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interstate Banking and the Economy Remarks o f Robert P. Forrestal President, Federal Reserve Bank o f Atlanta to the National Association o f Accountants Atlanta, Georgia, February 18, 1985 It is a pleasure to meet with you today. I have always fe lt a sort o f kinship with accountants, since you share a good many interests with bankers and our paths cross rather frequently. You have asked me to address two topics — current developments in interstate banking and the economic outlook. L e t’s begin with interstate banking, an area that has been seething with activity o f late. Interstate banking has been a topic o f keen interest at the Atlanta Fed since late 1982, when we surveyed the industry and found that a number o f the nation’s larger banks already operated hundreds o f offices o f one sort or another from coast to coast. Some had come into existence through the "nonbank bank" loophole. Some were holding company subsidiaries established under Section 4(c)8 o f the Bank Holding Company Act. Market forces were triggering these operations. Even foreign banks were involved; Barclays Bank, for example, was among those with hundreds o f consumer finance and leasing company offices nationwide. edging into bankers’ turf. And nondepository firms, too, were Firms like Merrill Lynch, American Express, and even Sears, Roebuck and J.C. Penney were beginning to make their presence felt. It was in 1982, then, that we began to speak o f interstate banking as an accomplished fact. Just last fall, we sponsored a conference on "Interstate Banking: Strategies for a New Era," and invited a number o f uniquely qualified authorities to examine various aspects o f the phenomenon. -2In accordance with our usual practice, we are sharing the results o f that conference in the form o f two special issues o f our Economic Review. these two issues was published in January. The first o f I have brought along a supply for those o f you who want to delve into it more deeply. That issue is devoted to various business strategies — including mergers and acquisitions — that large and small banks may find useful in the new environment. A second issue o f the Review, due out in about three weeks, w ill deal with the public policy questions raised by interstate banking. If that aspect o f interstate banking is also o f interest to you, you’ll find instructions on how to request the March Review inside the cover o f the January issue. Some o f the major conclusions arising from that conference had to do with factors that w ill be keys to success in a future environment characterized by still more interstate banking. One major conclusion was that bank size is unlikely to be important. Two o f the more solidly researched conclusions are, first, that above $75 million or so in asset size, banks do not appear to gain economies o f scale in producing basic banking services. TTie second is that over the past 15 years, when large banks have entered markets in competition with smaller banks, the larger banks have failed to penetrate the market significantly. There seems to be a place for both large and small banks in our financial system. Small banks provide both continuity and sophistication o f service for customers too small to have their own financial specialists. succeed. They must be close to the customer to Large banks, on the other hand, serve large m ulti-office or even multi national customers. They are, in many cases, providing transactions services on a huge scale for customers who employ their own highly specialized financial experts. -3The absence o f size advantages emphasizes the fact that it is the quality o f management that really determines the future o f a given bank. banks can survive. Both large and small However, unless the costs o f obtaining funds and providing services are strictly controlled, the quality o f service is carefully maintained, and technological and structural change is managed creatively, success may be elusive. Edward Furash, a Washington-based financial consultant and one o f the speakers at our conference, noted that interstate banking actually had little a ffe c t on those requirements. With or without interstate banking, the basic challenge to bank management remains essentially the same. But our future environment will include a great deal o f interstate banking. is very real, and its impact w ill be widespread. It Legal and communications innovations are allowing market forces to break more geographic barriers almost every day. Let me review some o f those recent events for you. It is interesting that one o f the first items o f note on the recent interstate banking scene involves not a bank, and not even a primarily financial firm, but Sears, Roebuck. Just before the end o f last year, we learned that Connecticut Banking Commisioner Brian W oolf had ordered Sears to stop taking deposits at two Sears Financial Centers in Waterford and West Hartford. According to W oolf’s order, Sears must stop offering a "sweep account” in which their Dean W itter brokerage service sweeps funds into Sears Savings, the firm ’s savings and loan association. be no more than a delaying action. But this may Under Connecticut law, if the banking commissioner deems a holding company to be in the banking business, it can establish no more than two nondepository offices in that state per year. Sears has responded with a