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THE FUTUR E OF THE F IN A N C IA L SERVICES IN D U ST R Y A N D THE ROLE OF C O M M UNITY BANKERS Remarks o f M r. Robert P . Forrestal President Federal Reserve Bank o f A tlanta to the B A I Spring Forum fo r Community Bank Presidents Hilton Head, South Carolina A pril 15, 1985 It’ s a real pleasure for me to be here with you this morning to lead o ff the twentieth anniversary o f your Spring Presidents’ Forum. Your meeting's emphasis on improving profitability and developing new products is a very tim ely one in view o f the fast pace o f change and the intense level o f competition that have become prevalent in banking today. services, in general. I would like to talk about the future o f banking and o f financial In that context, I'll have some comments on the role o f community banks in tomorrow's financial services industry, and what some o f the critical success factors might be. Banking—Today Versus Yesterday L et me begin by telling you unequivocally that community banks are here to stay! Certainly, mergers and consolidation are likely in the banking industry, but, in my opinion, community banks will continue to play an important role in Am erica's evolving financial system. Obviously, banking has changed enormously over the past 15-20 years, and, in my judgment, this transformation is by no means over or at a plateau. The industry as a whole and many individual banks, in particular, will face many significant com petitive challenges, even threats, in the years ahead. Still, most banks can thrive and prosper if they have the desire to succeed. In order to see where banking is headed, I think it's a good idea to look around and see where we stand today compared with, say, the situation 10 years ago. If a -2banker whose work experience spanned the decades from the 1930s to the 1960s were, like Rip Van Winkle, to awaken today from a 20-year slumber, he would scarcely recognize his old profession. This old-timer would discover that while he was napping, market forces had changed the regulated world o f the past into one that requires much more creativity and less adherence to procedures. Not many years ago, the world o f depository institutions was surrounded by a fence posted liberally with "no trespassing" signs. Within that fence were walls that neatly segmented the various types o f depository institutions. You could tell them apart a mile away: savings and loan associations could not o ffe r checking accounts or anything resembling them. unions. Neither could credit Commercial lending was reserved strictly for bankers, but virtually all aspects o f investment banking, including brokerage services, were off-lim its to commercial banks. The institutions within that fence were closely regulated. Rigid limitations restricted their freedom to establish branches or other offices, and banks' markets were generally confined to their own states or even to certain counties or regions within those states. lines. Other inflexible restrictions regulated their ability to expand product Legal ceilings created a cap on the level o f interest rates they could pay on various kinds o f deposits, dampening any competition that might emerge. During this long period o f shelter from outside competition, financial institutions were almost guaranteed a profitable operation if they complied with regulations, did their arithmetic carefully, and offered a reasonable level o f service to their depositors. Banks did not chafe at their geographic limitations, or they did not mount pressures to remove such limitations, in large part because their local and state markets tended to provide good profits within the sheltered regulatory environment. Competition within the enclosure was muted, and banks' potential competitors showed little desire to o ffe r banking services, and, thus, penetrate the regulatory fence. The friction introduced by interest -3ceilings made the situation appear stable for a while since these ceilings deterred nonbanking financial institutions from entering the markets traditionally dominated by banks. Today, the situation is quite different. through that once-protective fence. Some gaping holes have been punched Many o f the "no trespassing" signs have been trampled down, and the walls within that fence have been breached so often that many depositors forget they ever existed. The first major change to occur was in the type o f businesses offering financial services. Beginning in 1973, Dreyfus, M errill Lynch, and other nonbanking financial service companies began offerin g money market mutual funds. These interest-bearing deposits were a close substitute for bank deposits, and their popularity accelerated sharply in the latter half o f the 1970s. Not only have nonbanking financial institutions played an increasing role in the line o f commerce once the exclusive domain o f banks. In addition, even nonfinancial companies, such as Sears and the finance company subsidiaries o f GM, GE, and other manufacturers have expanded beyond their traditional roles o f financing the products o f their parents and are competing more and more in the markets once dominated by commercial banks. Another major change, and one that was led by banks, was in the area o f geographic expansion. Interstate banking has been spreading rapidly. By the end o f this year we will find banks from about one-third o f the states operating deposit-taking offices across state lines in at least 40 states. What's more, individual states have adopted laws that allow out-of-state banks to operate within their borders, further weakening geographic limitations. In all, 23 states have approved laws o f