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For R e l e a s e on D e l i v e r y Saturday, M a r c h 23, 1974 10: 00a.m., CDT (9:00 a.m., EDT) PROTECTING A N D NOT PR O T E C T I N G T HE SMALL INDEPENDENT BANK Remarks by Robert C. Holland, Member Board of Governors of the Federal R e s e r v e System before the A n n u a l Conv e n t i o n of The Independent Bankers A s s o c i a t i o n of Ame r i c a D a l l a s , Texas M arch 23, 1974 I a m glad to join your A n nual Convention, and to be a part of the discussions concerning some of the k e y issues facing banking today. The winds of change are blowing strongly through our financial system. The y carry w i t h them some problems and some opportunities, bot h for y o u and your colleagues and for me and mine. One troublesome difficulty is that some of the problems look like opportunities and some of the opportunities look like problems. We need to reason together carefully to sort out these challenges and to attack them constructively. Some of these issues revolve arou n d matters of Federal banking law and regulation. Since I am p a rtly in that business, I think that yo u are entitled to k n o w the general frame of mind w i t h w h i c h I appr o a c h these issues. First and foremost from your point of view, let me tell you how I feel about the small independent bank. I should admit at once two particular c o n tributions to my background of thinking. First, I - 2 - have been trained as an economist, and I bring the trappings of that profession to any appraisal that I make of the banking business. But, long b e fore I took an economics course, I learned something else. In the little town where I grew up, it was a small, independent banker who first aroused m y interest in banking, and who showed me h o w m u c h a good banker can benefit his community. The combination of both those experiences v e r y mufch affects what I have to say today. Let me summarize m y major points in a few w o r d s , and then return to each one to elaborate m y reasoning and to provide a few examples. First, I believe the small but w e l l - r u n independent ba n k can provide some special economic benefits to its customers, its community, and the n a t i o n at large. Second, I think the small independent ba n k is vulnerable in some respects to d i s advantageous forces that can come b o t h from - 3 - within the banking industry and fro m without, and needs and deserves a measure of protection against those f o r c e s . But third, I believe some of the protections provided or sought for small independent banks are m i sdesigned or have been rendered obsolete by the onrush of events, and consequently our communities are not realizing all the benefits w h i c h they could and should enjoy. Given these circumstances, it seems to me there is good reason for the current ferment of reform concerning financial laws and regulation to extend to the small inde pendent bank, but such r e form needs to be carefully and w i s e l y tailored if it is to make our communities better off rather than worse. N o w let me expand a bit on eac h of these points in turn. - 4 - What is special about the small independent bank? I expect we are all generally aware of the m a n y benefits that a good banking s y stem can confer u pon a country. Some of those benefits flow in greater m easure from one type or group of banks than another. For purposes of this discussion, however, I want to focus on those benefits that can be especially conferred b y the operation of a small independent bank. To my mind, two such advantages stand out above all others. One is entry into the banking business. All n e w ban k managements start out as small independent b a n k s - - virtually by definition. A n d n e w banks- - n e w outlets for banking services where customers can find a new and different set of bankers to deal with--are one of the most vital elements in our banking structure. T hey represent opportunities for innovation, adaptation to changing community structure and interests, and invigoration of competition that are w e l l -nigh indispensable to a progressive banking system. - 5 - The second k i n d of benefit I have in mind is m ore cumbersome to state. I think a small independent b a n k can produce a banker who has k n o w n his community long and well enough to understand the long-run best interests of his customers and his community, and who feels his fortune sufficiently tied to those long-run best interests to make his own credit and service decisions based upon them. not "does." Note that I said "can" and Th e corporate structure of a small inde pendent bank accommodates this kind of banker strategy, but it does not guarantee it. I have known small-town bankers who found the status quo too comfortable for t hem to upset b y introducing some new customer service. I have known others who were too sentimental about M a i n Street or some long-time farmer customers to make objective credit decisions concerning them. On the other hand, I have k n own branch b a n k managers who h ave involved themselves deeply in their adopted community and who have time and again made decisions - 6 - that avoided the temptations of short-run p