Full text of Statements and Speeches of Silas Keehn : Changing Financial Structure and Its Implications : Vanderbilt University Luncheon Remarks, Nashville, Tennessee : Speaking Notes

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FEDERAL RESERVE BANK
OF CHICAGO

MEMO
DATE:

March 28, 1991

TC:

Silas Keehn

FROM:

Herb Baer

SUBJECT:

Vanderbilt speech

, )(

d- SJ

Attached is the text of your speech alon with matching hardcopies of the siides.
The slides themselves should be ready at the end of the day tommorrow. We will
give you any corrections on Monday.
The books were mailed today and readings were mailed this last Monday.

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Federal Reserve Bank of St. Louis

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The changing financial structure
The 1980s have been a decade of change for the financial services Industry. The last 8 years
that I've spoken to MBAs at this school, I've spoken about those changes.
Securitization, loan sales, and off-balance-sheet guarantees have become a crucial part of the
banking business. Competition from nonbanks and foreign banks has eroded banks' market
dominance In many areas.
Restrictions on branching relaxed and prohibitions on Interstate acquisitions have been
ellmlnated. Regulation

a which restricted the ablllty of banks to pay market rates on deposits Is

an historical artifact and the Glass-Steagall Act which has kept banks out of underwriting has
been partially breached.
During the 80s, regulators sought to bolster the capital of the banking Industry. These efforts
culminated In the adoption of the risk-based capital requirements which came Into effect In
1990.
On a less uplifting note, the 80s has also revealed.some glaring weaknesses In our system of
bank safety and soundness regulation. The S&L Industry erided the decade $200 bllllon In the
red and the solvency of the BAnk Insurance Fund was beginning to be questioned.

THE CHANGL.'lG ROLE OF COMMERCIAL BANKS

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 1

The changing financial structure

What I would like to do today Is review some of the changes that have been occurring and to
explore the Implications of these changes. My comments can be divided Into four parts :
A discussion of the changing role of banks
An examination of the reasons for these changes
The future direction of the Industry, and
Proposals to reform the regulation of the Industry

THE CHANGING FINANCIAL STRUCTURE

Analyze banks' changing role
Examine why their role has changed
Discuss future changes
Reform regulation

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 2

The changing role of commercial banks

Financia1 intermediation

I am sure you are all well aware of how the
financial intermediation process works, but
allow me to run through it very briefly .

THE CHANGING ROLE OF COM:\-lERCIAL BANKS

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Federal Reserve Bank of St. Louis

Financial intermediaries--banks, S&Ls,
finance companies, life insurance companies,
brokerage firms, and mutual funds--issue
claims on diversified pools of assets.
claims are held by corporations and
households with funds to invest.

FINANCIAL INTERMEDlARlES
Liabilities
Assets

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Federal Reserve Bank of St. Louis

Cash

Deposits

Securities

Other borrowings

Loans

Capital

These

The claims include liabilities of depository
institutions such as demand deposits, time
deposits, bankers acceptances, and repurchase
agreements, as well as non-deposit
liabilities such as commercial paper issued
by finance companies, mutual funds shares,
reserves of life insurance companies, and
pension fund reserves.

ASSET

/'ri-t;"(",..,.,,,,_"f'ol,A .,....fn'"I
HOUSEHOLDS

BUSINESSES

Deposits

Dq,osiis

Mania! funds shares

Mutual funds shares

Life insur:utCe reserves

Commercial paper

Peas ioa funds reserves

FINANCIAL INTERMEDIARIES

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Federal Reserve Bank of St. Louis

Assets

Liabilities

Cash

Deposits

Sccarities

Other borrowings

Lo111ts

Capital

Financial intermediaries can be directly
involved in creating the assets that make up

these pools.

This is the case with banks and

finance companies, which typically originate
and service a large portion of the loans in
their asset portfolios .

