The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
STRATEGIC A G E N D A FOR THE U.S. BANK IN G SYSTEM Remarks by Robert P. Forrestal, President Federal Reserve Bank o f Atlanta To the Conference Board 1990 Financial Outlook Conference February 14, 1990 Good afternoon! It is a pleasure and an honor to participate in this conference on the financial outlook for 1990. As we consider the year ahead, I think all of us share the feeling that we stand at a watershed in modern history. In the closing months of 1989, the Soviet Union and Eastern Europe moved abruptly to end their isolation from the rest of the world. Those dramatic events capped a decade of growing international awareness on the part of Americans. It was a period in which "globalization” became a commonlyused term in our economic vocabulary to describe the increasingly international scope of business and financial activity. In the decade ahead, globalization will become a fait accompli—and I do not need to describe to this audience the benefits and opportunities this development will present to consumers and businesses alike. Nonetheless, I am deeply concerned that in this globalized market the U.S. banking system, the keystone of our economy, will find itself lacking some of the tools it needs to compete effectively. To ensure that this nation's ability to do business abroad is not compromised by structural weaknesses among our banks, we need to do several things, and do them quickly. These are: (1) Congress needs to free banks to do more types of business and to do business wherever they wish. (2) Congress also should act to return the deposit insurance system to its original intent. Deposit insurance was meant to underwrite the stability of the financial system and not to assure some institutions that they are "too big to fail." And (3) the banking industry must abandon the mindset that comes from 50 years of government protection and adapt to the rigors of the marketplace. Today I would like to suggest a strategic agenda, one that will help prepare the U.S. banking system for the challenges of 1990 and beyond. I would like to stress that the -2 - measures I will outline pertain to policymakers and bankers alike. Let me first set the stage, however, by describing the competitive disadvantages of U.S. banks in the current environment. Regulation and Protection The international pressures that U.S. banks face today have followed quickly on the heels of domestic market challenges that rocked the industry in the late 1970s. The first steps toward bank deregulation here were taken in an effort to "level the playing field" among depository institutions and nonbank providers of financial services. What had tilted the playing field against the banks in the first place was, in part, advances in technology and communications. Computers and "800" numbers gave the public direct access to nonbank institutions that offered innovative products like interest-bearing checkable accounts and also interest rates above the ceilings then placed on bank rates. These options became more attractive to consumers in the inflationary, high-interestrate environment of the 1970s. Direct financing through placement of commercial paper also began taking a greater share of banks' traditional base of business customers at that time. These developments have led to fundamental changes in the ways banks intermediate between savers and borrowers in our economy. Many banks no longer find it economical to perform the full spectrum of traditional financing services. That is, instead of handling funding, originating, insuring, and servicing loans themselves, banks have found ways to spin o ff some of these functions. The rise of asset securitization is a good example of this unbundling. Banks now hold few er loans on their books until maturity, and this shift in emphasis may have long-lasting implications for the riskiness of their operations. Market standards for securitization imply that the best loans may be sold off. This pattern could leave banks holding assets of slightly higher risk. -3 - To help stem the tide of disintermediation, the Monetary Control Act of 1980 removed interest-rate ceilings, and the banking legislation two years later allowed depository institutions to offer NOW accounts. However, the addition of other powers that would have allowed banks greater diversification has not followed. Moreover, banks are still hampered in geographic expansion by a hodgepodge of state and federal regulations as initiatives to allow banking across state lines have had to sneak in through the back door, so to speak. Thus, deregulation has not gone far enough to allow banks to match the products and services offered by their nonbank competitors. I might add that nonbank companies that deal in insurance and securities may welcome the ability to provide banking services as well. Current regulations deny them this avenue, however, and deprive consumers of the potential improvements in price and convenience that could arise from this additional source of competition. Meanwhile, as technological advances speed us toward a 24-hour-a-day global financial market, U.S. banks must contend with foreign providers that have few er constraints on the scope of their business activity. What is more, the European Community's market unification will escalate these competitive pressures on our banks, and that development is less than three years off. As barriers to international flows of capital, goods, and services are lowered in the EC, we can anticipate extensive