r o f i tability in favor of building the long-run financial strength of their customers. But as a general tendency, I believe the small unit bank has the edge in leading the banker to associate his own personal w e lfare w i t h the long-run best interests of his customers and the community. I do not want to be misunde r s t o o d here. I do not regard the above two special benefits as o v e r riding all o t h e r s . There are other aspects of b a n k i n g — efficiency, technical expertise, and service innovations --in w h i c h other forms of banking organizations have enviable track r e c o r d s . What I a m trying to do in this discussion is to pinpoint those special attributes of small independent banks that deserve to be carefully nurtured. Points of v u lnerability that warrant protection T h e small independent banks that offer the a bove-described benefits are also vunerable in - 7 - certain respects to forces around them. Public policy can counter some of these or moderate t h e m constructively, in ways that I believe advance the b r oad public interest. For example, it typically costs more per item to process a small n u mber of banking items than a large number. There are limits beyond w h i c h this kin d of efficiency does not appear to be r e gistered in bank earning and expense f i g u r e s , but the evidence to date does suggest that the further b e l o w $20-25 million in deposits a ba n k is, the more it m a y suffer higher p e r - item costs because of its volume handicap. These economies of scale are legitimate cost savings w h i c h the customers of larger banks should not be denied, but there are certain governmentally levied charges for doing business that have been lightened for small banks and w h ich help offset their cost disparity. Thus, with all other small businesses, small banks enjoy a lower income tax rate on their taxable net profits than do large institutions. Similarly, Federal Reserve reserve requirements have long been - 8 - set substantially lower for small banks than for large o n e s . A n other area in w h i c h a small independent bank can suffer a troublesome handicap is in obtaining equity capital. I need hardly explain to this audience w hy that is so. One of the avenues often u s e d by smaller banks to obtain an infusion of ne w capital, p a rticularly in connection wi t h changes in controlling o wnership and management, is the organization of a o ne-bank holding company. The tax laws enable certain savings through such a corporate arrangement w h e n an owner borrows to buy stock. In addition, the Federal Reserve allows more liberal debt-to-equity ratios for one-bank holding companies w h e n w a r r a n t e d as part of a change in local ownership of a community bank. A more insidious threat to small independent banks can arise if large financial institutions drawing strength from a number of markets should try to b i d for funds or offer services through their own competing local outlet at temporarily unprofitable rates simply - 9 to attract customers to them. - This k i n d of effort to break the back of less powerful local competition has been so strongly criticized in a v a r i e t y of industries that Federal laws have been passed to try to prevent it. Nonetheless, it can emerge in subtle ways, and examiners and law enforcement officials have to be alert to stamp it out. Some ideas for protection go too far Some elements of current or suggested p r o t e c tion for the small independent bank, however, strike me as going too far. For example, in efforts to protect local banks from predatory outside competition, some jurisdictions have severely constricted the chance for new banks to enter their territory. Carried to an extreme, this kind of policy can deny the affected communities all new bank entry and the accompanying promise of more vigorous competition in the v a r i e t y and costs of banking services. Coming closer to home, I think interest rate ceilings on time and savings deposits are sometimes - 10 - v i e w e d in an overly protective light. The Federal r e gulatory authorities oftentimes are bombarded w i t h plausible arguments as to w h y an increased deposit rate ceiling cannot be tolerated by particular institutions--and sometimes they are persuaded b y what they hear. In the case of small town banks, the argument is sometimes accompanied b y explanations that for reasons of convenience, convention or borrower relations, it is impractical for the m to recover the cost of higher time deposit rates by raising rates on their local l o a n s . Underlying developments, however, seem to me to be evolving in an opposite direction. W i t h depositors free to move their funds and nationwide communications and funds transfer systems becoming increasingly pervasive and efficient, the chances are gradually dwindling for holding funds in local communities while paying them rates far b e l o w what is available elsewhere. In the broadest sense, paying below-market rates for deposits while charging below-market rates for - 11 - loans is asking the savers in effect to subsidize the borrowers. A m o n g its other drawbacks, that procedure is indirectly inflationary, since it discourages savings