this type. The best known are the 10 states that have adopted regional reciprocal interstate banking laws. These states are concentrated primarily in New England and the Southeast. -4This geographic and institutional expansion o f financial markets has occurred in tandem with product expansion. product lines. Institutions have bypassed the old restrictions on Banks and thrifts have the money market deposit account and the Super NOW account with which to compete against money market funds, and they have had some success in drawing back deposits form erly lost to CDs offered by nonbanking financial institutions. In addition, some banks o ffe r discount brokerage services. Thrifts and credit unions o ffe r checking accounts, and a myriad o f financial instruments and services are available to the consumer. A final major difference between today’s and yesterday's financial services industry pertains to the character or style o f business. The financial services industry seems to have lost some o f its staid and stable character. In the last two years the number o f bank failures has increased sharply, from about four per year in the sixties and about eight per year in the seventies to 48 in 1983 and 79 last year. occurred at FDIC-insured commercial banks. These failures More recently one o f the nation's largest banks virtually failed, and in the last few weeks problems with S&Ls in Ohio have worried depositors and financial markets here and abroad. Forces o f Change How did all this happen? How and why did our traditionally conservative sector o f the economy undergo such dramatic changes in such a short time? three fundamental forces account for these changes. As I see it, These are inflation, technology, and competition, with its attendant pressures for deregulation. Market forces and inflation deserve much o f the credit—or blame, depending on your perspective—for interest-rate deregulation. The acceleration o f inflation in the 1970s began to make bank accounts, with their interest rate ceilings, look less appealing to depositors. Who -5could get excited about earning 5 i percent when inflation was shrinking the buying power o f deposits faster than the accrued interest increased their nominal value? Investors sought and found opportunities to earn more. Some unregulated and quite innovative businesses on the other side o f the fence recognized the opportunity and conceived the money market fund. Since those outside businesses were free o f the regulations limiting banking institutions, they could o ffe r depositors market rates o f interest on funds placed with them. The result was inevitable: investors searching for more lucrative returns began to remove their deposits from depository institutions and to swell those money market funds. The fence that once seemed to shelter the regulated depositories quickly began to look more like a prison wall. Bankers could not win at their own game. Banks' com petitive problems generated momentum for the drive to liberalize government regulations. Many regulatory restrictions have been eliminated. the deregulation o f interest rates on deposits is virtually complete. Today, Only passbook savings accounts, NOW accounts, and, o f course, demand deposits are limited by interest ceilings. These accounts make up less than 40 percent o f total commercial banks' deposit liabilities and only 18 percent o f interest-earning deposit liabilities. Ceilings on all interest-earning accounts will be eliminated on or before March 31, 1986. Deregulation and innovation are also eroding barriers to interstate banking and product diversification. Although the legislative barriers to interstate banking still stand, banking across state lines has, nonetheless, emerged as a marketplace reality. Through a variety o f strategems—including such devices as loan production offices, bank holding company subsidiaries, and the so-called "nonbank banks"—firms ranging from -6banks and thrifts to supermarkets and general merchandisers are offering a mixture of financial services through offices scattered from the Atlantic to the Pacific. I f we count the number o f offices o f foreign banks, Edge A c t corporations, loan production offices, and other nonbanking subsidiaries o f banks and bank holding companies as well as grandfathered interstate banking offices that are operating across state lines, the number o f interstate offices offering various types o f banking services totals almost 8000! When you compare this figure to the number o f commercial banks in the United States—a total o f 15,000 with 55,000 offices engaged in full-service banking, you can see that we have an enormous amount o f interstate banking already. Some o f the latest proliferation o f interstate banking offices has occurred as a result o f a Congressional loophole—the 4 (c) 8 clause o f the Bank Holding Company A c t that defines a bank as an institution that accepts deposits and makes commercial loans. Some financial corporations interpreted that clause to mean that subsidiaries which engage in one, but not both, o f these two functions could legally o ffe r such services across state lines. This either/or interpretation gave rise to the term ’'nonbank bank," with which you’ re all now quite familiar. I sometimes awaken from a dream, or perhaps a nightmare, in which a non-Fed Fed is trying to oversee these nonbank banks. A fte r a lengthy period o f legal wrangling, and after it became apparent that Congress was not likely to address the issue anytime soon, the Comptroller o f the Currency last fall approved a number o f long-pending applications for nonbank bank charters. Over 100 were subsequently approved by the Comptroller, the