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THE FU TUR E STRUCTURE OF THE BANK IN G IN D USTR Y Remarks by Robert P. Forrestal, President Federal Reserve Bank o f A tlanta To The Graduate School o f Banking o f the South May 23, 1989 Good evening! I am pleased and honored to be a participant in the 40th session o f The Graduate School o f Banking o f the South. Over the past 40 years, this institution has put the finishing touches on the training o f many o f our region's best bankers. The lectures and classes you attend will provide ideas on how intelligent management can maximize performance and profitability in the years ahead. Equally important, with about 900 o f you here having on average 8 years of banking experience each, you bring upwards of 7,000 years worth o f practical information to share. The school thus provides an environment in which theory meets practice. By doing this, it has become a significant source o f strength for banking in the South and, indeed, for the nation as a whole. This evening I would like to give you my views on the future structure o f the banking industry. To do so, I will begin by sketching what in my opinion would be the ideal banking system for the evolving financial needs o f this country. Then I will outline several obstacles that seem to preclude such substantial banking reform. Finally I will suggest some ways we might make the present system approach the ideal. Attributes o f the Ideal Banking System We all know that technological changes and the increasing merger o f national and regional markets into a single global market are rapidly changing the conditions under which banks operate. Globalization and technological advances, along with the general growth and development of our economy, call for an efficien t banking system that is com petitive at home and abroad. Such a banking system would, in my view, possess at -2- least three general sets o f attributes. It would, first and foremost, not propagate systemic risk} it would also address customers' needs; and it would o ffe r basic protection to consumers, particularly small depositors and less sophisticated borrowers. I shall discuss each o f these attributes in turn. Lack o f susceptibility to systemic risk is my first ideal attribute. We must prepare for as yet unknown risks as financial activity assumes worldwide scope and high-tech speed. Moreover, in the past decade we have learned painful lessons about dealing with risk that I would hope we can avoid repeating. For these reasons, I think it is important to make the costs for excessive risk-taking high. I would like to see these high costs exacted by a combination o f three forces: the market, supervisors, and insurers. As I see it, the threat o f prompt closure is the sine qua non o f risk discipline. In the best o f all worlds the market would take the lead in discovering when riskiness reaches unsafe levels and closure becomes warranted. Investors with their money on the line have strong incentives to keep close tabs on bank management and give immediate as easily understandable signals o f their displeasure with weak decisions. There may be limits to market discipline, however, especially in smaller banks. Supervisors should supplement market discipline by identifying conditions that require attention. Part o f their job is to ensure that directors and management are aware o f high risk. Seeing to the replacement o f weak management and effectin g early and orderly closure are the correct tools for supervisors to use in controlling risk. I think insurers, too, should build accountability for their risk into their charge for coverage o f deposits. They should adjust premiums to reflect the relative risk o f loss to the insurer posed by banks' policies and portfolios. This would make deposit insurance more like other forms o f insurance and reduce the risk incentives o f today's flat-rate -3- coverage. Together, a blend o f market surveillance, strict supervision, and risk-based deposit insurance o f this nature would, it seems, increase the costs o f risk sufficiently to control systemic danger. Second, if I were designing the banking system o f the future, I would want it to address all its customers' needs by being flexible, dynamic, and com petitive in all markets. To me, flexib ility means that banks should be able to do whatever financial business they wish wherever they want to do it. I would therefore not have financial product restrictions in my ideal banking system. There may be synergies in the activities o f banking and insurance, for instance. The ability to sell and invest in securities is also harmonious with many o f the things banks already do. Broad powers could be a means o f diversifying bank portfolios and thereby potentially reducing overall risk. I also think nationwide interstate banking is essential. Like broader powers, free geographic expansion would allow greater portfolio diversification. Many o f the existing problems in the banking industry can be traced to economic downturns in oil-producing areas o f the Southwest and agricultural regions o f the farmbelt, for example. If banks could maintain business in a variety o f areas, the danger o f overreliance on one region's economic health would be reduced. Aside from enhancing competitiveness and helping to manage risk, I believe that greater geographic and product flexibility would engender increased competition. This in turn would contribute to a dynamic banking system that continually pushes for better products and services. Users of financial services, including businesses, governments, and consumers would obviously have their range of choices amplified by new banking options. In addition, it is important that all markets enjoy a high level o f competition. Thus, the optimal banking system should be resistant to undue concentration. - 4- The third plank