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Mardi 9, 1984




DARWINISM AND THE ECONOMIC EVOLUTION

Remarks by Preston Martin

Vice Chairman
Board of Governors of the Federal Reserve System

at the

Ccrmonwealth Club of San Francisco

San Francisco, California

March 9, 1984




DARWINISM AND THE FINANCIAL SERVICES EVOLUTION

California

is truly a laboratory filled with plen­

tiful evidence of the rapid evolution of

tions

of

all types.

embedded in the

financial

institu­

The evidence is not fossilized remains

strata

of

previous

stages

of

evolution:

rather it comprises a 60-year record of financial innovation.

Since

the

1920s,

California

has

led the way in

branching systems for institutions, a cornucopia of

consumer

services, successful retail banking, and innovations in mort­

gage lending and mortgage-backed securities.

Continuing

in­

novations in providing ccmnunity-backed financial services is

evidenced by the plethora of successful

de

novo

cannercial

banks and thrift institutions in the face of intense competi­

tion by existing institution management.

Far from being a fossil from a bygone era, the com­

munity

bank may be emerging as a principal competitor in the

financial services industry.

If cannunity bankers choose the

2

right niche, and a correct combination of strategic and

tac­

tical alternatives, community banking will continue to evolve

into one of the stars in the firmament of banking.

will prevail:

The

the race is won by adaptation.

structure of cannercial banking is no longer a

subject for the technician or

States

the

specialist.

The

of

services

of

goods whether manufactured or harvested.

in part, this is a function of the plethora

of

services,

Of course,

governmental

which the "public" demands through its elected rep­

resentatives. The consumption of financial services

creased

United

has became a service economy, one in which most of us

are employed in the production and consumption

not

Darwinism

markedly

over the past decade.

has

We have a sharpened

awareness of the costs of borrowing and the opportunities

incane fran savings and from financial investments.




in­

of




3

Inexorable

market

forœs have carpe lied financial

institutions management to change and

adapt.

For

sane,

a

major objective is to become a "financial supermarket."

This

objective is understandable as comercial bankers

wit­

nessed

the

loss

have

of market share to thrift institutions and

money market fund managers in deposit markets.

Deregulation

of deposit instruments has enabled a recapture of sane of the

share loss to the money market funds but at rising costs

funds.

The blurring of the lines between and among different

kinds of financial institutions leads management

gies

of

to

strate­

providing financial services as well as traditional

banking to its

most

for

obvious

increasingly

example

is

sophisticated

the

customers.

The

discount brokerage now being

offered in one form or another by many of the

cial banks and thrift institutions.

large

commer­

4

Perhaps

helpful.

thal

a

reference

to a Darwinian matter may be

Europe was inhabited only by humans of the Neander­

type

35,000

years

ago.

Dr. Robin Torrance has been

cited by the London Econcmist as pointing toward

tors

which

to

Sheffield argues that the Neanderthals did

very

fundamental

environmental

modem man prevailed through the means

ticularly

weaponry.

Is

the

of

computer

arrow

in

not

changes and that

technology,

and

par­

comnunications

equipment the equivalent of the throwing spear

and

fac­

caused Neanderthal man to be replaced by modem-

looking man.

adapt

those

and

today's survival of the fittest?

the

bow

I think the

analogy is a bit strained here.

This is not to deny that one-stop shopping for

nancial

services does not have its advantages, but there are

disadvantages. Indeed, it is not completely clear

small




fi­

institution

that

the

cannot through franchising, leasing lobby




5

floor space, and other joint participation techniques provide

a multiplicity of financial services.

Furthermore, financial

services supermarkets will offer different products of

ing

convenience

and quality.

It is a rare management which

is equally competent in several fields.

may

offer

several.

with

a

single

insurance

it

affiliated

another may offer

with

full

Already sane commercial

service

research departments while others

brokers

carrier,

with

bank

funds

is affiliated, another may specialize in no-

load or tax-advantaged types.

are

One commercial

One bank management may sell only the mutual

which

vary­

brokers

are

with expensive

related

a purely order-taking function.

banks

to

discount

As the evolu­

tionary process stimulates adaptation, the odds are that each

cotmercial

bank

or

thrift

will

offer

some services in a

really competitive way and other services which

tained

elsewhere

advantageously.

The

can

be

ob­

conclusion is that

6

the financial services supermarkets of the

future

will

not

eliminate the ccmnunity bank from all submarkets or even from

most.

It is instructive to review the

from which

tomorrow's

canmunity

current

situation

bank will evolve.

Let us

examine the record in terms of the following characteristics:

o

profit performance,

o

growth,

o

economies of scale,

o

technology, and

o

risk.

