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Remarks by

Preston Martin
Vice Chairman
Board of Governors of the Federal Reserve System


The Securities and Exchange Commission's
Conference on Major Issues Confronting the Nation's
Financial Institutions and Markets in the 1980s
Washington, D.C.
October 7, 1982


I am pleased to be here tonight to comment on the many changes that
are taking place in the banking system as a great wave of innovation sweeps
through the industry.

I will attempt to provide some perspective on innovation

and its causes, and will discuss some of the consequences of the changes we
are experiencing.

Because many of the issues being discussed at this conference

are clearly products of the innovations occurring in the financial industry,
I will touch on some of the related regulatory problems.


Lest we think that the current period of financial innovation
is unusual, note thait innovation is an unique and integral part of the free
market economic system.

The drive to maximize profits in the long run creates

an incentive to innovate.

The lack of a similar mechanism to encourage the

development of new products and methods of production is a frequently cited
criticism of the centrally planned economies and bureaucracies.
In his analysis of various types of economic systems, Joseph
Schumpeter, the Austrian-born Harvard economist, placed great emphasis
on the role of innovation in the free market economy.

He advanced a theory

of creative destruction of old products and methods in favor of new and
improved goods and means of production.
Schumpeter pointed out that change often comes from firms in related
fields, or even from outside the industry, rather than from within an industry.
The impact on the banking system of money market funds is quite consistent
with Schumpeter's analysis.




Moving beyond the normal competitive forces, we can identify
other factors that are somewhat more specific to current innovations in the
financial industry.

Certainly persistently high and fluctuating interest rates

have played a leading role, as the spectacular growth of the money market
mutual funds so vividly demonstrates.
Yet, by themselves, high interest rates are not a unique cause
of change.

Rather, innovation has been generated by the combination

of high market interest rates and the Regulation Q ceilings.

The traditional

depository institutions have been prevented from paying market rates on deposits
and a profit making opportunity was created for money funds and other investments.
In other countries, where institutions were not similarly constrained, high
interest rates did not lead to the development of new nonbank financial products.
In analyzing the roots of financial innovation, we must also mention
the impact of technological change.

Innovations have been facilitated by the

revolutionary developments in data processing and communications.

For example,

the electronics revolution is making possible, the rapid expansion of new financial
service delivery systems, such as automated teller machines and point of sale
terminals, Fedwire, Bankwire, Clearing House Interbank Payments System (CHIPS)
and Society of Worldwide Interbank Financial Telecommunications (SWIFT).
McLuhan's global village is here.
There are very few barriers to the introduction of new technology for
the provision of lower cost or different, but equal cost, financial services.
The innovations are not destroying the economic value of older capital invest­
ments, but are expanding the markets in some ways.

Unlike innovations in

manufacturing, which have resulted in enormous quantities of the U.S. "plant”




becoraing economically obsolete before it is physically obsolete, the financial
services delivery revolution is occurring in an area of the industry that has
not been capital intensive.

Computers are being reprogrammed to provide new

types of accounts or new services.

New delivery vehicles, such as ATMs, can

replace functions of brick and mortar branch offices.

The decision of bank

management to maintain extensive branch networks to maintain market share
in "retail" banking has become the most important strategic decision.
In summary, we have a wave of innovations resulting from the
confluence of a series of factors.

In addition to intra- and interindustry

competition, innovation is propelled by high interest rates, altered law and
regulation, perceived high profit opportunities, technological developments
and the low barriers to the deployment of new technology.


Having considered some of the causes of financial Innovation,
let us consider some consequences in the areas of financial change,
structural change, regulatory change, and monetary policy.

Innovation and Financial Change
The list of financial changes resulting from innovation seems
virtually endless when we compare the present to the early 1960s.

We are

all familiar with the rapid increase in the types cf financial instruments
now available to consumers and the benefits consumers have received
from the development of new financial services, such as sweep accounts,
NOW accounts and money fund accounts.

The consumer has also benefited




frota the availability of more financial services from the thrift industry
and nonbank financial firms.
Also on the positive side for consumers, innovation has brought
the return on savings to a market determined level.

Freed by the money

market mutual funds from the artificially low interest rate ceilings imposed
by banking law, small savers can obtain a market rate of interest.

The subsi­

dization of borrowers by savers, which occurred when market interest rates
exceeded Regulation Q ceilings, is being wiped out by innovation and deregulation.
Consumers will also be impacted by a significant change in mort­
gage financing mechanisms.

