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For Release on Delivery ___
9:00 a.m. PST (12:00 a.m. EST)
Thursday. Deceriber 12, 1985

SAVINGS BAHONG IN THE NEXT DECADE

Preston IlartLn
Tiff» fliairmm

Board of Governors of the Federal Reserve System

Eleventh Annual Conference of the
Federal Home Loan Bank of San Francisco
"Financial Stability of the Thrift Industry”
San Francisco, California
Decenher 12, 1985

SAVINGS BAIIONG IN TEDS NEXT DECADE

Preston Martin
Vice Chairman
Board of Governors of the Federal Reserve System
Eleventh Annual Conference of the
Federal Home Loan Bank of San Francisco
"Financial Stability of the Thrift Industry"
San Francisco, California
Decenber 12, 1965

Why is it that the dialogue regarding financial institutions always
emphasizes the failures and the risks? I marvel at that, not because I fail
to recognize the extensive risks in our system but because successful
adjustments to the decade long financial services revolution are virtually
ignored. We cannot have a reasonably clear long-term view of the financial
services industry without recognizing that thrifts, banks, securities firms,
and insurance companies have succeeded in evolving and in adapting each of
their major activities in some way — v t t r that adaptation is in assets,
r ie he
liabilities, cash flow, or geography. The marvel is that the forces for
change have come from the market. Regulators have merely reacted to those
forces. The wonder is not that there have been failures, but that there have
been hundreds of successes.
I believe there are basic trends that are irreversible because they
have such momentum that turning them aside will be improbable. One such trend
is deregulation. A tenet in the United States is that regulations are often
poorly designed and administered and that they can have negative effects on
efficiency, equity, and stability.

Of course, the costs and uncertainties of

transition from the previous state of over-regulation are considerable.
Certainly the coribination of regulatory liberalization apd market innovation

2
has enabled some managers to engage in growthmanship and excessive
risk-taking.

Outweighing these real and pervasive costs, however,

deregulation has allowed customers to enjoy the largest increases in rate of
return and in new services in the history of this or any other nation.

Market

participants and regulators all over the world are studying our experience and
are emulating us in various ways.

The deregulated environment, with seme

reregulation for safety and soundness around the margin, is here to stay.
In part because of deregulation, the encroachment by one kind of
institution into the markets of others will continue over the next decade, but
management will be free to specialize in new and different combinations.
Specialization will proliferate, not perish.

Since there will always and

everywhere be a need for housing specialization, the returns on investment in
savings banking will be ensured for well-managed institutions.

I am using the

term "savings banking" in a broad sense to subsume all of the ways you will be
serving your comnunities. "Thrift" just does not cover the present or the
future situation.

In fact, I just hope you don't oversell your credit

services to households the way some marketeers are doing today.

That

certainly is the antithesis of thrift!
Fine, you may be thinking, but how can a financial system that is so
open to competition and innovation survive the slings and arrows of the spec­
ulator/gambler type of managers? Won’t their excesses and failures lower our
customers' confidence? And won't these failures result in the national­
ization of great segpients of our industry?
answer:

I'll give you an unorthodox

not if your industry will corrmit itself to self-regulation.

No I

don’t want to replace the FHLBB and the FSLIC nor, heaven forbid, the Fed!

3
Self-regulation to me means that management of the strong
institutions, acting for the common welfare, become the militia and the
national guard of savings bank supervision — at first by ensuring that the
known, good policies regarding asset acquisition and management are spread
throughout the industry.

Sharing information, procedures, and analytical

tools in a structured environment can help propagate good management practices
and drive out the bad.

That is the essence of self-regulation — effective

management acting responsibly.

Once the preventive maintenance is under way.

then I advocate industry surveillance of and counseling with certain of the
fast operators in the business.
A Savings Bank Principles Board could be the forum for establishing
standard business practices.

In the future, such a Board could encompass such

areas as a code of ethics, accreditation programs for savings banks (and maybe
even for individual managers), forums for the discussion of problem
situations, strategic planning models, and ultimately a mechanism for
enforcement.

The exact structure of the Board is much less important than the

impact of its being created and supported by the industry.

Successfully

implemented, such a board could be the major change in how the industry
regards itself, how it restores ebbing public confidence, how it adapts to
change, and how it relates to the regulators.

