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CONSOLIDATION AND EFFICIENCY IN THE BANKING INDUSTRY Remarks by Robert P. Forrestal President and Chief Executive Officer Federal Reserve Bank of Atlanta To the Conference on Efficiency in the Financial Services Industries Atlanta, Georgia September 25, 1992 In a perfect world, major reforms would allow the financial services industry to operate with complete efficiency. As a policymaker, though, I am all too painfully aware that we do not live in a perfect world where major reforms can be agreed upon by all parties, much less implemented. Thus, I would like to address my remarks today toward both some ideal and some pragmatic solutions to the problem of inefficiency in the banking industry. Without belaboring a point that has certainly already been made by other speakers, the financial services industry is not as efficient as it should be, particularly in a global environment. Some basic legislative and regulatory changes to the system, which I will discuss, could solve the problem. In lieu of such changes, consolidation is a reasonable alternative on paper and may eventually work in practice. I believe, however, that policymakers should take the initiative to rectify the adverse effects that regulatory policy is having on the efficiency of the industry. Before I discuss these alternatives, let me first recap how we got to where we are today in terms of the structural and regulatory causes of inefficiency in the U.S. banking system. Structural Causes of Inefficiency in the Banking Industry First, no other advanced economy has such a complex system of restricting bank competition geographically. While many other countries allow banks to set up branches nationwide, U.S. banks can expand outside of their home states only where there are reciprocal 2 agreements and then only by acquiring an existing bank and operating it as a separate subsidiary. This form of expansion requires redundant levels of management, including multiple boards of directors. While this situation stemmed from the history and geographic size of our nation, technology has clearly made these restraints obsolete and costly. Second, U. S. banks have more restrictions on the products they can offer, often limiting them mainly to deposit-taking and lending activities. Contrast this situation with that in Germany, where a universal banking system does not divide banks into commercial and investment banks, and banks can deal in securities. Other countries, too, including Japan, have long allowed banks broad powers-such as owning stock in companies-that are not allowed U.S. banks. These same product restrictions have caused some banks to diversify their output in circuitous and inefficient ways, such as off-balance sheet accounting. Perhaps the most important cause of inefficiency is the overcapacity that has crept into the system, which-to borrow from the old saw about money-has led to too many banks going after too few sound loans. Deposit insurance is the culprit behind the scenes in this area. It is true that deposit insurance has helped shield the industry from systemic bank runs and has provided security for small depositors. However, it has also contributed to the overcapacity problem, which is really an inefficiency problem. Deposit insurance has served as an implicit subsidy, creating the sort of limited liability that makes it attractive to open a bank in an already crowded banking system. Compounding the problem is the government’s desire to protect depositors at problem institutions, which makes it difficult for banks to exit the industry. As a 3 result, the United States now has too many banking institutions vying for too few sound loan prospects, reducing profitability to unsustainably low levels. Ultimately, this situation could pose a risk to taxpayers as well. Finally, the regulatory burden thrust upon banks because they are in fact a protected industry raises the costs for all banks, but particularly for smaller institutions. Smaller banks are more affected by this regulatory burden than larger banks because many cannot distribute the legal and other overhead costs incurred in dealing with regulations across a large institution. Effects of Inefficiency in a Global Environment These differences have become more glaring recently because of the global integration of financial markets and the approach of EC ’92 and North American Free Trade Agreement (NAFTA). Although the Maastricht agreement, which posits one central bank and one currency, may be facing some delay, the single European market is not. EC ’92, which will be complete in three short months, will liberalize banking practices further with a home country versus host country rule. Under the EC system, banks will be able to expand across borders based on a single license granted by the home country regulators instead of having to seek approval from the host country. The result should be expanded and more efficient international banking in Europe. Looking ahead to the probable signing of NAFTA, we must also recognize that banks in both Mexico and Canada have broader powers than U.S. banks do. For instance, Mexico 4 switched to a universal banking model in 1990. In Canada, banks have been allowed to own securities subsidiaries since 1987, and, thanks to passage of a new bank act, Canadian banks may now also engage in insurance activities. If all three countries ratify NAFTA, we will soon be tied together more closely than before. This trade accord makes it that much more important for U.S. banking laws to be more congruent with those of Mexico and Canada. Even if NAFTA were not to be ratified, though, clearly U.S. banking laws hamper the industry from competing fully in the global marketplace. One obvious example of this hindrance can be seen in terms of growth. Geographic and product restrictions are keeping U.S. banks smaller than their counterparts abroad. For example, U.S. banks no longer rank among the top 10 in the world in terms of assets. Instead, six Japanese and four European banks now take the top rankings. While bigger is not necessarily better—or more efficient—it is undeniable that the geographic limitations and the need to form separate organizations not only keep U.S. banks smaller but also make it difficult for them to provide a full complement of financial services to customers. Take a small business located outside of a major metropolitan area that needs to hedge an export contract. This small business could do so more easily in Canada with its national banking system than it could in the United States. In addition, product restrictions prevent banks from diversifying. Thus, compared with banks in other nations, U.S. banks are less well positioned to serve the needs of U.S. businesses that compete globally. In turn, the banking industry, in some senses, serves as a drag on the efficiency of U.S. companies in the international competitive arena of today. 