Home financing costs, which tended to be the bene­

ficiary of the low interest rates paid to small savers, will be in a less
advantageous position as the returns to savers rise to market levels.


the loss of this subsidy from savers will not be popular with borrowers.


if society wishes to subsidize home ownership, society in general should assume
more of the cost.

I don't think that the subsidy should come only from the

While interest rates were low and stable and consumers had few sav­
ings options, the thrifts could borrow short from depositors and lend long to
home owners.

But, that system resulted in the thrifts assuming massive amounts

of interest rate risk.

Now that interest rates are very high, the yield on

their mortgage portfolios is less than their cost of obtaining funds and
thrift institutions are suffering massive losses of capital.

In the future,

there must be a greater sharing of interest rate risk between the mortgage
lender and the borrower.

This is not a welcome change for the borrower.

But, it is probably necessary if we are to have both a viable system of long



term home financing and a set of financially stable thrift institutions.
Business firms have also experienced expanded financial service
options, especially in the area of cash management techniques.

The incentives

provided by high interest rates have led to the development of new ways
for the business firm to minimize its idle balances.

These changes have led

to a restructuring of their competitive position by several banks with a few
banks deemphasizing their consumer business in order to specialize in servicing
business customers, while others are emphasizing service to specific consumer

I would expect more of these specialization experiments as banks

attempt to find their own niches in the market.
Turning to a second area of financial change, it appears that inno­
vation is converting the source of bank funds from traditional core deposits
into purchased money.

Many institutions that once operated on a stable supply

of locally-generated deposits are now being forced to compete for funds
against the national money markets.

To obtain funds, banks will have to pay

market interest rates on an increasing proportion of their liabilities.
Increasingly sophisticated suppliers of funds will place a premium
on bank liquidity and soundness.

The bank that is perceived to be weak or

poorly managed either will not be able to raise funds or will have to pay
premium rates.
The final financial factor that I will cite is the likelihood
that more banks will experience financial strains in the future.

I say this

not to create alarm, but to point out that by opting for deregulation,
we have also opted for a riskier banking system.

This is part of the price

that we pay for a competitive free enterprise system.

A highly competitive

-6 ~
system paying market determined rates of interest is going to experience more
financial strains than a system protected by barriers to competition and
paying below market interest rates.
We might conceivably have chosen to maintain the old system by
extending regulation to all the new financial services and financial firms.
By not extending regulation, we implicitly decided that the social cost of
more and more regulations on more and more firms was likely to be higher than
the social cost of resolving more problem institution situations.

The die was

probably cast with our decision not to regulate the money market mutual funds'
interest rates or investment characteristics.

If the money funds and the

other nonbank financial firms had been brought within the scope of bank regulation, it might have been possible to maintain the old system longer.
However, a tightly regulated banking system subject to Regulation Q could
not coexist with unregulated nonbank firms.

Once the decision was made to

permit the continuation of the unregulated sector, the pressures to deregulate
the banking system increased.
In the more competitive future environment, the regulatory efforts
of the supervisory agencies will be supplemented by the discipline of the market.
The partial loss to the uninsured depositors in Penn Square has already made
the suppliers of funds more aware of their responsibility for evaluating bank

The information for making these evaluations is available.


fore, agency examinations, rarly warning monitoring systems and the discipline
of the marketplace should combine to discourage institutions from taking the
excessive risks that lead to financial difficulty.

When all systems within the banking sector fail, the FDIC




is adequately capitalized to protect the small depositor, and the Federal
Reserve System functions as a lender of last resort, when it is appropriate
for it to do so.

The key, of course, is that the confidence engendered by the

FDIC's existence prevents the spread of panic, as I think was demonstrated pointedly
by the Penn Square experience.

Structural Changes Resulting from Innovation
Moving on from the unpleasant subject of financial problems, let us
look at some changes in the structure of the financial system.

Except for

the thrift industry, there has been less structural change than most
observers were forecasting twenty years ago.
Beginning with commercial banking, the bank holding company move­
ment has been part of the process of change.

The one bank holding company

permitted the expansion of banking organizations into permissible nonbank
financial activities.

Because these activities were customary and usual

practices in banking already, very little real product diversification was
achieved by this route.

In terms of geographic diversification, the one

bank holding company did allow organizations to expand their activities on an
interstate basis.

While a bank cannot operate banking offices in other states,

its sister holding company affiliates in mortgage banking or consumer finance
can expand without regard to state boundaries.
The multibank holding company offered the route around restrict­
ive branching laws in some states. In other states, it was the transition
vehicle between a unit banking system and statewide branching.