o f my idealized system would be adequate protection fo r small depositors and less sophisticated borrowers. Those o f us who deal with financial markets on a daily basis should not forget how complex the range o f investment choices can appear to many average consumers. These choices continue to multiply as technology pushes up the intensity o f market activity. In this environment, useful, accurate information is crucial to consumer protection. To ensure the availability o f such information, consumer-oriented regulations like ’’Truth in Lending,” which help people shop around among competing institutions, should be aggressively enforced. Adequate competition in local markets also helps prevent unethical bankers from duping customers into paying too much or receiving too little. Along with promoting competition and the exchange o f information, though, I think it is reasonable and proper for banks to provide safe depository vehicles as part of their lineup o f products. This, I believe, requires continuing some form o f deposit insurance, but a form free o f some o f the risk promoted in today's system. In summary, the ideal attributes are a banking industry with institutions that are com petitive in every market including the global market. These institutions need risk discipline exercised by the market, supervisors, and insurers; the flexibility o f a full range of commercial powers and nationwide interstate banking; and adequate protection for small depositors and less sophisticated borrowers. Impediments to Realizing the Ideal System Let me now turn to current issues and identify some o f the impediments to bringing a system like the one I just outlined into existence. One overriding issue that detracts from efforts to introduce greater risk discipline from the marketplace and to broaden banking powers as well is the overextended deposit insurance safety net. Deposit - 5- insurance was established in part to prevent runs on the banking system. With their money guaranteed, depositors had little incentive to pull out o f institutions in which they had fo r some reason lost confidence. social compact. This guarantee has taken on the dimensions o f a However, certain adverse consequences o f the system have made insurance in some ways as much a danger as a safeguard. First, depositors, who could provide some first-line discipline on bank management, have little incentive to monitor banks. They have been relieved o f any concern over the security o f institutions. their funds and have no qualms about doing business with troubled Indeed, they are often attracted by the higher interest rates such institutions o ffer. What is worse, the safety net at times extends coverage to all investors' losses and may even make depositors and investors in financial institutions other than banks fe e l they are protected also. This has further reduced equity- and debt holders' discipline o f risk taking by management. We have seen such situations escalate rapidly in the S&L industry, where owners o f weak thrifts, confident the government would not let them fail, have increased their risk-taking. While pricing deposit insurance to make it commensurate with insurers' risk is a good theoretical approach to this problem, we all know the difficulties in attempting to adjust premia in advance. It is clear, though, that reining in the safety net in some -/ay is a necessary step before reforms on powers and greater market participation will attract a following in Congress. For this and other reasons, competitive flexibility in banking is still constrained by product regulation and prohibitions against nationwide banking. The artificial distinctions between banking and investment banking in the Glass-Steagall A ct have outlived their usefulness, and piecemeal efforts to breach the wall separating these -6- activities is under way. Some states have allowed banks to engage in insurance and real estate businesses. The Fed, within the limited statutory discretion available to us, has recently taken carefully measured steps to permit banks to underwrite corporate debt as long as adequate safeguards are in place to minimize risk. Within a year we will review the situation with an eye toward allowing bank holding companies to underwrite and trade equity securities. Nonetheless, the path to Congressional action that would give broader powers to all banks at once is mired in conflicting interests. The various industries that provide financial services are unwilling to yield any o f their individual domains. Thus the securities industry opposes banks' dealing in stocks and bonds, and the insurance industry prefers that banks not handle underwriting. Vested interests—in this case bankers who want to avoid outside competition as long as possible—also stalls momentum toward nationwide banking in Congress. Happily, progress has been made on a state-by-state basis A recent study at the Atlanta Fed documents how far the interstate movement has come in the past 5 years and how far we still have to go. As state laws allowing entry from other states spread, the number o f interstate offices doubled between 1983 and 1988, to reach over 14,600. Significantly, the number of full-service offices grew to account for half o f the total. The study also shows, however, that the regional focus o f banking laws in southeastern and New England states, which were pioneers in the early days o f interstate banking, could dampen further growth by large banks there. Other states have seized the initiative by opting for full national interstate arrangements, and banks in these narrow compact regions will have increasing difficulty finding new merger partners. - 7- Reaching Toward the Ideal Clearly a number o f stumbling blocks stand between our present, im perfect banking scene and what I view as a more ideal way fo r the industry to function. However, recent