consolidation among banks as within other industries there. Giant pan-European corporations are likely to seek banks large enough to provide one-stop shopping for all the services they require. The same will be true of U.S. businesses which penetrate the EC market. Current product and geographic restrictions in this country prevent U.S. banks from expanding their operations in scale and scope to match the potential growth of their European counterparts. Most foreign banks already have considerably greater latitude in the types of activities in which they can engage than do ours. Banks in West Germany, -4 - for example, can hold equity positions in private companies while banks here cannot. Moreover, it appears that EC banks will soon be able to cross international boundaries in Europe with much greater ease than U.S. banks can cross state boundaries here. Thus our continuing stalemate in regulatory reform threatens to limit U.S. banks' opportunities in the potentially fertile post-1992 EC market as well as in other parts of the global market. This situation may appear to be a matter of concern only to banks, or even to big banks, but the scope of its adverse impact is much broader. It is possible that small and medium-sized firms in the United States may be at a disadvantage in expanding internationally because their financial intermediary cannot provide the same range of services that their European counterparts can obtain through their banks. Clearly, then, we all need to be concerned about the U.S. banking system's competitive disadvantages, and from what I have said so far it might seem that we need to mandate a further regulatory rollback. Unfortunately, there is one other, quite different problem that must be resolved first, in my opinion. That is deposit insurance, which has effectively placed the full faith and credit of the U.S. government behind our banking system. An unfortunate legacy of the 1980s was the discovery that deposit insurance extended an implicit safety net under all the activities of a bank that was "too big to fail." We believed that it was cheaper to use the insurance fund to pay o ff uninsured as well as insured holders of bank liabilities when a large bank's failure posed a threat to the entire banking system. The thrift industry fiasco also made it apparent that deposit insurance carries the same type of moral hazard that has been identified with respect to other types of insurance. In this case, the fact that institutions were insured against loss led them to take on riskier activities than they would have had they not been insured. A t the same time, the security offered by insurance made depositors less likely to impose market discipline on bank management by withdrawing their funds when an institution's performance faltered. In all these ways, deposit insurance has come to insulate depository institutions from market feedback that would improve their -5 - efficiency. Thus, I believe we need to start using a new metaphor to understand the banking industry's weaknesses better. as much as it is regulated. We must think of banking as an industry that is protected This remains the case even though some regulatory subsidies—such as the interest-rate ceilings that placed a cap on banks' cost of funds— have been removed. As a protected industry, banks share some of the symptoms of competitive atrophy that other protected industries display. Such industries tend to become ensnared by the safety net that was spread out to protect them. They lose the incentive to make improvements that would improve their performance and reduce the need for special treatment. Banks in some areas have also used their influence with state legislatures to slow the pace of change in interstate banking prohibitions and keep their markets protected from outside competition. In this regard, policymakers and the banking industry both have work to do in overcoming the inertia that now besets the movement toward industry restructuring. I would like to turn now to look at the strategic agenda I envision for each group. The Agenda fo r Policymakers For policymakers, the agenda primarily involves revising a structure that has been essentially a social contract among consumers, bankers, and legislators to provide certain subsidies in pursuit of a more stable financial system. However valid it may once have been, this arrangement reflects U.S. financial and economic circumstances of the 1930s and not the 1990s. With the widespread bank failures of the Great Depression, many important banking restrictions were enacted in an attempt to right perceived wrongs. It was believed—though never conclusively proven—that banks' securities dealings contributed to the stock market collapse of 1929 and the economic contraction that followed. Thus the Glass-Steagall Act of 1933 prohibited commercial banks from -6 - investment-banking activities. It also instituted the FDIC to reduce the likelihood of depositor runs, disallowed interest on checking accounts, and placed ceilings on the interest rates banks could offer for time deposits. As long as interest rates remained relatively stable, as they did through the early 1970s, banks were quite comfortable within their regulated preserve. Beginning with banks' inability to adapt to the higher interest-rate environment of the mid-1970s, however, the major provisions of 1930's banking legislation have proven either outmoded or, in the case of deposit insurance, in need of revision. A clear example of how perverse the influence of old regulations became in the 