Now, in a

movement that will probably not become a major short run trend, three states

have chosen to permit entry by out of state bank holding companies.

The 1975

recodification of the Maine banking code allowed entry by bank holding compan­
ies headquartered in states extending reciprocal entry rights to Maine bank
holding companies.

Recently, New York and Alaska adopted interstate banking

Alaska's law, the most liberal yet, does not require reciproc­

al entry rights.
Each of these three states appears to have had a different motiva­
tion for interstate banking legislation.
new funds for economic development.

In Maine, the goal was to attract

Alaska's bill appeared to be an attempt

to get ahead of the rest of the nation, while New York's law seemed to be
inspired by the expansion desires of the large New York City banks.
I hope that the interstate expansion resulting from these laws
will be procompetitive and result in an increased number of organizations
competing in each state.

There would appear to be few consumer benefits

if interstate banking simply means the acquisition of a large local firm
by a large out of state firm.
A second major structural innovation is the rapid development
of local and regional ATM networks.

We appear to be nearing the establish­

ment of a number of nationwide networks of teller machines.


not providing full interstate banking, the ATM networks will permit the consumer
to obtain funds from his bank accounts while he is outside the market area of
his bank.

The legal and antitrust issues posed by these networks are not fully

resolved as yet, but this development could represent the start of a
movement toward more extensive interstate banking activity.

that the innovations of recent

-9years will lead to a consolidation of the financial system into a relatively
small number of very large nationwide financial organizations.

But, there has

not been any demonstration of the need for this potential reshaping of the
banking system.

The services and technology that the smaller banks cannot

develop on their own are available from outside vendors.

While very few banks

have the capacity to expand on a nationwide basis, there is nothing to preclude
a system of various size banks, such as now exists in California.

While the

largest organizations will compete in many markets on a national or regional
basis, they will have to compete with local institutions in each of those
The restructuring effects of innovation have been much greater
in the thrift industry than in commercial banking.

Even with the thrift

assistance provisions of the Garn bill, some further restructuring will
probably take place.

In the long nan, if there is to be a stable set of

thrift institutions, I doubt the industry can ever return to its traditional
operating procedures.

The mismatching of asset and liability maturities

that was possible in a highly regulated system simply is not viable in a
deregulated environment.
The expanded lending powers of the thrifts and the gradual consumer
acceptance of variable rate mortgages will enable the thrifts to increase the
yield responsiveness of their portfolios to changes in market interest rates.
But, the thrifts must also extend the average maturity of their deposits, if
they are going to resume their historic role in home financing.

The longer

average maturity of thrift assets permits them to offer a longer maturity
fixed rate deposit instrument.

I think that the thrifts should develop

-10attractive long term consumer savings plans because, unless longer term
fixed rate deposits are secured, thrift earnings will continue to vary widely
over the interest rate cycle.
The final structural change that I will mention here is the provision
of financial services by nonfinancial firms.
the nonbank financial firms.
over banks and thrifts.

Much has been written about

3eing unregulated, they do have some advantages

But, by virtue of their desire to avoid regulation,

they cannot provide all of the products of the full service commercial bank.
In addition, do they have expertise equivalent to that accumulated by the banking

Will they be able to persuade consumers to buy their stocks where

they buy their socks?

While there is certainly a reasonable fear of these

new competitors, they have a long way to go before they will be able to
establish a track record that will endanger the competitive position of the
banking industry.
On a more general level, the entry of nonbank firms into the provision
of bank type services raises the issue of the separation of banking and commerce.
We should not give up this traditional separation without a careful reexamination
of the original reasons for the policy and the implications of commingling
banking and other lines of commerce.
The money market mutual funds clearly are different than many of the
nonbank suppliers of financial services. The funds were established by existing
financial organizations, many of which already operated a variety of mutual

They had the expertise and operating systems necessary to attract

billions of dollars from the banks and thrifts.

Yet, much of their success

is based on exploiting the regulation of deposit interest rates.

When the




banks are able to offer a competitive instrument and deposit insurance as
well, the thé money market funds may lose a good deal of their current

I would expect there to be at least a partial flow of funds

back to the banking system when the phase out of Regulation Q is completed.

Regulatory Changes Resulting from Innovation
Moving to the topic of regulation, I would like to say a few words
about the impact of innovation on bank regulation.

Although we are deregulat­

ing and trying to maintain the competitive position of the banking industry,
we must not lose sight of the fact that the public expects the banks to be a
safe haven for their funds, and expects the bank regulatory agencies to make
sure that the banks are living up to that obligation.