lawsuit -4challenging the constitutionality o f the Connecticut law restricting activities o f bank and savings and loan holding companies. The outcome obviously could have important implications for both interstate and interindustry competition for banks. Just a couple o f days after that bit o f news broke, we heard that U.S. National Bank o f Oregon, the state’s largest commercial bank, had broken ranks with Oregon’s banking industry over a plan calling for regional interstate banking beginning in 1986. The Oregon Bankers Association had agreed to a plan that would allow most banks in the state to be purchased by banks in eight other western states. U.S. National Bank, which supports interstate banking, objects to two key aspects o f that plan; it objects to its lack o f a reciprocity requirement, and it objects to a provision that would allow endangered Oregon banks to be acquired earlier than other institutions. Oregon’s legislature began its 1985 session this month: it will be interesting to see whether the lawmakers pass some sort o f regional interstate bill and, if so, what shape it will take. The new year was only about a week old when one o f the most significant news items reached us. The U.S. Supreme Court agreed to determine the constitutionality o f state banking laws that limit interstate mergers to certain other states. The case before the Supreme Court was filed by Citicorp and New England Bancorp o f New Haven, Connecticut. They are challenging Federal Reserve Board approvals o f mergers under state laws that limit such mergers to states participating in the New England regional interstate compact. o f course. That is o f particular interest to us here in the Southeast, I ’m sure that legislators in Oregon and many other states also will have that pending decision in mind as they debate the formation o f similar regional interstate pacts. When it comes, the ruling will have a crucial impact on the strategies o f manv bankers. -5It is difficult to predict when that ruling may be forthcoming; the Supreme Court agreed to hear the case only quite recently, and it seems unlikely to depart from its usual deliberate course in arriving at a decision. be heard until next month at the earliest. The oral arguments probably can’t If they are not heard by April, the case may not be decided before the Court’s current term ends around midyear. In that event, the case could not be decided until the court’s next term begins in October. Such a delay would make it difficult to sustain several interstate deals struck in New England. However, it would not necessarily slow the development o f interstate deposit-taking. Nonbank banks, interstate deposit brokerage, and other developments will continue to spread. In a related move that created headlines on January 23, Citicorp filed suit in the U.S. Court o f Appeals for the Second District in New York to block the SunTrust merger. That merger between banks in Georgia and Florida was the first approved by the Federal Reserve Board under state laws that created the Southeast’s regional interstate banking compact. A t that time, an attorney for Citicorp reportedly said that negotiations were underway that could suspend that lawsuit until the Supreme Court decides the New England case. Among the significant recent developments that promise interstate deposit-taking without regional compacts is the Federal Reserve Board's proposal to allow BHCs to provide certain administrative and back-office services to their nonbank bank subsidiaries. This proposal could give new legitimacy and efficiency to out-of-state nonbank banks. Services like data processing and bookkeeping would be included, and the holding company and its nonbank subsidiaries could also share officers and directors. In addition, the proposal would preserve any trust service agreements between trust companies and -6subsidiaries converted into nonbank banks. This is just a proposal now, but it does reflect the concern of the majority o f the Board o f Governors for the efficiency o f banks’ operations. About two weeks ago, the Federal Reserve Board granted approval for Chase Manhattan Corp. to establish limited-service banks — another expression meaning nonbank banks —■ in five states. Chase promptly announced plans to open such banks in three o f those states — Arizona, California, and Minnesota — next month. Chase expects to go into the other two states — Illinois and Ohio — in April. Ib is latest flurry o f action on the nonbank front obviously puts further pressure on Congress to address the interstate banking issue. The chairmen o f both the House and Senate banking committees have threatened to press for legislation that would close down any such nonbank banks, so a showdown appears to be shaping up. The nonbank issue is heating up elsewhere. Recently, the Federal Reserve Board asked the Supreme Court to hear an appeal o f an important lower court ruling on permissible activities o f nonbank banks. That lower court had overturned an earlier Fed ruling that would have expanded the definition o f banks under the Bank Holding Company Act. What we call the ’’nonbank bank loophole” opened up because that act defines a bank as an institution that accepts deposits and makes commercial loans. To get around that, corporations began to create subsidiaries that performed one o f those functions, but not both; hence the term ”nonbank bank.” Tbe Fed was trying