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For Release on Delivery , A p r i l 17, 1974 , EDT We d n e s d a y 8:00 p.m. WHAT LIES A H E A D IN BANKING? Remarks of ROBERT C. HOLLAND Member Board of Governors of the Federal Reserve System before the Finance Forum of the School of Business Admin i s t r a t i o n AMERICAN UNIVERSITY Washington, D.C. April 17, 1974 WHA T LIES A H E A D IN BANKING? I a m pleased at the o p portunity to join w i t h y o u at this pre-graduation dinner. The proper subject for the gra duation season is the future, and therefore I should like to discuss wi t h you the future that concerns me most, namely, the longer-term outlook for the b a n king industry. This will, I hope, prove a topic of some interest not onl y to those of you directly interested in the future of b a n k i n g and finance, but also to those w h o wi l l be shaping the future of business generally. For the w e l l - b e i n g of business is significantly dependent on the future health of the financial system, an d the commercial banking industry is a central element of that system. I should emphasize that in these comments I speak only for myself and not for m y colleagues on the Board. These represent my personal views of the factors that appear to be impelling the rap i d evolution of the banking system. 1/ — For assistance in the preparation of this paper, I a m indebted to Mr. Paul Metzger, who is A s s istant to the M a n a g i n g Director for Operations and Supervision and the chief long-range planner on the Board's staff. The views herein expressed, however, are m y personal responsibility. - 2 - The changes that have taken place in banking over the past decade, as well as those changes that will occur over the next decade or so, have, in m y view, been expressions of certain underlying causal forces. In order to give you as balanced a sense as I can of where banking m a y be headed, I shall touch not only on the impact of these f o r c e s , but also on certain vulnerabilities and constraints to w h i c h they may be subject. The Board's Longer-Range Concerns Whi l e these views are v e r y m u c h my own, they have been shaped in part by the on-going discussions about the future of finance and banking that have, for some time now, been taking place w i t h i n the Federal Reserve Board. We have been attempting at the Board to take a longer v i e w of possible developments in the financial system, and particularly in the banking industry, in order to be better able to assess the - 3 - p ossible impacts of these developments on our areas of r e sponsi b i l i t y and determine what we should do about them. Let me give you two recent examples of how such concerns have been reflected in positive initiatives u n d e r t a k e n by the Board. One such concern has to do w i t h the need to insure an adequate future base for m o n e t a r y policy. It is in this light that the Board's p r oposed legislation broadening the scope of reserve r equirements can best be understood. In a second area, the Board has sought to insure the continued smooth f u n ctioning of the payments m e chanism over the longer t e r m t h r ough the establishment of Regional Check P r oc e s s i n g Centers designed to speed up the flow of checks. A n additional outgrowth of this same concern for the efficiency of the payments mec h a n i s m has been the Board's proposal regarding the steps that might be taken to move us towards a national electronic funds transfer system. - 4 - Having said something now of the Board's efforts to assess longer-term trends and to act to meet the possible future impacts of those trends, let me turn to an examination of what seem to me to be the basic forces n o w at work in banking, and ho w they may shape its future over the next decade or so. The Banking "Revolution11 It has frequently been said that over the last ten to fifteen years a virtual "revolution" has been underway in the v e r y nature of banking, as compared w i t h Depression-era banking. I wou l d agree w i t h those observers who have noted that banking is taking on a strikingly new pattern, a pattern that is a ke y part of the evolution that the entire financial system is undergoing. To appreciate this rather dramatic change more fully, we need only think about a few of the more salient developments that have been taking place. These w o u l d - include: 5 - widespread bank utilization of certificates of d e p o s i t and other m o n e y market instruments in order to raise funds; the growing reliance of ban k s on services for a fee to offset increasing customer economization on demand deposit balances; the h e avy dep e n d e n c y on computer t e c h n o l o g y both within and between financial institutions; the g r o w t h and diversification of bank h o l d i n g companies b o t h in the United States and abroad; the development of the Eurodollar market; and the increasing integration and interdependence of economic and financial systems t h roughout the world, particularly among the highly i n dustrialized nations. These ve r y significant changes hav e required most leading banks to develop a different style of m a n a g e m ent--more sophisticated, frequently internationally oriented, even e n t e r p r e n e u r i a l . It