The alternative is an

inevitable overkill in re-regulation some time in the next decade.
None of us can go back to the bad old days v f e thrifts were
tin
inhibited by state usury statutes, depository rate ceilings, and tax
advantages that led to over concentration of fixed-rate residential mortgages
in portfolios.

Nor can we, as have past generations of Americans, consider

4
the fixed-rate residential mortgage as a God given or Constitutionally given
right — another "entitlement."

It seems so long ago that these conditions

prevailed, but it was less than 10 years past.
In today's deregulated world, the survival of many institutions is
under question.

Wall Street has both a cult of "performance" and a huge

appetite for securities backed by pools of residential mortgages.

Inflation

is in remission, and sore mortgage defaults are occurring even at the first
payment date, in part because pricies of homes in a low inflation environment
no longer rise inevitably.

Core deposits are hard to find or even define.

Funding is at market rates, and those rates fluctuate as much within a week as
they once did within a Presidential term.

Housing is low on the public policy

agenda, and even our family structure is significantly different.

Despite all

of these changes, the specialized housing institution remains, but its assets
and liabilities reflect management’ decisions over 20 years or so within a
s
rigid governmental framework.

The burden of old, fixed rate

below-current-market mortgages contrasts sharply with liabilities whose costs
are very much at current market rates, which vary hourly.
Inexorable market forces have compelled financial institution
managers to attempt to change and adapt.

For some, a major objective is to

become a "financial supermarket." This attitude is an understandable response
to loss of market share.

But deregulation of deposit rates has enabled

cotrraercial banks and savings banks to recapture some of the market share lost
to the money market funds — albeit at rising costs.

The blurring of the

lines between and among different kinds of financial institutions leads
management to strategies of providing wide ranges of financial services to its

5
increasingly sophisticated customers. But deregulation has enticed a new
breed of high risk-talcing owners and managers into the industry.
This is not to deny that one-stop shopping for financial services has
advantages as well as disadvantages.

Indeed, it is clear that large and small

institutions — through franchising, leasing lobby floor space, and other
joint participation techniques — can compete by providing a multiplicity of
financial services.

Furthermore, financial service supermarkets offer

different products of varying convenience and quality, in part because
management is typically not equally competent in several fields. As the
financial revolution compels adaptation, the odds are that each savings bank
or cormercial bank management will offer sane services in a really competitive
way but stay away frcra other services that can better be obtained elsewhere.
My conclusion is that the financial services supermarkets of the future will
not eliminate the more specialized financial institution from all or even most
submarkets.
But vhat will the economic environment of the next ten years be like?
Will the soaring inflation of the 1970s return and lead to deposit interest
rates that will reverse today's favorable interest spreads? And can we expect
economic growth over the decade to continue at the sluggish rate of the past
year or so?

Since the answers to these questions will importantly affect the

outlook for your industry, let me give you the macroeconomic assumptions
underlying my outlook.
I expect the economy to grow at a moderate and relatively stable rate
for the next decade.

Potential output may grow at nearly a 94 percent rate,

with higher trend productivity increases partially offset by a slcwer rise in

6

the labor force.

The economy may also stay much closer to its trend growth

path than has been t e case over the past several years.
h.

Although there will

be unavoidable fluctuations in economic growth, I do not expect a repeat of
the extrerne boom-bust cycles associated with the supply shocks and
accelerating inflation of the 1970s.
Hie Federal Reserve's policy of careful monetary accommodation —
together with deregulation and intense foreign competition — will in my view
contribute to U.S. progress toward price stability over the next decade.

For

the next fev. years at least, inflation will be held down by ample productive
7
resources both here and abroad.

World manufacturing and agricultural capacity

is underused; unemployment is rife in Europe and the IDCs; and we, too, have
our jobless.

An optimistic inflation outlook depends, of course, on resisting

moves toward re-regulation and protectionism that stifle competition.

It is

also a function of continued trliming and skimning of costs by U.S.
businesses. Disinflation also depends on the Federal Reserve's coranitinent to
pursue sustainable economic growth, but to resist truly inflationary increases
of money and credit, a commitment I can assure you is intact.