chief regulator o f national banks. However, a suit by the Florida Independent Bankers Association challenging the jurisdiction o f the Comptroller over nonbank entities has brought the form er flood o f approvals to a standstill, and the status o f nonbank banks remains in legislative and judicial limbo. -7Our legislators in Washington and in state capitals may debate the merits of these trends fo r a few more years, and they may influence the speed and course o f interstate banking. Nonetheless, it is probably too late for legislators to stem the tide o f interstate banking that is being propelled by underlying market forces. is true o f the judicial decisions pending. The same Early in 1985 the U.S. Supreme Court agreed to determine the constitutionality o f state banking laws that lim it interstate mergers to certain other states. The case before the Supereme Court was filed by Citicorp and New England Bancorp o f New Haven, Connecticut. They are challenging the Federal Reserve Board's approval o f mergers under state laws that lim it such mergers to states participating in the New England regional interstate compact. That is o f particular interest to us here in the Southeast, o f course, but this decision will also be watched closely by legislators from other states such as Oregon, where regional interstate banking is under contemplation. It could have implications for the merger o f Florida's Sun Banks and Trust Company o f Georgia as well since Citicorp has also filed suit in the U.S. Court o f Appeals for the Second D istrict in New York to block the SunTrust merger. It is difficu lt to predict when the Supreme Court's ruling may be issued although present indications are that a decision could be forthcoming by July. Even if the case were delayed until the fa ll term in October, however, interstate deposit taking would not necessarily slow. A recent Federal Reserve Board proposal to allow bank holding companies to provide certain administrative and back-office services to their nonbank bank subsidiaries would sustain the expansion o f interstate depost-taking even without regional compacts. This proposal could give new legitim acy and efficien cy to out-of state nonbank banks by including data processing and bookkeeping services under the umbrella o f activities that nonbank banks would be allowed to perform. This proposal would also permit holding companies to share officers and directors with their nonbank -8subsidiaries. In addition, the proposal would preserve any trust service agreements between trust companies and subsidiaries converted into nonbank banks. is still just that—a proposal. This proposal Y et, its consideration by the Fed reflects the strength o f competitive market forces that are working toward greater efficien cy in the financial services industry. Thus, its existence even as a proposal im plicitly provides further evidence that interstate banking is here to stay. A t the same time that deteriorating legal barriers and intensifying competitive pressures have been transforming the financial services industry in dramatic ways, a revolution has been taking place in our payments system and, thereby, contributed significantly to changes in the nature o f banking and other financial services. ATMs and other computerized services put customers and banks in touch more quickly without the personnel and capital expense o f bricks and mortar branches. Thus, the physical branch system o f banks and S&Ls, one o f their unique features, has become less significant. Moreover, banks’ direct access to the payments clearing mechanism has lost some o f its importance. foreseeable future, paperless Although checks and cash will remain important into the transactions involving wire transfers and automated clearinghouses are growing far more rapidly. Networks linking automated teller machines are offerin g consumers unprecedented convenience. For example, travelers a thousand miles away from home can withdraw or borrow cash after banking hours. When you stop to think o f it, you cannot help but be amazed by the sweeping changes that have taken place. Those ahead may be still more amazing. -9The Future o f Financial Services Where is banking going and what is it going to be like to do business in a bank o f the future? As I see it, four major forces will shape the course o f tomorrow's financial services industry. These are macroeconomic growth, further increases in competition, regulatory changes, and even more exciting technological innovations. Clearly, macroeconomic factors will play an important, and I believe positive, role in determining the direction taken by banks, thrifts, and other financial institutions. Provided progress can be made toward lowering the very large federal budget deficit, the U.S. economy is likely to grow at a sustained strong rate over the next decade. This growth should help m itigate problems such as the high incidence o f bank failures. This expected expansion will also increase demand for all kinds o f financial services, thereby creating an environment o f growth and opportunities for bankers like yourselves. Since this sort o f macroeconomic growth will require a stable as well as a highly developed and responsive financial system, we will probably experience some changes in the regulatory environment to ensure the continuing soundness o f our financial system. Increases in bank capital ratios have already been enacted. deposit insurance to a tiered system. We may see a change in Critics o f the present system have proposed deposit insurance fees based on bank risk, strict limits on payoffs for failed banks, private co-insurance, and more intense supervision. The thrust o