PROFIT PERFORMANCE

Today's community banks, those under

assets,

generally

larger banks.

measured




by

$100

have a higher return on assets (ROA) than

They also appear to have a lower risk position

capital ratios and liability structures.

half 1983 profit statistics indicate that the banking

as

million

First

system

a whole had an ROA of 0.75% while canmunity banks had an




7

ROA of 1.18%.

0.54%.

Large money center banks had an

ROA

of

on.lv

What happens to the profit of a comnunity bank when a

subsidiary of a large bank holding company enters its submar­

ket?

There is evidence that in many markets the profitabil­

ity of connunity banks is not significantly affected.

"bottom

line"

connunity

At the

banks have demonstrated a credible

track record at this stage of their evolution.

GROWTH

A number of current studies substantiate

that

the

rate of growth of connunity banks has generally exceeded that

of large banks; especially banks with assets over $1 billion.

A

more

important

observation

is that generally the growth

rates of connunity banks do not appear to be affected by

entry

of

larger

competitors

the

into their submarkets whether

through acquisition or on a de novo basis.




8

Submarket entry by larger banks, of

to

increased competitive pressures.

course,

leads

However, it may be that

a resulting shift in management practices of canmunity

is generated by enhanced carpetition.

munity bank managements

their

market

often

can

More importantly, can­

stimulated

to

increase

share as a result of this competitive process.

The message appears to be that

banks

are

banks

respond

to

management

competitive

of

same

smaller

challenges posed by new

large market entrants.

ECONOMIES OF SCALE

The jury is still out on the

economies

of

scale

banking industry.

costs

have

are

question

of

whether

generally important to the overall

In retail banking with multiple

mitigated against such economies.

branches,

However, some

studies have shown that average operating costs (as a percen­

tage

of

assets) appear to decline in banks with deposits of

9

up to $75 million.

phenomena

until

Thrifts appear

deposits

to

reach $500 million.

company affiliation appears to have an

on

overall

experience

operating costs.

the

same

Bank holding

insignificant

affect

As retail (branch) business is

succeeded by AIM networks or by banks stressing a "wholesale"

banking

format,

the

subject

will require new studies.

this stage, however, the case has not yet been

sively

that

made

At

conclu­

bigger is necessarily better in all submarkets.

Cbviously there are national markets and

international

mar­

kets not open to the smaller community-based institution.

TECHNOLOGY

Today

we

stand

payment system network of

whose

settlement

on

the threshold of a world-wide

almost

infinite

complexity,

processes can be in microseconds and whose

observation is or soon will be on a real time

basis.

dollar

the




payment

one

networks

such

as

Fedwire,

New

Large

York




10

Clearinghouse CHIPS system,

international

flows

by

SWIFT,

handle balances measured in the trillions of dollars not just

the billions.

is

paying

Certainly it is true that the ccmnunity banker

more for his funding these days, 150 to 200 basis

points, and he is faced with

competition

tends to hold down his margins.

for

loans

Add to that the necessity of

capital investment to keep up with 'technological

his

survival

appears

which

threatened.

change

Fortunately, the capital

investment is becoming easier as hardware and software

decrease.

Also,

through their auspices.

cards are good examples.

of

travelers

costs

many services that cannot be produced eco­

nomically by community bankers can be distributed by

vendors

and

outside

Travelers checks and credit

While there are only a

few brands

checks, there has been entry into the business

and it has become highly competitive. The inability to offer

its

own

brand

of

travelers

checks

has

not

seriously

11

handicapped the community bank.

made

for

bank credit cards.

The

parallel

argument

is

Today we see the beginnings of

shared automated teller machine networks that are

city-wide,

region-wide, and cross state lines.

Of

course

new technological developments will re­

quire sophisticated data processing systems, but a whole

dustry

in­

of outside vendors will be carpeting to provide these

services to bankers.

RISK

Are cannunity banks judged more

banks?

In

disadvantage

in

banks)

terms

are

of

o credit risk
o interest rate risk
o operating risk
o managerial risk

placed

risk.

cannunity-based banks being defined in terms of:




than

large

my view, no systematic evidence appears to exist

that small banks (i.e., community

competitive

risky

at

Risk

a

in




12
Of course, credit risks can be generated by

originations

being

credit

geographically concentrated and interest

rate risk may be present due to

past

operating

strategies.

However, in ray view, bank size and risk does not appear to me

to be directly correlated with competitive disadvantage.

What is

the

future

of

ccmnunity-based

banking?

Should or will ccmnunity-based banking in the 1980s and 1990s

be business as usual?

titive

I think not.

The increasingly

compe­

banking environment will not easily allow any bank to

pursue a status quo situation:

even if past

profit

perfor­

mance presents a rather rosy picture.