1970's setting can be seen in one of the ways banks lost out to certain money market funds. Fund managers attracted small deposits out of banks and packaged them in larger denominations, which they then redeposited into banks as jumbo CDs. These instruments yielded higher interest because they were not subject to regulatory interest rate ceilings, yet they were implicitly protected by deposit insurance. As a result, banks costs of funds increased, but they received no offsetting boost in revenues. Though this particular situation has been resolved, the banking system still has many irrational features. Thus, I believe Congress should adopt a two-pronged approach that simultaneously reins in the regulatory and protected dimensions of the U.S. banking system. First, in terms of product and geographic regulation, we need to allow banks to meet their domestic and international competitors on a more equal footing. A t the same time, the original intent of protecting limited amounts of consumers' funds through deposit insurance must be restored. In place of the broad insurance safety net that ne w exists, we should promote safety and soundness in banking by alternative means such as adequate capital standards, less regulatory forebearance, and greater market discipline. Let me elaborate briefly on ways Congress might strike this balance between regulation and competitiveness. -7 - To begin with, I think Congress needs to revise those portions of Glass-Steagall that keep banks from conducting at least those enterprises that are consistent with their banking expertise. Banks are quite good at processing information on an asset-by-asset or account-by-account basis. These skills could be safely applied to activities that are now prohibited—insurance and corporate debt underwriting, for example. The experience of U.S. bank subsidiaries that have handled similar business overseas convinces me that the risks of expanding powers in this direction do not outweigh the benefits. Moreover, it has been suggested that combining insurance services with traditional banking business actually reduces overall risk. I recognize that this move entails complexities that run to the heart of this nation's financial regulatory structure and to the corporate structure of banks themselves. Who should regulate banks' securities activities? Should they be contained in a subsidiary of a bank holding company where fire walls might keep problems from consuming the entire edifice? Or will U.S. banks remain at a competitive handicap against Europe's "universal banks," which are required to have little or no institutional separation between investment and commercial banking activities? questions, I admit, are tough ones to answer. These However, our policymakers have yet to give debate of these matters the priority that I feel reflects their importance to the nation's economic future. Aside from broadened bank powers, Congress should move directly to nationwide interstate banking. While we will approach de facto interstate banking through the laws of individual states by 1992, this country will still be left with a plethora of different laws and the unnecessary inefficiencies this lack of uniformity creates. Some states still allow cross-state banking only by banks headquartered in states within the same regional compact, and even within such regional compacts the set of reciprocating partners often varies from state to state. Together, broader product and geographic powers could bring new latitude in decisions banks make regarding the size and scope of their operations. It should also allow opportunities for diversification and profit that do not exist today, both - 8- for U.S. banks and many businesses. However, no expansion of commercial powers should come without shrinking the extent of explicit and implicit federal deposit insurance protection. We can work to restrict the latter by ending regulatory forebearance~the doctrine of "too big too fail." Still, even the explicit safety net needs reform because of the perverse incentives deposit insurance creates, as I have already described. By reform I do not mean repeal. Many would argue that deposit insurance has helped stabilize the U.S. financial system. In addition, consumers here seem to want some degree of deposit insurance, though given the fact that the banking industry is in a state of transition, it is difficult to estimate the true extent of demand for insurance. One possibility might be to reduce the limits for coverage to a level that would prompt smaller depositors to pay more attention to their banks' performance. Personally, I believe this change might simply heighten activity in brokered deposits. Given the number of insured banks and the proliferation of communication technology, investment firms could break deposit pools into smaller increments without adding significantly to their costs. If this happened, lowering the threshold of insurance coverage would bring little net gain in depositor surveillance nor would it reduce the government's exposure. Another way we could address the moral hazard problem and also assess the demand for deposit insurance would be to provide insurance for only one type of account or a single subsidiary of a holding company. With well supervised corporate divisions in place and the limits of the safety net clearly defined, banks could do whatever they wished in their other subsidiaries without abusing the insurance privilege. By the same token, if consumers favored uninsured accounts paying higher interest, we would have