Overall, I

expect inflation to average less than 4 percent over the next decade, with
further gradual declines in the core inflation rate and only limited cyclical
variability around that rate.
Lower inflation will allow further declines in interest rates.

Rates

have come down a long way since mid-1984, but there is still considerable room
for further declines.

However, long-term interest rates, including mortgage

rates, can only settle so far unless federal, government spending and budget
deficits can be brought under control.

As you know, Congress and the

7
Administration have been negotiating ways to bring budget deficits down over a
multi-year horizon.

If they are successful — as I pray they will be — we

could see single-digit fixed-rate mortgages within the next few years:

rates

on conventional mortgages are already at the lowest level in six years.

In

addition, the more stable economic growth and low inflation I project will
tend to limit the fluctuations in interest rates.
Can you remember how to manage a savings bank in an economy with low
and stable interest rates? Let me ask a more pragmatic short-run question:
are you selecting the best index for your adjustable rate mortgage portfolio
if rates come down and the classic upwardly sloping yield curve prevails in
the future? Do you really want to continue to tie rates on ARIls to short-term
Treasury rates?

The answers to these questions require that you plan today

for the more stable environment I think you will face tomorrow.
Tomorrow’ savings banker must be a strategic planner, not because
s
his MBAs want him to be but because the strong institutions will have so many
ways to specialize, some of which are incompatible.

Of course, you could

indulge in all of the opportunities afforded by deregulation, securitization,
computerization, and internationalization.
to do so.

But I don’ think you will decide
t

The strong management will choose an interrelated set of activities

and a few geographical areas on a profit center basis.

Among these inevitably

will be portfolio lending and origination-for-sale. Securitization of both
your mortgage and consumer paper will be matter of fact.
practice relationship banking:

You will likely

from the student loan to the reverse annuity,

your customer will be served, paid returns, insured, advised, and informed by
telecomuni cations devices as yet unknown but soon to be commonplace.

Direct

8
investment will be taken for granted, as will your customers' participation
therein through both simple and complex syndications.
My notion of your strategic planning isn't the once a year variety
put together at a resort with your directors and then tossed on the shelf.
With a cornucopia of alternatives from which to choose, you will engage in
virtually continuous fine tuning of your organization regarding both the
allocation of management and financial resources and the method of correcting
inevitable mistakes.

Strong management will play an important role in a

dynamic, changing U.S. econony that will demand the continuing revolution in
financial institutions and practices.

Why do you think the British and the

Japanese are so interested in the sweeping changes in our financial system?
Thus, you can see that I believe the strongly managed firms are in
for a challenging and profitable decade.

There is no such rosy future,

though, for the several hundred weakest operators, whose numbers have been
frequently exaggerated but whose asset-importance for your industry has not.
The decade to come will be marked by failure and absorption of these firms and
of any others that are practicing growthmanship in defiance of new regulatory
limits.

There will at some stage be a further reaction — call it

re-regulation if you will — to limit the growth of institutions with such
characteristics as inadequate tangible net worth.

This need not and should

not mean reversing broader powers for strong institutions.
mean much more severe penalties for fraudulent behavior.

But it may well
Also, accounting

conventions cannot forever condone bleeding away capital through unwarranted
dividend payments while preserving the fiction of a remaining net worth.
Indeed, I ask you to join me in demanding that the CPAs serve you more
adequately in testing the quality of assets.

9
Meanwhile, difficult political decisions must be made.

Do you envy

our politicians facing such issues as possibly merging the FDIC and the FSLIC,
special premium assessments, and structuring of equitable risk-based insurance
premiums and/or capital requirements? What will the next Bush Cccmission
recoGmend with regard to who should insure and who should regulate?

How will

some future Congress reconcile the new product, local orientational advantages
of the dual chartering system with the disadvantage of the super risktakers it
attracts?
Well, don't despair of the political process in these matters.

We

will reach solutions that will ultimately buttress this the most adaptable
financial system on the planet.

As I suggested in my opening thesis, we have

together survived a financial services revolution against a background of
social change unequalled since the 1930s.

As the hundreds of new examiners

leam how to do their jobs in the changing environment, we can hope that the
prevailing political climate will produce better supervision without
unnecessary re-regulation.
M y caveat is that better supervision will not be enough, given the
i
nurrber of institutions under water and the super risktakers who are right now
soaring off the high board, heading for the wading pool.