You

recognize

that

the

banking

changing into an industry that is more

environment

fine-tuned

the needs of cotmercial and retail consumers.

to

is

serve

The continuing

deregulation of the financial services industry

mandated

by

the Depository Institutions Deregulation and Monetary Control

Act

of

1980,

in

my

view,




13
will

facilitate

increased competition and specialization; a

fertile environment for ccmnunity banking.

California's financial institutions combine

cial

innovation

finan­

with the entry of new, smaller competitors.

In 1982 California's new de novo independent banks

accounted

for over 10 percent of such banks in the United States.

A

study

of

de

novo California independent banks

opened in 1970-1977 indicated that over 80

banks

were

percent

still independent at the end of 1982.

of

Addition­

ally, the return on equity (ROE) achieved by these banks

not

such

was

significantly different than the population of all Cali­

fornia independent banks.

statistics

In my view, these

cure

convincing

to support the continuing viability of caimunity-

based banking and the innovation of California bankers during

one

of

the

most

challenging periods in the history of the

financial services industry.

14

INTERSTATE BANKING

Finally, we have the key restructuring issue:

changes

in

the

banking industry would result from allowing

full interstate banking?

operations

The means by which sane

knew there are loan production offices,

tions.

ing

offices

of

We

nonbank

of bank holding companies and Edge Act corpora­

New England has pioneered a regional interstate bank­

concept.

Once again, advocates of full interstate bank­

ing have had their hopes aroused as Alaska,

York

interstate

are now conducted have been cited many times.

subsidiaries

What

Maine,

and

New

have made provisions for the entry of out-of-state bank

holding companies.

Given that no state provided for

state

1956 until Maine changed its law in 1975,

entry

from

the recent flurry of activity in this

area

The

that result from these

number

of

actual

acquisitions

legislative changes remains to be seen.

significant.

Litigation involving

interstate "nonbank" operations is ongoing.




is

out-of-




15

Would

the general introduction of interstate bank­

ing produce a major restructuring of the banking system?

answer

appears

to

be

that

interstate

banking could, but

doesn't have to be, the catalyst for restructuring.

like

to

spend

The

I would

a few minutes examining the evidence on this

point.

First, and most importantly,

interstate

banking

does

not

doomed, although seme will of

banks.

the

introduction

of

mean that community banks are

course

sell

to

out-of-state

The research done by our staff does not suggest that

there are any basic economic forces

solidation.

As

requiring

massive

con­

I indicated earlier, the economies of scale

argument is not substantiated by the evidence.

Just as small banks can survive and compete profit­

ably in an environment of statewide bank holding companies, I

believe that a well-managed community bank can

prosper

with

16

interstate

banking.

Those

banks

that have been protected

from new entry into their markets will have to sharpen

skills,

control

their

their expenses, and select those sectors of

the financial marketplace they can serve most efficiently and

profitably.

The

strongest factors they have going for them

are their knowledge of their

market,

their customers' banking needs.

their

customers,

and

They must provide those ser­

vices at competitive prices so as to maintain customer loyal­

ty in the face of new entry into the market.

A

major concern in interstate banking involves the

large bank's attention to cannunity credit needs.

local

branch

of

an

of




Sane fear that the small town

the large out-of-town bank will simply siphon off

deposits to its hone office.

local

the

out-of-state bank be responsive to the

credit needs of the ccmmnity?

branch

Will

credit

needs

is

The bank

clearly

not

that

does

going

to

not

meet

be

very




17

profitable in the long run.

holds

needs.

their

deposits

is

People expect that the bank that

also

If there are unmet local credit

will be attracted into the market.

is a policy destined to

other

produce

to meet their credit

needs,

other

banks

Thus, the failure to lend

losses.

While

there

are

factors to be considered in the debate over the merits

of interstate banking, I think

ground

going

to

we

have

covered

sufficient

suggest that interstate banking per se should not

be an inevitable cause of

a

radical

restructuring

of

the

financial system.

For

us in our roles as consumers, the evolution of

the financial services industry is very positive indeed.

course

we

will

become accustomed to shopping for financial

services in new ways.

our

community

Of

banker,

Whether we patronize a

we

"Megabank"

or

will have the opportunity of the

convenient purchase of several services in one

location

and




18

the

confusing

excitement of access to as much technology as

w e want to subject ourselves.

The march of evolution for the management of finan­

cial

institutions

exhilarating.

not

be

worth adapting.

My

be likewise as uncomfortable and as

For sane, the changing environment will simply

peting with a

again.

will

larger

argument

To others, the satisfaction of com­

institution

will

make

managing

here is that neither the economics nor

the regulatory environment of the future precludes a

of

fun

mixture

sizes and types of financial specialists and generalists,

sane local, sane interstate, and some international.

would be proud.

Darwin