evidence for further modifying the system. There may be other ways to increase market discipline while maintaining deposit insurance. Larry Wall, one of our economists at the Atlanta Fed, has suggested the -9 - creation of a class of 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 at any time. Banks would be required to maintain a minimum amount of this debt to stay in operation. If investors 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 of market judgment would make regulators more effective in their jobs of identifying troubles in their early stages and effecting timely closure when necessary. The latter issue is a particularly thorny one for bank supervisors. We do not want to go in too early and jeopardize a bank's chances of correcting difficulties on its own. But if we wait too long before acting, the costs of resolving the problem can grow exponentially. Finally, I feel capital standards that are adequate with respect to variations in institutional risk should be a prerequisite for broader banking privileges. The risk-based capital standards adopted by international regulators are a positive step, though these remain to be tested. These standards convert on- and off-balance-sheet credit exposures into on-balance-sheet equivalents, and in this way provide a better assessment of an institution's overall riskiness. They also raise the minimum standard of total capital to risk-weighted assets to 8 percent by 1992. In sum, the task before Congress is to broaden banks' powers to world-class standards while decreasing the public exposure and moral hazard associated with deposit insurance. Legislators need to recognize the increasing costs of inaction and take these steps with all due haste. fairly short order. I see no reason why this reform could not be accomplished in It would help, however, if the banking industry would close ranks around the kinds of proposals I have made. Unfortunately, while many bankers agree individually that such steps are necessary, as a group they have been unable to reach a -1 0- consensus on what should be done. I would like to conclude my remarks this afternoon by suggesting that the industry's agenda should be to agree on a program for reform and to set to work with policymakers on putting it in place. Agenda fo r the Banking Industry Far from showing a united front, the various industry lobbying groups send mixed signals to policymakers. For example, on one hand, many bankers clamor for broader powers, but on the other, they resist the strengthened capital standards that would make broader powers feasible. Again, bankers claim to desire greater competitiveness, but they have used their clout to keep new competitors from entering their own markets in certain regions. Those regional banking compacts provide a good illustration of the protectionist attitudes that work against progress toward industry reform. In spite of the fact that some larger banks have now for the most part exhausted their avenues for growth within their regions, many have shown little interest in opening their state boundaries to wider outside institutions. I can only assume they would rather limit their own horizons than accept greater competition. Such an attitude represents as much a failure of imagination as of ability to compete. Industries that have faced up to outside competition and streamlined their operations in response have emerged stronger than ever. The textile industry in my part of the country is one example. A fter being battered by cheaper imports, textile manufacturers brought themself back to profitability by adopting productivity-enhancing equipment and procedures. This is the correct—indeed, the only way to succeed in the global market. In many ways, U.S. banks have shown a great ability to innovate in response to changing market conditions. In recent years banks have pioneered a number of new -1 1- products, like swaps, which help businesses manage interest- and exchange-rate risk, and the growing securitization of assets, which broadens the pool of potential investors. Thus I am confident of the industry's creativity. Their record of innovation suggests to me that the industry is fully capable of meeting competitive challenges and has no need to hide behind protective barriers. Instead, bankers need to shake o ff the narrow ways of thinking that linger from half a century of protection and turn their energies to forging a unified program for progress. If they do not, they risk allowing their competitors to dominate the global banking market. Conclusion In conclusion, I feel the market for U.S. banks—and hence for all American businesses—is potentially much greater as the global market evolves. However, the industry must prepare itself for broader competitive challenges as well. Banks need to end their opposition to the dismantling of government protection and find ways of being more competitive in a free market. A t the same time, policymakers must break their own gridlock and renew efforts to complete the job of deregulation. It is clear what needs to be done—reform deposit insurance, end the remaining constraints on interstate banking, and repeal Glass-Steagall. make the time for doing it short. It is also clear that developments like Europe 1992 U.S. banks need to be ready for the post-1992 global market, and U.S. industry needs our banks to be ready for it. It is time for bankers and policymakers to come together and bring our banks into step with the historic changes transforming the world's economic and political landscape.
@FedFRASER