should be noted that all of these developments are by no means fully integrated as yet into banking or the broader financial system, but - 6 - rather are g r adually becoming assimilated, and so the full impact of these changes has perhaps still to be felt. Forces Shaping Banking It seems to me that the basic causal factors reshaping the banking industry have been, and will for the foreseeable future continue to be, customer demand and bank management response thereto. The nature of this demand has become evident in several w a y s . Banks have to face increasingly affluent and increasingly sophisticated individual and corporate customers who are insisting on a return on their money, and therefore tending to draw down demand deposits to minimal w o r k i n g capital needs. These same customers are requiring more elaborate and complete financial services, placing pressure on banks as their financial suppliers to provide more integrated and convenient services for a still wider range of customers. Customers' concepts of m o n e y management have thus become muc h more - 7 - sophisticated, and a new generation of b a n k management --trained in business schools--is m o ving rapidly in this direction. These demands from customers for an attractive return on their funds and for the ready a v ailability of a broad spectrum of sophisticated financial services, will, in my view, act to m a i n t a i n the m o m e n t u m of the current trends in banking, barring the intervention of certain vulnerabilities and c o n straints I will touch on shortly. The attitudes toward ban k stocks on the part of shareholders and bankers are also undergoing s i g n i f icant change. Stock market investors are taking a k een interest in performance-oriented banks. As a consequence, bank and bank holding company managements, p arti c u l a r l y those of larger institutions, have become m u c h mor e conscious of bank earnings, level of performance and extent of leverage to support the m a r k e t a b i l i t y of their new stock issues and thus the avail a b i l i t y of equity capital for expansion and diversification. - 8 - It is important to note that this increased pressure on managements to insure the adequate p e r formance of their banks and bank holding companies is also producing a new management style that is spreading rapidly through the larger units of the banking system. It is a style that contrasts w i t h a prior t r adition of management. It is, on the one hand, more driving, innovative, international-minded and sophisticated. But, it is a style that, on the other hand, sometimes can be a bit incautious in its striving for p r o f i t a b l e market performance. A n o t h e r major causal factor b e hind the changes b a nking has been undergoing has been the force of inter-indxistry competition. Banks have been u n d e r growing competitive pressure not only from other banking institutions, but from thrift institutions, insurance companies, diversified financial corporations of various kinds and from nonfinancial firms that extend consumer credit. Thus, a significant factor - 9 - behind the movement of banks and bank holding companies into bank-related financial areas has been the impelling force of the intrusion of non-banking firms into tr a d i tional banking areas. Those firms that n o w face n e w competition from banks should recognize that this is in part due to a reaction by the banking industry to the n e w competition it has had to face. This heightened competition both in traditional banking areas and in bank-related businesses can, if suitably disciplined, serve to promote the public interest. In the international area, banks and bank holding companies have expanded their operations sig n i f icantly, in large measure in response to the need to serve better the U.S. firms that have greatly enlarged their own overseas activities. In the future, as more foreign corporations open U.S.-based operations, A m e r i c a n banks will no doubt have further reason for d i versified foreign activities, since they will want - 10 - to serve directly the overseas pareui_ firms of the U.S. subsidiaries w h ich may become Lneir clients here. Some major A m erican banks and bank holding companies have already earned, and more will earn, a substantial portion of their profits from dealings w i t h foreign customers both in the United States and abroad. In so doing, they need to be able to compete w i t h foreign banks in the United States and overseas on an equitable basis. Viewed from a wider perspective, the overseas expansion of the larger U.S. banks and bank holding companies can be seen as part of the broader movement towards an increasing level of w o r l d economic and financial integration to w h i c h I alluded earlier. Similarly, these same f i r m s 1 domestic expansion, diversification and changes in management style can be v i e w e d as part of the broader pattern of change that is transforming major corporations generally. level of responsiveness by U.S. banks to the forces The - 11 - altering so many of their corporate clients may, to a large extent, determine the capacity of these banks to serve these clients adequately and thereby retain their business. The factors I have sketched out here that seem to me to