to tighten up this loophole by expanding the definition o f ’’commercial loan” in the Bank Holding -7Company Act. In that category we would include interbank loans, purchases o f CDs, sales o f federal funds, and several other activities. If the Fed’s regulatory power to redefine the term "commercial loan” is upheld, the impact would slow the future evolution o f interstate banking through nonbank banks. I won’t try to predict just what the new definition might be. But I would point out that, once the water is over the dam — that is, once nonbank banks have been established — it would be extremely difficult if not impossible to pump it all back to the high side. A lengthy story in the February 8 edition o f American Banker reported that, at an informal meeting in Washington two days earlier, Fed attorneys had sought guidance and testimony on the validity o f state laws that prohibit nonbank banks. That story speculated that the Fed was likely to deny "a boatload o f applications” filed by outof-state bank holding companies seeking to set up nonbank banks in Florida — one o f the most tempting markets in the nation, o f course. Some o f those attending that meeting also suggested that the decision, expected early in March, would contain some sort o f statement expressing serious doubts about the constitutionality o f state laws prohibiting nonbank banks. That will be another interesting decision to watch for, although it may be delayed while the Board evaluates the information gathered at that informal meeting. Another important decision that was scheduled to be made before the end of February may also be delayed. The Federal Reserve Board was scheduled to rule on an application by Citicorp to acquire a North Carolina industrial bank. However, the Fed may choose not to act on that until a Citicorp lawsuit against the North Carolina -8banking commissioner is resolved. The commissioner denied C iticorp’s application last year. A fte r a lengthy period o f legal wrangling, and after it became apparent that Congress was not likely to deal with the issue anytime soon, the Comptroller o f the Currency last fall approved a number o f long-pending applications for nonbank bank charters. Since the dam broke, the Comptroller — who is the primary regulator o f national banks — has approved 167 o f these applications. scheduled for approval last Friday. acquisition o f only about a dozen Another large batch was The Federal Reserve Board has approved the nonbank banks by bank holding companies so far, but the situation is changing rapidly. A ll this activity is evidence that the market forces behind interstate banking remain strong. Many participants in the financial markets see profits to be made in interstate deposit-taking and lending. A setback or two in a regulatory or legal case w ill not dissipate those market forces. It is highly significant that the American Bankers Association finally reversed its long-standing opposition to interstate banking just about a week ago. The ABA has now proposed a plan that accepts the closing o f the nonbank bank loophole in return for laws permitting new banking powers and formalized interstate banking. That certainly doesn’t end the controversey, but it is further evidence that the idea is gaining acceptability. And that’s where we are at this point. Where will we be in 1995? likely that interstate banking will continue to spread. It seems There probably w ill be a good -9many mergers and acquisitions within regional groupings o f states — and possibly nationwide, if the last geographic barriers are blown away by Congressional action. There will be few er banks by 1995, but there will still be both large and small banks to meet the varying needs o f our diverse economy. Now, le t ’s turn from interstate banking to the economic outlook, a subject o f interest to bankers and accountants alike. for the most part. I think you’ll find the outlook quite pleasant, There are some unusual opportunities available to us, and I ’ll share with you my thoughts about how we as a nation can take advantage o f them. But there are also some hazards to be wary o f —- hazards that might possibly put the opportunities out o f reach. I think we know how to avoid those hazards, but steeling our national will to the task may present a problem. H ie National Outlook A year ago, many economists had serious doubts about the recovery’s strength and durability. Most were predicting rather modest GNP growth, and many thought inflation would be higher than in 1983. On the brighter side, some forecast a decline in the exchange rate o f the dollar and thus some improvement in our nation’s international trade situation. My views were generally similar. A t that time, I projected that the economy was likely to slow to a growth rate o f around 5 percent and that unemployment would probably hover around 8 percent, perhaps dropping to 7.5 percent by the end of 1984. In addition, I expected inflation to pick up to about 5 percent. Although these projections were not far o ff the mark, it was my happy experience to have erred on the side o f underestimating the enormous growth in GNP while -10overestimating both the inflation and unemployment that actually occurred in 1984. As you all know, 1984 brought heady economic growth in the first half. GNP expanded at a rate far in excess o f what had been anticipated, and the full-year growth rate was nearly 7 percent, the