Thus, as we deregulate

and produce a somewhat more risk-prone banking system, the responsibilities of
the regulators increase.

At the same time, however, we want to reduce the

total burden of regulation, only some of which is associated with bank soundness.
Balancing all of these objectives is going to be difficult.
While both the banks and the bank regulators want to avoid financial
difficulties, each new problem teaches everyone a new lesson about risks to be

For instance, the problems arising from the mismatching of asset

and liability maturities have caused the development of new monitoring techniques.
Simple computer programs are now available to assist bank management in
controlling this type of risk exposure.

All of us must attempt to anticipate

the development of new problems and learn new solutions to those new problems.
From today's conference agenda, I know that you have heard many
specific issues of financial regulation discussed.

The changes and innovations

-12in the financial marketplace do necessitate a rethinking of the regulatory
As the memorandum for this morning's first panel discussion
noted, we do have a large number of federal and state agencies regulating
specific segments of the total financial industry.

This has always been the

case, however, and I would not assert categorically that this diversity of
regulation is all bad, even though it may not conform to a neat functional
organization chart.

For example, it may well be worthwhile for an activity to

be regulated differently when it is performed by a bank than when it is
performed by a nonbank.
Much of the current justification for regulatory change is probably
based on the commonly held view that the financial industry is going to
become increasingly homogenized in the near future.

By this popular

view, all financial firms will soon produce all financial products.


a few firms will indeed produce nearly all financial products, I am not
convinced that all firms will produce all products.

In ten years, I think

that we will find that most banks are still basically providing traditional
banking services, just as most insurance companies will still basically
provide insurance.

Having these reservations about the homogenization

hypothesis, I would hesitate to make sweeping recommendations about the
reorganization of regulation along functional, rather than institutional,

This caveat, however, does not justify the clear regulatory

inequities that may occur because of divided regulatory responsibilities.
As a final point on regulation, I would suggest that in your
deliberations you should not overlook the potential role of the market-

-13place as a regulator of financial activity.

Given the freedom to operate

and the appropriate information, the market can be the most efficient
regulator of all.
who do not.

It will reward those who manage well and punish those

While it does not require any regulatory structure, the market

is still the best arbitrator of economic performance and will ultimately
determine the extent to which the predicted homogenization of institutions
will take place.

Monetary Policy
Innovation has undoubtedly complicated the process of conducting
monetary policy.

The development of new payment instruments, both inside

and outside of the banking system, requires periodic redefinitions of the
various money supply measures and loosen? the relationship between money and

The shifting of funds between types of payment accounts causes

particularly difficult problems of interpretation during transition periods.
Technological improvements to the payments system tend to increase the velocity
of the money supply and permit a smaller money supply to support a larger
volume of payments.

The behavior of the monetary aggregates still seems to

me to be the best monetary policy guide available, as long as one is
cognizant of the propensity for fluctuations and short run distortions
of the aggregates.
Innovations in payments systems and savings instruments also compli­
cate economic forecasting.

Econometric models, used by the Board and other

forecasters, are based on past relationships among variables and changes
in those relationships reduce the reliability of forecasts.

Old relationships

may no longer be relevant, or the magnitude of mathematical relationships

-14among variables may change.

For example, interest rate fluctuations in recent

years have been much greater than in the years on which most models are based.
Before leaving the topic of monetary policy, I ’d like to comment
briefly on some current initiatives In Congress which would explicitly
require targeting interest rates as a monetary policy goal.

Some versions

would have us focus on so-called real interest rates, that is, interest
rates adjusted for inflation expectations.

In addition to a multitude

of technical problems— like defining the appropriate rate and managing to
control it— it seems to me that these suggestions generally have more
fundamental and dangerous flaws.

Importantly, we must ask whether in

today's environment the Fed can simply push interest rates down without
running a serious risk of stimulating inflationary monetary growth.
answer clearly is no.


These proposals no doubt reflect a genuine and

understandable wish to lower the cost of credit.

One must be extremely

careful, however, to distinguish between serious technical discussions
about monetary targets and recommendations that would merely shift current
policy objectives toward easy money.


To summarize, I have tried to emphasize the important role of
innovation in our economy in general and in our financial system in

Perhaps we will pass through the current wave of change

and things will settle down again.
cope with all of this change.

But, in the meantime, w? must attempt to

Each new development must be analyzed in terms

of its potential effects on the total financial system, including the maintenance
of a viable and competitive banking system.