underlie the on-going transformation of the banking industry are probably not transitory in nature. They should, I believe, continue to exert pressures on banking to change along the lines I have attempted to delineate. Of course, as events evolve, it may be helpful to remember that some of these forces will produce what can best be characterized as " passing fads" in bank management practices. Other bank responses, however, will prove to be lasting alterations of the industry. Distinguishing between these two types of changes may often prove a difficult task for both bankers and bank r e g u l a t o r s . - 12 - Consequences and Vulnerabilities Certain consequences flow from the scenario of causal pressures I have described. Banks w i t h the wherewithal will probably continue to press to expand the number and nature of the financially-related services they can provide. They may also seek broader geograpic scope for their expanded services with some chance of success particularly through their near-b ank corporate affiliates. There should also continue to be heavy emphasis on the performance of services for a fee in order both to offset the e c onomization of demand deposit balances to w h i c h I referred before, and to insure enhanced profitability. We can anticipate that additional efforts may be made to create instruments attractive to investors and rewarding to banks. As a consequence, variable- interest-rate instruments may be expected to proliferate, and the use of "equity kickers" may also grow. - 13 - Yet another consequence that ma y follow is the gradual emergence of an electronic payments system. S uch a means of transferring funds will offer man y n e w o pportunities for banks to develop innovative methods of m e e ting their customers' demands for more convenient and comprehensive services. But just as the banking industry will seek to utilize an electronic funds transfer system as a source of greater profitability, so too will other institutions w h i c h may also be afforded access to such a system. Thus, an electronic payments mechanism w ill no doubt become a source not only of heightened profits for those institutions which u t ilize it s u c c e s s fully, but also of heightened competition among them across a broad spectrum of both new and old services. In short, most banks (except those which, for reasons of size and market scope, are relatively insulated from the pressures I have examined) will have to be innovative and responsive to their customers' - 14 - needs in order to perform adequately their basic function--gathering funds from saver-investors and disbursing them in an inventive manner and at a reasonable profit to the borrowers who seek them. These developments in banking will, however, most likely be subject to certain constraints imposed b y regulatory authorities (which I will detail in a moment) and also perhaps by the impact of certain other factors in the financial environment that I wo u l d like to outline briefly now. The banking industry has, I believe, three fairly prominent points of vulne r a b i l i t y where damage might be inflicted should adverse factors materialize. The first of these points of vu l n e r a b i l i t y is governmental. M y experience over the years in W a s h i n g t o n suggests that banks are not nearly so potent in this city as their competitors sometimes imagine. For one thing, their legislated powers are subject to continuing pressure from a number of powerful competing groups. - 15 - For another, bank or bank holding company f a i l u r e s -or even an upsurge of ver y high interest rates--could have the potential for triggering constrictive Congressional reactions. A second major point of vu l n e r a b i l i t y could be created by the managements of banks and ba n k holding companies themselves. Excessive efforts b y a management to promote earnings performance could result in a p ossibly dangerous over-extension of the institution. Moreover, the management of a bank holding company might devote too muc h attention to its nonbanking subsidiaries' performance, to the neglect of its bank and w i t h possibly damaging consequences for that institution. The final substantial point of v u l n e rability is related to the possibility of turmoil in the inter national monetary system. Some large banks are particularly vulnerable to such a circumstance in terms - 16 - of the relative volume of their assets and earnings derived from foreign operations. Because of the sheer size of these i n s t i t u t i o n s , if for no other reason, any difficulties resulting from such a state of turmoil might have a significant adverse impact on the banking industry and, indeed, on the financial system as a whole. These, then, are three areas of potential v u lner a b i l i t y I see that might cause trouble. If these points of v u lnerability are not adequately protected, they could serve to stem the trends that are reshaping the banking industry. But there are also, it should be remembered, unique protective constraints imposed on banking by the agencies that regulate it. If we as regulators are able to perform our tasks properly, we can--in some if not all of these areas--act so as to reduce the likelihood that these points of vulnerability will result in injury