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Before the First Annual Convention of the Ohio Bankers League, Columbus, Ohio
November 12, 2002

The Banking Industry in 2002 after a Decade of Change
Many of us began our careers in the financial services industry during an era when bank and
thrift executives saw each other as both business competitors and political foes. I distinctly
remember one experience I had as a member of the American Bankers Association's
Government Relations Committee in 1979. At our first meeting of the year, the
"quarter-point differential" that thrift institutions were allowed under Regulation Q was the
banking industry's top political priority. For those of you too young to remember, Regulation
Q established the maximum allowable interest rate that could be paid on deposit accounts,
which at the time was a quarter point higher for thrifts. This first annual meeting of the Ohio
Bankers League following the merger of Ohio's banking and thrift trade associations is
emblematic of the changes that have taken place in these two industries. And this event
presents a good opportunity to review today's depository financial service industries in the
context of a decade of major change. To begin, let's review the highlights of the past decade.
First, there was the bank and thrift crisis of the late 1980s and early 1990s. Many banks and
thrifts failed, and many others were weakened to the point that they became acquisition
targets. The Congress and the regulators responded forcefully with the Federal Institutions
Reform, Recovery and Enforcement Act (FIRREA) in 1989, and the Federal Deposit
Insurance Corporation Improvement Act (FDICIA) in 1991. These legislative initiatives
restricted banking practices, limited the supervisors' discretion in dealing with weak banks,
imposed new regulatory requirements--including prompt corrective action--and strengthened
supervisory oversight overall.
Beyond the bank and thrift crisis in this country, there were also indications that banks of
other nations followed different norms of capital adequacy, which had implications for
competitive equity and for the overall soundness of the global banking system. The G-10
nations responded with the Basel Accord, a single, fairly simple global standard that was
implemented in the early 1990s. The Basel standards have become somewhat less simple
over the years and are again under review. But achieving international agreement on both
components of capital and a risk-based approach to capital adequacy was a major
achievement.
A second force for change was the growing integration of banking markets, both
geographically and functionally. Through the 1980s and the first half of the 1990s, the
various states were liberalizing or eliminating their restrictions on interstate bank ownership.
At the same time, nonbanks aggressively developed and offered products that could compete
directly with banking products.
The Reigle-Neal Act of 1994 was the epilogue to the saga of interstate banking, eliminating
the remaining barriers to interstate ownership and interstate branching. As a result, in an era

of consolidation and innovation, banks could pursue merger partners and branching
strategies on the basis of economics rather than geography while also consolidating and
rationalizing their own legal structure.
The boundaries between banking products and other financial service offerings have also
become less clear. Over the past decade, banks were increasingly interested in providing the
full range of products and services available from their nonbank competitors, to create
operating efficiencies, diversify potential revenue sources, and allow these banks to compete
effectively with other [nonbank] full-service financial services firms. The bank holding
company structure was one vehicle for doing so, especially securities underwriting and
dealing through section 20 subsidiaries. Although revenues from bank-ineligible securities
activities were initially limited to 5 percent of a BHC's income, the Board subsequently
increased that limit to 25 percent. At this higher level, we began to see significant merger
activity between securities firms and bank holding companies.
In 1999, the Congress passed the Gramm-Leach-Bliley Act, arguably the most significant
banking legislation in the last quarter of the twentieth century. It dismantled much of the
Glass-Steagall Act, which for more than fifty years separated the banking and securities
industries.
The most significant changes, however, did not occur in the Congress. Indeed, they occurred
in the marketplace. We experienced unprecedented change, from innovation in market
practice to new technologies that created new products and financial vehicles. In the
process, we also spawned a new generation of more sophisticated and rigorous
risk-management practices. The expansion of securitization and derivative markets allowed
for management and transfer of risk, which in turn created opportunities for banks to
specialize increasingly in those phases of the financial-intermediation process in which they
have an advantage, while also offering new hedging and risk-management opportunities.
Finally, it is important not to overlook a fourth force for change, a decade of economic
prosperity that provided a rich context for growth and opportunity in the banking industry,
and for financial markets more generally. This prosperity was fueled significantly by capital
investment in information technology and in telecommunications capabilities. Ongoing
advances in technology, related in part to this investment, further supported the level of
economic activity. The resulting structural improvements in productivity allowed for
significant growth both in output and in compensation to workers, who in turn could acquire
consumer goods and make financial investments in debt and equity markets.
Given the magnitude of the changes over the past decade, how does the reality of the
current industry status compare with our expectations of ten years ago? Let's start with the
thrifts. Many, if not most observers expected the thrift industry to struggle, perhaps never
fully recovering from the problems of the 1980s and early 1990s. Indeed, the future of any
financial institution that specialized in originating and holding residential mortgages seemed
somewhat murky. By the same token, many anticipated that the banking industry would be
reined in by heavy regulation, the new regulatory capital standards, and--perhaps-significant aversion to bold new initiatives. And many expected that gradual movement
toward broader interstate banking would bring about massive consolidation in the banking
industry that would raise serious questions about the future of community banks and the
value of the community banking franchise more generally. Broader interstate banking also
raised questions about the viability of the dual banking system, and the state banking charter
in particular. Technological improvements were expected to dramatically reduce the use of