highest in over 30 years. TTiis expansion was led by consumers; their purchases o f homes, cars, appliances, and a myriad o f durable and nondurable items spurred businesses to increase production, expand their work forces, and build their inventories in anticipation o f continued strong sales. Businesses also served as a dynamo o f growth by sharply increasing their spending on capital goods. Business investment, particularly in machinery and other equipment and, to a lesser extent, in new plants, contributed significantly to the expansion we witnessed in manufacturing as well as construction. A sharp slowdown took place in the third quarter, reducing GNP growth in that quarter to less than 2 percent and raising concerns in some quarters that our expansion might not last substantially. response much longer. Consumer spending, including auto sales, cooled Construction o f single-family homes had slowed earlier in the year in to upward movements in interest rates. The third-quarter moderation in consumer spending caught many producers and retailers o ff guard. previous weakening in construction, Coupled with the the reduction in consumer spending left many manufacturers and merchants with large inventories accumulated earlier in the year. To stem this unintended buildup o f stocks, businesses cut back their orders for new goods, and repercussions were fe lt throughout the economy. In addition, the widely predicted decline in the dollar’s strength never materialized; instead, the dollar gained record strength. Consequently, exports lagged, braking the speed o f expansion even more. -11Fundamental strengths persisted through the slowdown, and signs o f improvement began to appear as early as October and November. It now seems clear that the weakness in the third quarter was part o f a transition from the unsustainably rapid growth in early 1984 to a more sustainable pace in 1985. Indeed, the rapid growth o f the first half o f last year bore troublesome inflationary implications. For example, capacity utilization rose to over 80 percent, a level many economists believe cannot be sustained without creating bottlenecks that drive up prices. Consequently, some slowing seemed necessary, although, like most people, I was surprised by its abruptness. Fortunately, even during the weak third quarter, most o f the important underlying economic conditions remained positive. Personal income, for instance, continued to grow at an annual rate o f about 4 percent, and personal savings rose as Americans spent less o f their increased incomes on consumer goods. Inflation remained around 4 percent throughout the year, a low level given the robust expansion in early 1984. Business investment slowed in the third and fourth quarters but remained essentially strong. Finally, interest rates began to fall late in 1984. By year-end, a number o f indicators were already displaying renewed strength. Thus, the fundamentals seem to be in place for healthy growth in 1985, although at a slower pace than in 1984. Consumer purchases, investment by businesses, and expenditures by the government all should contribute to making 1985 a good year, with real GNP growth probably in the range o f 3 to 3.5 percent. Consumer spending is likely to rebound since personal income and employment continued to grow even during the lull. Business spending on capital goods should continue to fuel expansion in 1985, even though the growth rate in business investment, like that o f consumer spending, probably w ill be slower than in 1984. Last yea r’s legislation modifying the tax treatment o f -12business investment did not substantially alter the favorable climate for spending on capital goods established by Congress and the administration a few years ago. Ironically, recent Treasury Department tax reform proposals, which would eliminate many special provisions designed to spur investment, could actually stimulate investment in equipment this year. Some businesses may try to take advantage o f such provisions before they are rescinded. A third source o f short-term strength is fiscal policy, which is highly stimulative. Defense spending in particular should help maintain momentum in the the nation’s factories, even if the defense budget is cut along with other federal programs. Military projects approved in the past few years should maintain strong activity through at least 1985 and possibly into 1986. Another source o f stimulus is the interest rate decline late in 1984. Reduced credit costs should spark at least a temporary revival in residential housing by attracting buyers back into the market and making it relatively cheaper for builders to undertake new projects. Finally, while monetary growth did weaken for several months, particularly in the case o f M l, recent numbers show a substantial rebound. In fact, M2 and M3 have been expanding rapidly in the past few months. Of course, some potential problems and weaknesses loom in the months ahead, and certain sectors o f the economy are less likely to join in the expansion this year. The construction industry will probably show mixed patterns in 1985. up demand for housing has been filled. sensitive to mortgage rates. in 1984. Remaining demand w ill probably be rather Multifamily building may have grown faster than demand Apartment vacancy rates are high in many areas, and the stock o f unsold condominium units is also substantial. Much o f the