduct financial transactions at every check-out station
with almost the flip of a switch.

These potential developments in financial markets are
not a new phenomenon.

On the contrary,

they are merely a logical

extension of trends underway throughout most of the postwar period.
We can therefore judge how commercial banks might fare in the
emerging competitive environment by seeing how well they have
adapted to change in the past.

Consider, first,

the share of credit supplied to all

nonfinancial borrowers by the commercial banking system.


banking system's share of total credit flows was 26 percent during
the past five years.

This was a little lower than the 28 percent

share recorded in the first five years of the 1970's, and lower
still than the 31 percent share that prevailed in the I960's.




But it is well above the 19 to 20 percent share of the total
that prevailed in the 1950's, when the innovations we have been
discussing got underway.

Perhaps the biggest single factor

in the ability of the banking system to increase its share of
total credit supplied since the 1950's has been the added funds
for lending obtained by commercial banks through development of
markets for negotiable CD's.

The share of the household savings flow captured by
commercial banks follows a broadly similar pattern.


holdings of currency and commercial bank deposits over the past
five years account for 34 percent of the increase in total holdings
of currency, deposits at all depository institutions, money
market fund shares and credit market instruments by the household
and nonprofit sector.

This compares with 39 percent in the first

half of the 1970's and 43 percent in the I960's.

Again, however,

the share in the past five years is substantially above the 28
percent figure of the decade of the 1950's.

Banks are not only obtaining a bigger piece of the action
than they did in the 1950's, they are also putting the funds to
profitable uses.

In the 1950's, the net income of all insured

commercial banks was about 0.63 percent of total assets.


ratio moved up to .75 percent in the 1960's, and to .81 percent


in the 1970's.


Since bank capital has risen somewhat less

rapidly than assets,
still more.


the ratio of net income to equity has risen

In fact during the past five years the ratio of

net income to equity at all insured commercial banks was more than
50 percent above its level in the first five years of the 1950's.

You might well argue that these figures do not tell the
whole story, and that a more careful look at the data would
uncover evidence of slippage in the relative position of commercial
banks in one or another areas of the financial system.


there has been some slippage in recent years, particularly relative
to the I960's.


some of the increase in earnings

probably reflects additional risk-taking.

But the record of

the past 30 years does indicate that banks have done quite woll
in a world of rapid financial innovation,
and advancing technology.

increasing competition,

I see no reason why that should not


Of course,

the rewards will be greatest for those bank

managers who can adapt most readily to a changing environment.
Banks will have to learn how to price their deposit services in
a world in which, ultimately,

there will be no ceiling rates of

interest on time and savings deposits.

They will need to tailor

their liabilities to meet the demands of highly sophisticated and




sensitive deposit customers--the small depositors as well as the
large ones.

Unbundling of bank services (a trend that is already

underway) will probably continue, and explicit pricing of
individual banking services will become more common.

The way

customer relationships are valued will therefore change.


premium will be placed on accurate determination of accounting
and service costs and on the development of profitable pricing

There will clearly be a need to stay abreast of

technological developments that help to reduce costs and to
provide better services to bank customers.

Borrowers will, I suspect, continually press for
absorption by lenders of some of the risk of interest rate

After all, borrowers don't like the ur-ertainty

of volatile interest rates any more than lenders do.


adequate funding for longer-term customer projects, while
maintaining profit margins over the interest rate cycle, will be
a central portfolio management problem for banks.

It will be

particularly critical to avoid the temptation to speculate
aggressively on the course of interest rates, a temptation that
has brought grief to more than a few financial institutions in
recent years.




If commercial banks are to maintain their position
in the markets for financial services,

they and their competitors

must play the game on a relatively level playing field with respect
to rates paid, reserve requirements and the geographical scope of
banking activities.

The Monetary Control Act of 1980 took an

important step in this direction, but it still left some things
to be done.

The ultimate goal should be to insure that

competition takes place on the basis of price and quality of
services rather than by exploiting regulatory advantages or

Let me say a few words on this score, reminding

you that I am expressing personal views and not those of the Board
of Governors.

The question is often asked whether cash management

shares of money market mutual funds, and similar

substitutes for bank deposits pose a significant problem for
the monetary control.


the answer to that question

is, I think, no.

The volume of cash management accounts is

still quite low.

Moreover, available evidence suggests that

average turnover rates for money market mutual fund shares are
very low.

In this respect, money market fund shares are more

like passbook savings accounts than checking deposits.




New financial assets that could potentially be used
for transactions purposes are, however, proliferating at a rapid

It would therefore seem to me useful if the Federal

Reserve had the power to define as deposits for purposes of
Regulations D and Q any financial asset that is properly
classified as a transactions balance.

Such a step seems to

me important for reasons of equity as well as for purposes of
monetary control.

Generally speaking, however, public policy should not
seek to close loopholes by extending regulation to the offending
instrument or institution.

History clearly indicates that such

a course of policy only perpetuates the basic problem and creates
further opportunities for other unregulated firms.

The better

solution to deal with competitive inequities in financial
markets is gradual, but steady, deregulation.

Let me close by emphasizing the importance of moving
gradually toward greater freedom for you in the commercial
banking industry to compete with your rivals in the provision of
financial services.

It seems to me obvious, as I'm sure it must

to all of you, that our thrift industry is under intense earnings
pressure at the moment and will remain so until interest rates come
down significantly.

A worsening of this problem could have serious

consequences for thrift institutions and perhaps for banks,





The more fundamental reason for moving toward deregulation
gradually is that the ultimate results of structural change in
financial markets are only dimly perceived when the structural
change begins.

The history of the postwar period indicates,


believe, that the side effects of innovational change can easily
escape us, and often do.

The task we face is to use public

policy to guide the innovational process in financial markets in
ways that contribute to a healthier, more efficient, and more
equitable financial system.

I look forward to working with you

in that endeavor.