to our nation's banking system. - 17 - Constraints on the Banking System There are two special constraints placed on banking that require it to function w i t h i n strictures not imposed on less regulated businesses. The first of these constraints is created by the n e e d to insure the safety and soundness of the nation's b a nking system. To my mind one of the critical issues in this area today is whether or not the risks undertaken by a holding company parent and its nonbank subsidiaries m ay eventually have to be borne by the firm's banking subsidiaries. In either case, some common understanding of w h e r e risks ma y ultimately fall should exist in the minds of investors, regulators, creditors and the general public. The recent banking emergencies involving the U.S. National and Beverly Hills National Banks are perhaps illustrative of the types of misunderstandings that can arise w h e n it is not agreed who shall be the final bearer of any losses. Such common u n d erstanding does - 18 - not exist today, and it seems particularly important that this question be clarified w i t h reasonable p r o m p t ness . A second important facet of the safety and soundness constraint is the need perceived by the Congress and by the relevant regulatory agencies to confine bank holding companies to activities closely r elated to the banking business. I do not believe that w e can, or should, anticipate that this line of demarcation will be permitted to disappear w i thin the foreseeable f u t u r e . A third issue under the safety and soundness heading is that of capital adequacy for banks (and bank holding companies). The limits that are placed by the r e gulatory agencies on capital leveraging by banks are necessitated by the special requirements for capital a dequacy under whi c h banks must operate in order a d equately to safeguard the public interest. As regulators we must recognize that our task is to insure - 19 - that the capital of banking institutions will be adequate to meet eventualities that may materialize. To require too little capital in banks w o u l d create a hazard for the entire financial system; to require too m u c h capital would reduce their efficiency and p ossibly damage their ability to compete. Thus, regulators, like careful poultry farmers, have to insure that the proverbial "goose that lays the golden egg" has sufficient provender to nurture it, but not so much that i t ,chokes. As you may know, this issue of what constitutes adequate capital for any given bank is a controversial question. The answer to that question involves many judgments, on whi c h reasonable men can differ. The Board has been engaged for some time now in careful r é évaluation of this complex issue, in v i e w of the changed banking environment. We hope, in the not too distant future, to be able to cast some further light upon this subj e c t . - 20 - The second of the constraints to w h i c h I have referred is imposed by the needs of m o n e t a r y policy. The commercial b a nki ng industry performs the v e r y difficult but necessary role of the transmitter of m o n e t a r y policy. As such, it is directly subject to the periodic tightenin g of money t h rough the operations of the Federal O p e n Market Committee, the various controls placed on the discount window's functioning, and the impact of reserve r e q u i r e ments on banks that are members of the Federal R e s e r v e System. I think banking must come to accept that it will continue to find itself subjected to the periodic pressures imposed by the need for monetary restraint. On the other hand, it is clearly inequitable for only some commercial banks, and not others, to bear the burden of the apparatus of m o n etary policy. The Board has therefore r e q u e s t e d Congress to place more u n i form reserve requirements on all institutions accepting demand deposits. These proposals we believe w o u l d broaden the base of mo n e t a r y p o licy and promote greater competitive equality w i t h i n the b a n k i n g - 21 - industry and, to some extent, between banking and thrift institutions. Conclusion I hope that my remarks here this evening, delineating my particular personal v i e w of what may lie ahead in banking over the next decade or so, have proven helpful to you. The forces shaping the evolving banking system are, I believe, long-term ones that will prevail, unless stemmed by the vulnerabilities of banking or e xcessively hampered by the constraints u n der w h i c h banks must operate. The transformation that the banking system has undergone thus far, and should continue to experience, should not be a cause for alarm, but for gratification over its potential contributions to national economic w e l f a r e - - a n d for renewed efforts on the part of banks' competitors. W e must remember that the forces that are a ltering the nature of banking are, in greater or lesser degree, also impacting on the entire financial system. To move through this period of significant and wide- - 22 - ranging change smoothly, innovatively, profitably, and with consideration of the larger public interest we all serve, is the great challenge confronting those of us with an abiding interest in banking and finance.
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