and encourages borrowing to some extent at a time when we are being plagued w i t h a virulent inflation that demands the best combined efforts of all of us to brake. Unpopular though it may be w i t h you, I must also say that I regard Federal Reserve reserve r e q u i r e ments in a similar vein. Most small nonmember commercial banks--and most other institutions as w e l l - - c o n t e n d that meeting Federal Reserve reserve requirements would reduce their earning assets and their earnings. Some calculations I have seen exaggerate that earnings effect, and give inadequate weight to the accompanying privilege of using the Fed discount w i n d o w in time of need. Nonetheless, I appreciate the cost concerns that member and nonmember banks alike have regarding reserve requirements. I take that as indicative to - 12 - the Federal Reserve that it ought to do what it can to adjust reserve requirement percentages (and also the implicit v a lue it returns in services it supplies to those institutions meeting its reserve requirements) so as to limit and distribute that reserve burden equitably. But it does not seem fair to me for many banks not to share in that burden a t all. Nor does it seem fair to me for more and more thrift institutions to enter the field of supplying demand deposit-type services without bearing the demand deposit reserve requirement set by the m o n etary authority. Furthermore, if more and larger banks keep v o l u n t a r i l y withdrawing from Federal Reserve membership w i t h its obligatory reserve requirement, the resultant smaller and smaller reserve base will make monetary policy progressively harder to conduct effectively. Yet, in the inflation-plagued w o r l d in w h i c h we are living, financial institutions have a fundamental stake in an effective governmental anti-inflationary apparatus. It is in your long-run interest for the mechanisms of - 13 - m o netary policy to be strengthened, not weakened, in a decade like this one. Accordingly, I commend to your further and far-sighted contemplation the recent Federal Reserve proposal to make its reserve r e q u i r e ments applicable to all institutions accepting demandtype d e p o s i t s . Needed: a careful transition I k n o w that some of the elements of presumed s mall-bank protection w h i c h I have just criticized would, if removed, pose difficult adjustment problems for m a n y small independent banks. To m a i n t a i n adequate earnings, small banks I believe w o uld n e e d to develop n e w types of deposits and fund-raising instruments, and more flexible interest rate policies regarding ma n y of their loans. These kinds of changes in service pricing can take years to complete, especially in smaller communities. Accordingly, I certainly w o u l d advocate comparatively long-lived and liberal provisions for the gradual phase-in of any relevant public policy changes in order to make the transition easier. The - 14 - Federal R e serve Board has gone on record in favor of liberal transition arrangements in its own s t a t e ments concerning its proposed reserve requirements legislation and also concerning the Hunt Commision and related proposals for eliminating interest rate ceilings on deposits. Making broad-gauged changes in the laws and regulations covering financial institutions is a tricky business, in w h i c h many interests collide and a welt e r of arguments and counter-arguments a p p e a r s . I think, though, that there are two guiding principles w h i c h can help all parties involved to move in a constructive direction. One is to w e i g h the desirability of all proposed changes in terms of w h ether or not they are likely to produce improved services to customers and communities over the long run. The second is to judge the equity of proposed changes by w h e ther they move in the direction of making all financial i n s t i tutions w h i c h perform the same functions subject to the same kinds of governing rules and regulations. - 15 - I assure yo u the Federal R e s e r v e is trying its best to be guided b y these principles in its own activities affecting the financial structure. commend them to yo u as well. I I hope y o u will c o m m u n i cate w i t h us quickly, clearly and v i g o r o u s l y if and w h e n you see effects of our actions w h i c h you think are contrary to those p r i n c i p l e s . A n d I hope you will support us w h e n you believe we are applying them well. If the laws and regulations protective of small independent banks can be brought into general alignment w i t h those principles, I a m confident public p o licy will have made its proper contribution. It behooves all of us to remember, however, that b y all odds the best protection for the small independent b a n k is the independent banker who, fr o m the time he unlocks the front door in the morning until he goes home at night, makes his decisions w i t h the best interests of his customers and his c o mmunity clearly in view. I, for one, believe there are enough bankers - 16 - like that in this country to keep small independent banks a v a l u a b l e part of the financial scene for as far ahead as I can see.
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