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For release on delivery 12:45 p.m. PST (3:45 p.m. EST) 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