5 How to Make the Industry More Efficient The question becomes what exactly needs to be done to make the industry more efficient for the global environment? First, let me explain the perfect-world solution. Ideally, we should debate, as a society, the overall approach to financial regulation. Some of the questions we might ask ourselves are: Should reform be incremental as it has been over the last decade? Or, should we start with a new system that focuses more on functional rather than on institutional lines? In this arrangement, regulators would focus on certain activities without concern as to the corporate charter or industry segment, thus allowing financial firms more flexibility to adapt and change. Or should we eliminate the deposit insurance-safety net subsidy and let market discipline hold sway? The regulatory burden could be greatly reduced under this scenario. Unfortunately, we have not seen much interest in such major reform as represented by the second and third alternatives. Such comprehensive reform proposals as put forth by academics and more recently the U.S. Treasury have made little progress in Congress. Therefore, let me turn to the more pragmatic approach-although even if legislators take this approach, more than incremental change is urgently needed. Practically speaking, we must make four important changes to cure overcapacity and inefficiency in the industry. Although I do not want to comment about the current political situation, I do know what a new Congress must do. First, the United States needs to move quickly to the acceptance of nationwide interstate banking and increased bank powers. As I mentioned earlier, the present regulatory framework imposes unnecessary inefficiency on the industry in that it requires multiple boards of directors and other costly duplications. Nationwide 6 interstate banking would also promote more competition, something that is always good for customers. Small and medium-sized businesses could benefit from such an arrangement, because they would be able to look for credit from banks outside of the local community. Increased competition should also encourage banks to offer more services. In addition, U.S. banks must be granted new powers to catch up with banks in other nations that are allowed to offer securities, mutual funds, and insurance. I am in favor of all of these new powers, although I also realize that banks must be adequately capitalized to handle such diversification. In reality, we are already on the path toward some of these new powers, as the Fed and the Comptroller of the Currency have allowed bank holding companies and national banks to offer full-service brokerage to customers since 1987. In fact, three weeks ago, the Fed revised its rules to make it easier for banks to apply to offer these services. Second, it is imperative to reduce the deposit insurance subsidy by quickly implementing risk-adjusted premiums. The underlying lesson here is that we cannot have it both ways: we cannot have both an efficient industry and a protected industry at the same time. Although I believe it is socially desirable to keep deposit insurance, it is equally important, in my opinion, to reduce the deposit insurance subsidy and to rein in the safety net. By requiring certain banks to pay more for their insurance, we may begin to create the kind of liability that will make it less desirable for anyone to open a bank. Hand-in-hand with these risk-adjusted premiums must be the elimination of the too-big-to-fail method of protecting against bank failures. 7 A third area that I feel strongly about has to do with capital levels. I believe we should increase capital levels over time even more to separate the healthy banks from the weak ones. Eventually, this goal should be accomplished by increasing capital levels beyond those currently agreed to among international regulators. The reason to increase capital levels for all banks is to make it less likely that any of them will have to draw on the insurance fund, in part because of the greater cushion each institution would have. Moreover, higher capital ratios would place more responsibility for oversight on equity holders. In essence, a bigger capital cushion would serve as a reform of deposit insurance because it should obviate the need for the insurance. The fourth issue is that Congress must recognize that it cannot mandate sound banking practices. The attempts to do this have generated a regulatory burden that has become onerous for both banks and their regulators. If we look at some major pieces of banking legislation—such as the Expedited Funds Availability Act and the Federal Deposit Insurance Corporation Improvement Act (FDICIA)—we can see that these laws are so detailed as to leave very little flexibility for either regulators or banks. In response to perceived social problems, Congress has put regulators too much in the position of making business decisions for banks, even to the point of stipulating the level of executive compensation, without allowing banks to achieve reasonable solutions to the problems on their own. The key is for Congress to write laws that allow more flexibility when dealing with the banking industry. Now that I have laid out my legislative strategy for dealing with inefficiency in the banking industry, let me discuss the most practical solution of all. It is the most practical 8 because it is already taking place, and, of course, what I am speaking of is consolidation. In lieu of legislation that addresses the four issues I have outlined, consolidation can achieve some of the same effect. If all goes smoothly when two financial institutions merge, they can eliminate overlapping structures, improve their balance sheets, cut down on redundant services, and spread their regulatory costs over a larger organization. Obviously, as more institutions merge, the whole industry could become more efficient through this consolidation. However, analysis by the Atlanta Fed’s own economists argues that many banks have not achieved these efficiencies automatically. That is not to say that gains from greater efficiency will not eventually be seen, but the process could take a longer time than regulatory reform. Thus, while I believe in the larger sense that the industry still benefits from decreasing the number of banks in the industry through consolidation, we also still need a new Congress to take up banking reform for more immediate results. Conclusion In conclusion, the inefficiency in the banking industry, which has built up over decades, has a number of causes grounded in the regulatory framework of the financial system. If I were an academic, I would want to solve this problem by completely revamping the way we look at the industry. However, since I am a policymaker who must ultimately deal with the practical aspects of a problem as well as its theoretical aspects, I lean toward a legislative solution that could mitigate the effects of previous legislation. I have briefly outlined a number of changes this nation could make to bring the banking industry back into the global competition. Such changes will not only strengthen the industry but also put it back on the same level with banking 9 industries in virtually every other advanced economy. At the same time, I acknowledge that until banking legislation is enacted that promotes greater efficiency, consolidation remains the best method to achieve the goal of efficiency in the banking industry. Since I believe U.S. financial institutions must be able to compete globally, I also believe that any means that will make them more efficient should also make them stronger competitors. Those banks in the industry that survive the difficulties of today will have trimmed their weight through consolidation and, if Congress can be persuaded, they will have gained new powers. I, for one, am looking forward to the next decade when U.S. banks should be better able to prove that they can thrive in the global environment.
@FedFRASER