pent- Nonresidential construction should continue its -13momentum, but I am concerned about commercial building. O ffice vacancy rates in many cities are worrisome. Another important area o f continuing weakness is the international sector. high exchar^e value of the dollar and the slower considerable strength from American manufacturing. recovery The abroad have sapped Producers o f textiles, apparel, lumber, and other goods sensitive to foreign competition experienced weak growth in 1984, and their condition probably will not improve in 1985. In addition, industries heavily dependent on exports, such as agriculture and machine tools, cannot hope for much stimulus from foreign demand. Even if the dollar were to decline, it would take time to have a substantial e ffe c t on trade patterns. Because o f these weaknesses and the likelihood o f slower growth in consumer spending and business investment, unemployment w ill probably decline much less this year than it did in 1984. mark. Still, I am quite hopeful that it will fall below the 7 percent Also, at this mature stage o f a business expansion, the anticipated resurgence o f growth could possibly produce a somewhat higher inflation rate, probably in the neighborhood o f 4.5 to 5 percent. Overall, though, I look for respectable economic growth consonant with this stage o f the business cycle. Problem s I am basically optimistic about the future, but some problems — inflation, unemployment, real interest rates, the deficit, and international trade — still exist. Price increases did decelerate dramatically in the early 1980s and have remained a moderate 4 percent despite the recent, rapid economic growth. Nonetheless, little -14more than a decade ago 4 percent was deemed sufficiently high to warrant wage and price controls. Clearly, we have room for more improvement on this front. Similarly, our recent progress in reducing unemployment is cause for enormous satisfaction, but the current 7.2 percent jobless rate is still unacceptably high. Moreover, unemployment remains much higher in many industries and areas, including parts o f the Southeast. Certainly, we must strive to lessen the human suffering and unrealized economic potential implied by these statistics. A third problem is our high level o f real interest rates. High real interest rates increase business costs generally and discourage investment. Consumer demand for houses, autos, appliances, and home furnishings is also dampened. The large federal deficit seems likely to remain a source of upward pressure on real interest rates. Even adjusted to the level that could be expected if we had full employment, the deficit is now over 3 percent o f GNP, compared to about 1 to 2 percent in most o f the 1970s. This burden will carry over to future generations. We are obligating our children and grandchildren to save more and to pay higher taxes because o f our unwillingness to live within our means. D eficit problems a ffe c t not only domestic financial markets but also the international sector, as high real U.S. rates make dollar-denominated investments more attractive to foreigners. The higher return from holding dollars raises our currency’s exchange rate and thereby worsens our trade deficit. I have already mentioned that the dollar’s strength is hurting American exports and increasing imports ^iarply, exacting a considerable toll on American manufacturers in a wide variety o f industries ranging -15from labor-intensive apparel mills to capital-intensive steel mills. Our 1984 trade deficit totaled a record $123 billion — far above the previous record o f under $70 billion. A continuation o f the current international situation could revive protectionism. Many firms are holding on by a thread, hoping the exchange rate o f the dollar will decline. It is understandable that such firms would welcome protectionist measures to help them ride out what most economists view as an abnormal situation. protectionism by one country inevitably However, is followed by countermeasures in others. Moreover, by postponing necessary reforms, protectionism ultimately weakens the very businesses and workers it is intended to protect. Another adverse consequence o f protectionism today could be to snuff out the weak economic recovery in many developing countries by reducing their access to American markets, eliminating a major source o f the limited growth they have achieved. The situation in developing nations is also important because many o f them are heavily indebted. While default by a third-world nation is highly unlikely, LDC debt problems require careful consideration as we seek to correct domestic economic problems and promote growth in the United States. L et me conclude my remarks on the economy where I began. This will be a year o f strong economic growth, with relatively low inflation and unemployment. and always will be dangers, problems, and uncertainties. There are But I am an optimist, and I think we optimists have proven over time to be the realists. I really believe the future holds promise. We are at the threshold o f a new world, but we are also at a crossroads. If we can solve our problems, we have the chance to create an economy and a society - 16 that will provide unparalleled prosperity for us, our children, and our grandchildren in the years ahead. I believe we have the wisdom and the w ill to succeed.
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