checks and cash. Bricks and mortar branches were thought to be anachronistic, if not actual
impediments, to operational efficiency. Well, as you all know, forecasting is a difficult
business.
In the thrift industry, there has certainly been consolidation. There are now significantly
fewer, but bigger, thrifts. As of June, there were just under 1,000 thrifts, with total assets of
$960 billion compared with 1,952 thrifts with assets of $839 billion in 1992. The average
thrift now has assets of about $960 million--more than twice the average of $430 million in
1992--and has an annual growth rate of more than 9 percent. Over this period many thrifts
merged with each other while many others became part of bank holding companies, some of
these operating as thrifts. Some of those were Ohio thrifts that were acquired by major banks
in the late 1980s in the wake of the state deposit insurance crisis.
Today, the thrift industry continues to be strong and viable. In 2001, the industry generated
$10 billion in earnings, or a return on assets of about 1.09 percent--both about five times the
comparable figures for 1992. The extent to which the banking and thrift industries are
intertwined may be best reflected by the fact that 34 percent of savings institution deposits
are now BIF-insured.
The banking industry too has experienced consolidation, as the number of insured
commercial banks declined from about 11,450 in 1992 (with total assets of $3.5 trillion) to
about 7,960 in June of this year (with total assets of $6.7 trillion). Interestingly, the average
bank then, as now, was about $120 million smaller than the average thrift: $310 million in
1992 compared with $840 million as of this June. Banks have grown both organically and by
merger, in many cases combining multiple bank subsidiaries of the same BHC for efficiency.
These aggregate figures mask some significant differences between large and small banks.
Total assets at the largest banks--that is, those larger than $10 billion--grew most rapidly,
reaching $4.7 trillion compared with $1.4 trillion in 1992. That represents an annual growth
rate of nearly 14 percent. One has to be a little careful when comparing size categories over
a period of this many years. Over this period the number of banks over $10 billion grew by
half--from 51 to 77--because some smaller institutions were able to grow or merge their way
into this largest-size class. The advent of interstate banking provided important impetus to
this process, as noted earlier.
In contrast, total assets at all community banks--that is, those with less than $1 billion in
assets--have remained essentially unchanged since 1992, at just a bit above $1 trillion. Total
assets at regional banks--those between $1 billion and $10 billion--actually declined over
this ten-year period, falling from about the same level as community banks, to about $900
billion. The number of regional banks fell just slightly over this period, to about 320, while
the number of community banks fell quite sharply under the influence of consolidation.
Despite the consolidation in the banking industry, more than 8,000 separate banks [and
1,000 thrifts] remain, and for every four bank charters that have disappeared through
consolidation, one new de novo charter has been approved. While the number of banks has
declined, the number of bank branches and ATM machines has consistently increased over
the past decade. As for the future of state banks, 75 percent of all new charters are state
bank charters. The dual banking system, which is such an important part of our financial
heritage, continues, thanks in significant part to our nation's state banking commissioners,
who responded to the Reigle-Neal legislation by developing home/host state bank
supervision accords, which facilitated banks' wanting to branch across state lines.