f recommendations put forth by regulatory agencies other than the Federal Reserve is to place more risk on depositors. bank risk Under these various proposals, depositors would bear more o f the cost o f either because banks would be charged for their riskiness and pass the added costs along to customers or because insurance coverage would be limited. In either case, more o f the burden o f assessing risk would fall on banks' customers. None o f -10the proposals is free from bugs; none is terribly attractive. I believe that there will be some reform, however. Notwithstanding the probability o f some regulatory reform, I believe that the major thrust will be toward further deregulation. Laws and regulations, no matter how well thought out, are proving to be flimsy indeed when pitted against market forces that push money flows into their most profitable uses. Within fiv e to seven years, I feel, banks will be able to operate across state lines nationwide, and new powers will enable banks to o ffe r customers a wider range o f services. banking industry will be strong as banks enter new markets. Competition within the External competition will continue from Sears, Kroger, M errill Lynch and others, as well as from savings and loan associations and foreign institutions. In addition, consolidation o f institutions will continue or even accelerate, although I doubt that U.S. banking w ill be dominated by a handful o f large institutions as is the case in Canada and certain other developed countries. Banks in the $2 billion to $10 billion asset-size category, like the larger institutions in the Southeast, probably will find it more difficult to compete than either the small community banks with carefully defined niches or giant money center banks with their vast resources. The type and size o f Am erica’ s financial institutions will remain varied because beyond the range of $75-100 million in assets, economies o f scale apparently begin to diminish significantly. Furthermore, large banks have not significantly penetrated the markets or slowed the growth o f smaller institutions when they have entered into direct competition. One reason is that small institutions can o ffer many o f the same high volume services as large institutions through the vehicle o f franchising. Franchising relationships enable small institutions to provide many o f the low-cost services available at larger, more -11bureaucratic financial institutions without diminishing the special features that distinguish small institutions from larger ones. Will the likelihood o f further mergers and consolidation, even allowing for a continuing role for small, independent institutions, leave come communities capital poor? I seriously doubt such a development would occur. can earn the highest rate o f return. Money goes to wherever it We already have national capital markets. The fa ct that we do has been important in maintaining small, independent institutions since these national capital markets provide them a source o f funding fo r local projects and a means o f expanding their own sources o f revenue beyond the local loan market. Smaller, independent banks are also well positioned to assess the profitability o f community investments. I'll have more to say about this aspect o f banking in a moment when my comments turn to the future o f community banks. Before I do, though, I'd like to point to one final force for continuing change in the financial services industry, to wit, technology. The wave o f new technology will allow banks, both large and small, to operate more efficien tly, substituting ATMs, pointof-sales payments systems, and the like for brick-and-mortar branch offices. banking, utilizing the fam ily's personal computer, Home may also become a reality technological advances make it cheaper and more affordable as to a wide range o f households. R ole o f Community Banks What do community banks need to do to succeed in tomorrow's environment? First, you need to muster self-confidence by recognizing your current strengths—high -12profitability, lower risk as measured by capital ratios and liabilities, and a core of trusting relationships with your customers. The proliferation and declining costs o f technological changes are also working to your advantage by rendering the benefits of such innovations more available to institutions o f all sizes. Shared ATM networks are following the path o f other financial products like travelers checks, which did not long remain in the purview o f large institutions. A second ingredient for success should be defining your goals clearly. The fundamental goal o f community bank management, in my opinion, is to maximize shareholder value. This is true whether you want to continue in the banking business or to sell out to a larger concern because the attainment o f this goal simultaneously creates the largest premium for a would-be acquirer and builds the strongest foundation to remain independent or to acquire other institutions if desired. Maximizing shareholder value means seeking the highest possible return on assets and equity. For community bankers, achieving this goal will require a strategy o f excelling at basic banking. What is basic banking? maturities o f transactions. Matching suppliers and users o f funds as well as matching It means providing a reliable payments system, including the issuance o f accurate statements to your clients. For community banks, basic banking also entails assessing the risks o f local projects better than the branch manager o f a large money-center or out-of-state bank can do. communities all your lives. Many o f you have lived in your You know the people applying for business