developments and innovative suggestions convince me we w ill come fairly close to my ideal by the end o f the next decade. In order to create an environment in which progressive reform can take place, we must do something to introduce greater market discipline. The trick is to find a way to do this while still insuring deposits, which, as we have seen, can work against risk discipline in general. I might mention two proposals fo r achieving a balance between market forces and the desire to insure deposits. One idea aims for a minimal degree o f insurance coverage by segregating insurable deposits into what I have called a failsafe depository. By this I mean essentially an insured transactions account, although other types o f deposits might also be included as demanded. The failsafe depository would be kept separate from a bank holding company's other activities, all o f which would be uninsured. If adequate insulation to keep the holding company from drawing on these deposits in an emergency can be devised, the failsafe depository offers protection fo r the small depositor and encourages the introduction o f greater market discipline as well. Consumers who desire insurance could have it, and other activities can be carried on in response to market dynamics. A second approach, one that would allow for relatively broad deposit insurance coverage, has been advanced by Larry Wall, one of our economists at the Atlanta Fed. Wall has suggested the creation of a class o f puttable subordinated debt. He would like to see large banks in particular be required to issue bonds whose payment is subordinated to all other liabilities but whose owners are allowed to request redemption. Banks would be required to maintain a minimum amount o f this debt to stay in operation. If investors -8- began to exercise their put option in large numbers, the bank in question would have to issue new debt or perhaps sell assets to remain in compliance with regulations. Wall's barometer o f market judgment would make regulators more e ffe c tiv e in their jobs o f identifying troubles in their early stages and effectin g tim ely closure when necessary. O f course, I do not expect the market to do the entire job o f risk control. Fortunately, an important feature o f the regulatory framework undergirding further product deregulation is already in place, namely, the risk-based capital standards adopted by international regulators last year. These standards convert on- and off-balance-sheet exposures into on-balance-sheet equivalents, and in this way provide a better assessment o f an institution's overall riskiness. They also raise the minimum standard o f capital to risk-weighted assets to 8 percent by 1992. Risk-based capital standards are not a complete picture o f an organization's capital adequacy, o f course. Interest rate risks, asset quality, and other conditions must still be considered by examiners. However, the definitions o f capital in the standards provide a more objective basis fo r determining when a regulator's authority should be invoked. In terms o f expanded powers, I expect to see much o f the Glass-Steagall distinction between banking and commerce disappear over time. Individual states are providing some evidence that insurance and real estate powers do not necessarily destabilize banking. U.S. banks have also engaged in investment banking practices through their foreign subsidiaries without overwhelming problems. In these ways we are accumulating experience that favors broader powers, and I think that at some point in the next ten years these privileges will be extended to all institutions by Congressional action. In 1992, we will reach the point where more than half our states have laws in e ffe c t allowing interstate acquisition by bank holding companies from all other states under - 9- certain conditions. Thus, the move toward interstate banking should prove successful and provide new options for portfolio diversification for banks and greater competition for consumers. but Even so, we still might have a patchwork o f 51 laws that do similar things nevertheless contain enough discrepancies complicated than it needs to be. to make interstate banking more Because o f this potential disparity, I would still hope that Congress would give us nationwide banking in one decisive gesture. Another incentive to broaden banks' powers and geographical options comes from the intention o f the European Community to permit intercountry banking expansion as part o f the economic integration scheduled for 1992. European banks already have broader commercial powers than their U.S. counterparts. If they can branch freely across national boundaries a fter 1992 as well, a relatively restricted U.S. banking industry would fa ll further out of step with global developments. Europe are likely to gain in size also. Banks in post-1992 If size is a factor in winning the business o f multinational firms, these banks could win a com petitive edge over our larger banks. Conclusion In conclusion, I fe e l that in several important ways we are moving toward a stronger banking industry from all three perspectives I identified at the outset: lack o f susceptibility to systemic risk, responsiveness to customer needs, and adequate consumer protection. However, a good deal of thought and e ffo rt will be required to synthesize these elements into a full framework for banking in the global marketplace of the 1990s and beyond. Policymakers and industry leaders will need to work together to ensure that the industry's future structure promotes both the public good o f safety and soundness in banking and the private goal of bank profitability. I look to each o f you as representatives o f the South's banking leadership to apply your experience and your foresight to keeping the industry on track toward fuller realization o f these twin goals.
@FedFRASER