Let me focus for a moment on the performance of commercial banks. Across all size
categories, the banking industry continues to perform well, with strong capital and strong
balance sheets. Total bank profits are at record levels, having reached $73 billion last year,
and are on track for even better profits in 2002. In 2001, the industry's return on assets came
in at 1.16 percent, 20 basis points better than in 1992. Community banks came in just a bit
below the industrywide total--at 1.10 percent, about the same as the average thrift. This
year, banks--especially community banks--have been aided by low interest rates and the
accumulation of core deposits, together with more recent and modest resurgence in loan
demand.
Efforts to improve earnings on equity have also resulted in differences according to bank
size. The largest banks have most aggressively worked to improve their efficiency ratios and
expand their sources of non-interest revenue. Not surprisingly, these banks have experienced
the most improvement in their returns on equity. The smaller banks have had a much more
stable return on equity--at relatively high levels, I might add. A close examination of
community bank performance reveals a wide range of efficiency ratios among traditional
community banks, some of which have efficiency ratios under 50 percent. The changes in
return on assets among various size categories offer a somewhat different twist. All else
being equal, increases in capital will result in improved returns on assets. Indeed, the banks
with the most significant increases in capital are also the banks that have realized the largest
improvement in return on assets.
Mortgage-related banking continues to be attractive, particularly in this interest rate
environment. Although it has taken some toll on the value of mortgage-servicing rights, the
recent boom in refinancings has provided a nice source of fee income. However, acquiring
long-term, fixed-rate assets can also be a risky business, as we all know. Fortunately, bank
and thrift managements have learned much from their experience of a decade or more ago,
and financial innovation and advances in risk measurement have also helped. Financial
institutions are much more aware of the complexities associated with mortgage-related
activities than in earlier years and now have at their disposal better tools for measuring and
managing their risks. We hope that interest rate risk will never again be the problem for
depository institutions that it was for some in the 1980s.
Asset quality remains an area for attention today, with nonperforming assets at 1.16 percent
of loans and about 8 percent of tier 1 capital and reserves. These figures simply do not
compare with those of 1992 but tend to attract a supervisor's eye. Even at community banks,
which have not been affected so much by the recent spate of highly visible problem
borrowers, problem assets have increased to nearly 1 percent of loans and 6 percent of their
capital and reserves. Reserve coverage of problem loans also declined, to about 1.6 times
problem loans compared with about 2.0 times for 2000. The number of problem smaller
institutions has increased, and the costs of several recent bank failures raise the specter of a
return to significant insurance premiums.
While on the subject of the 1990s, I should note that bank lending to finance commercial
real estate has grown rapidly in the last several years, especially among regional and
community banks. As of June, community banks had about one-third of their loan portfolios
in construction and nonfarm nonresidential lending, compared with about one-fifth ten years
ago. Commercial real estate lending is, of course, a natural part of the community banking
business. Although few institutions have yet encountered material problems in these
portfolios, declining occupancy rates in some markets increases the risk. Underwriting
practices have been much stronger than in the 1980s, but the level of concentration at

regional and community banks is something that both supervisors and prudent bank
managers should monitor closely.
Let me also make a brief cautionary note about the importance of good internal controls,
and the need for management attention to their upkeep. This is simply good business
practice, of course, but it's more than that. You may recall that a provision of the FDIC
Improvement Act of 1991 required that banks--including many community banks--have
external auditors attest to the quality and integrity of internal controls, as part of their
broader program of evaluating and testing these processes. Unfortunately, in several recent
examinations, bank examiners were able to identify clear internal control weaknesses that
neither the banks' own processes nor outside auditors had noted. Some of these weaknesses
raised safety and soundness concerns. Much more progress needs to be made in this area,
and we will be following this matter closely in the coming months.
Overall, it is clear that U.S. depository institutions, including commercial banks, stock and
mutual thrifts, remain sound, with still historically strong profitability, capital ratios, and loan
portfolios. Without becoming complacent, the industry can take comfort, so far, that it has
withstood the last decade, and the more recent economic weakness, quite well. That said, it
will be important for bankers to stay on top of their asset quality and internal controls. The
increased sophistication in technology and product development has actually increased the
need for these controls.
In conclusion, I would like to thank you for the opportunity to discuss these issues with you
today. The past decade has been a time of dynamic change in the financial services industry
and there are no signs that the pace of change will abate. The challenge for regulators and
the industry is to revisit our assumptions, views, and policies frequently and to respond in a
manner that continues to ensure a sound and competitive financial system.
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2002 Speeches

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Last update: November 12, 2002