Government

supervision is for the most part after the fact, and it is implemented with
limited resources.

To ensure adequate oversight, strong managers in the

savings bank/savings and loan industry must increase their efforts in
self-regulation.

Already consignment management is working to stop the

accumulation of more bad assets by replaced management.

I personally hope the

"406 Corporation" or something like it comes on the stage and is followed by

10
other privately run entities.

In short, I am advocating a series of privately

supported, privately managed organizations.
Self-regulation will not replace the Federal Home Loan Bank Board,
the Federal Savings and Loan Insurance Corporation, and particularly not, from
c y current perspective, the Federal Reserve System.
r

Self-regulation is

certainly not a full substitute for supervision and regulation by governmental
authorities — that would be an abrogation of our responsibilities for a safe
and sound financial system.

But self-regulation could eventually reduce the

scope of government regulation.

Also self-regulation in the United States

does not mean restriction of entry.

It does not mean price or rate fixing —

fortunately, we do not suffer from that European disease.

Yet market forces

alone do not provide adequate safeguards, as experience with the crises of the
last five years demonstrate.

Because there have been very, very few failures

that have escaped the foreknowledge of competitors, we know that the detailed
knowledge is out there.

It must be brought to bear in a timely fashion.

If

it is not, you will continue to see the tendency for bad practices and runs to
threaten whole regional segjnents of the industry and for your credibility in
the opinion polls to plumaet.
Self-regulation isn't a part of the culture of finance, I concede.
It seems like an unorthodox idea for savings banks and cormercial banks, but
it is not at all unusual in other industries, where success stories offer a
trodden path for others to follow.

Examples of what I advocate can be found

in the New York Stock Exchange, NASD, municipal bond markets, and the
accounting profession.

Self-regulation in the Exchange begins with its

members, which impose rules of conduct on member firms.

A special

surveillance cctxattee of the Board of Directors keeps watch o . troublesome
n
situations and devises remedies.

In the public accounting profession, peer

review includes establishing professional standards for quality control and
monitoring compliance with those standards.
been fairly successful in policing itself.

In this way, the Industry has
After all, for every audit

failure, there are a thousand audit successes.
Lessons from these success stories can be applied to the savings
banking industry.

\Jhat is the opportunity for self-regulatory bodies in your

industry, which could among other things act as a liaison with regulators —
possibly through the Federal Financial Institutions Examination Council?

I

think many functions could be carried out by such groups, including
establishment of:
standards for good business practices, especially in unfamiliar
areas such as "securitized investments";
° a code of ethics that discourages risky or otherwise improper
behavior;
0

accreditation standards for institutions and perhaps even young
managers;

° model strategic plans, which could be especially beneficial to
small institutions; and
0

surveillance procedures, either through an independent entity or
as part of an existing organization.

1 am asking your serious consideration of what can be done frcta the
inside in such a way that the industry comes out stronger and more vigorous
and with a heightened public inage.

Hie potential for strong management to

12
reinvigorate the whole savings banking industry in the decade to come is
considerable.

But that potential could be squandered if the spillover effects

from weak and failing institutions lead to re-regulation.

I believe that the

industry has the knowledge and ability to contribute substantially to solving
its own problems, but there is not a moment — or at least not a month — to
lose.

Thus, I propose that you irrmediately form and fund an industry

ccemission instructed to come up with ways to cocmence the self-regulatory
process.
A growing U.S. economy with reasonable disinflation will continue to
provide a plethora of opportunities to those managers who can determine the
large or the small cccmunity' needs for longer-term financing and who can
s
develop the skills of risk evaluation, based in part upon intimate knowledge
of the carmunities in which they have studied and served for many years.

No

branch manager of a distant conglomerate can bring quite that qualitative kind
of skill to the lending decision.

Don't let the considerable opportunity be

lost because the excesses of a few go unchecked.
for the future.

Set up your own Commission

If you seize the opportunity and welcome the challenge, I

have no doubt that your industry will prosper over the next decade.
Charles Darwin said the fittest survive because they adapt.
should see you now!

Darwin