loans like no one from outside your community can. You also have an intimate knowledge o f your local economy, and this fam iliarity can help you evaluate the economic worthiness o f projects in a manner that goes beyond the abstract facts and figures on a piece o f paper on which a larger, nonlocal bank would have to rely exclusively. This special -13knowledge you possess should enhance your already strong image as a provider o f community services, as a community builder. This fa ct is another reason, in addition to those I mentioned a few moments ago, for me to doubt that interstate banking will draw capital out o f certain localities. Finally, the community banker may well have the broad perspective regarding costs and returns that should translate into greater profitability for the organization as a whole; in contrast, the specialization o f larger financial organizations often results in a narrow point o f view, whereby division costs are minimized or sales o f a particular service are maximized without full regard for the e ffe c t o f such operations, With their associated transfer pricing, on the whole organization's bottom line. Besides focusing on basic banking in order to maximize returns, community banks should also adopt a strategy o f competing on the quality o f their services in addition to price. It will take a "sharpened pencil" and all the incisive analysis which that term implies to keep abreast o f the constantly expanding array o f financial products that are emerging. However, community banks must be attuned, perhaps better than many are today, to the full costs and revenues o f each o f the products offered. Community banks can and probably should concentrate on the quality o f service because that area is one o f the strongest existing comparative advantages, and quality service usually can command a premium price. difference between revenue and costs. Remember, though, that profits are the No bank's profit margins will be able to remain high for long in today's com petitive environment if its management merely offers highquality service while neglecting to pay close attention to costs. Banks that do, whether large or small, w ill soon find competitors with lower price structures and purportedly comparable levels o f service attempting to erode their markets. -14The third element o f community banks' strategy must be to concentrate on a market niche, building on their existing customer base. Because you are already "close to the customer"—an attribute found to be critical in sustaining success in all businesses, you can help your clients make greater use o f automation in payments and to accept new changes such as check truncation. You have the advantage that a large company must constantly struggle to attain and retain, that o f being sensitive to your clients. I cannot imagine a community bank making the sort o f mistake that led Citicorp to set up, for the sake o f efficien cy, separate lines and levels o f facilities, ranging from fullservice tellers to ATMs, that depended on the size o f an individual customer’ s deposits. Although this program was quickly abandoned, to me it symbolizes the tendency o f large bureaucracies, including those in banks, to seek efficien cy sometimes at the expense o f the very customer relations that comprise the essense o f profitable business. If community banks can simply maintain their good record on this score, they will have a leg up on their much larger rivals. What else do community banks and other small institutions need to do? the last key is people. I believe I would advise you to attract and hold executives who will adopt and implement technology successfully, who understand and can manage costs, and who have merchandising and people management skills. In saying this, I'm suggesting that you need to build staffs with mixed and balanced talents. You need aggressive marketing people with a sound knowledge o f the latest financial instruments and services. You must have those with technical leanings and an appreciation for the importance o f technological innovation. You also need service-oriented people working as tellers and in other areas where your bank is in direct communication with the customer. One reason community banks are more profitable is that your customers want an added degree o f service—a smile, a remembered name, that extra e ffo rt that means so -15much—and they’ re willing to pay a premium for such service. I f you’ re to retain that important part o f your customer base, you need to take care in recruiting, training, and supporting your fron t-office staff. However, these retailing, technical, and marketing personnel skills institutions. are not sufficient to guarantee continuing profitability for your You still need to have people with the skills and determination to use that sharpened pencil I mentioned a moment ago and whatever other tools are required to carry out incisive financial analysis o f your products and your operations. By neglecting this type o f skill, you run the risk o f rendering the work o f other personnel futile. Conclusion L et me conclude by reminding you how exciting it is to be part o f today’ s financial services industry, with all its changes and challenges. Despite the sometimes intimidating nature o f these developments, community bankers appear to be in a good position to capitalize on the opportunities that continue to develop as the financial services industry becomes less regulated, more diversified, and more dynamic. In moving to take advantage o f those opportunities, I am sure, you w ill provide better financial services to the public.
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