These loans might

include loans to individuals for homes, cars,
etc. and loans to businesses for equipment,
working capital, etc .
Households and businesses do not have to use
the services of intermediaries to acquire
assets or receive credit.

In fact, some

evidence indicates that, in some instances,
financial intermediaries, and especially
depository institutions, are being bypassed.
This is certainly the case in short-term
lending to large firms.

TITLE
ASSET
BUSINESSES
Deposits

Deposits

Maltllll funds shares

Mataal funds shares

Life imaraDce reserves

Commercial paper

Pension funds reserves

FlNANCIAL IN"TERMEDIARIES

Assets

Liabilities

Cub

Deposits

Secarities

Other borrowings

Loam _ _ _
Capital _
,_

HOUSEHOLDS

BUSINESSES

Mortgage lou,s

Commercial IOUIS

Au10 loans

Commercial monpges

Credit c:ird loam

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Federal Reserve Bank of St. Louis

LIABILITY

10h

Several studies by my staff have found the
,,,

presence of significant competition in the
financial servces industry from nonbanks,
especially in providing financial services to
consumers..

In 1987, 28 nonbank firms, such

as GMAC and Sears, held 44 percent of the
consumer loans outstanding at the 28 nonbanks
and the 20 large commercial banking firms
studied.

Also, six of the 10 largest

consumer installment lenders were nonbanks.
GMAC, General Motor's captive finance
subsidiary, heads the list with over $55
billion of consumer loans, followed by
Citicorp, Ford Credit, and American Express.
Furthermore, four of the largest nonbank
providers of consumer loans held almost twice
the consumer loans

as the four commercial

banking firms in the top ten.

Consumer lenders study group: 1987*
\ \lilli1111 s llf doll;.irsl
GMAC

44,399

Ford Credit

38,147

American Express

28,884

Sears

26,068

Chase Manhattan

16,752

Prudential

14.795

Chrysler

12,236

Manufacturers Hanover

11,652

Security Pacific

10,798

"Includes credit card and all consumer
installment loans except mortgages.

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Federal Reserve Bank of St. Louis

S55,050

Citicorp

While nonbanks are clearly formidable
competitors of commercial banks, they are not
quite as impressive as they once were.

1982, for example, the same 28 nonbank firms
mentioned before held 54 percent of the
consumer loans outstanding at the nonbank and
banking firms in the study group.
The primary reason nonbanks have lost market
share is that commercial banking was, as I
mentioned earlier, significantly deregulated
during the 1980s.

A less regulated

environment has allowed commercial banking
firms to compete quite successfully with
nonbank providers of financial services.

BANKS VS. NONBANKS IN CONSUMER LENDING
Mar1<el share (percent)
70

58%

1962

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Federal Reserve Bank of St. Louis

1988

Consumers save less at banks

Deregulation has been of less help on the liability side of the balance sheet. In 1976, 75 percent
of the Interest bearing assets owned by households were Issued by banks and S&Ls. By 1990,
banks' share had fallen to 54 percent. But even here, things would have been even worse
without deregulation.
Consumer holdings of treasury securities and money market mutual fund shares grew rapidly in
the high Interest rate environment of the late 70s and early 80s when Interest paid on consumer
deposits was still subject to Regulation

At the end of 1982 MMMF shares stood at $242

billion.
In late 1982 banks were authorized to offer money market deposit accounts - a short term
savings account that paid market rates. Seven weeks often their Introduction, balances In
MMDAs surpassed $242 billion and by mld-1983, balances In MMMFs had declined to $180

billion. Without interest rate deregulation, this business would have been permanently lost to
banks.

CONSUl\lERS SAVE LESS AT BANKS
Percent

0.80

0.75

0.70

0.65

0.60

0.55

0.50

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1976

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Federal Reserve Bank of St. Louis

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Vanderbilt speech / March 28, 1991 / Page 9

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Top commercial lenders

As Is the case with loans to consumers, banks face considerable competition from nonbanks.
Half of the top 10 commercial lenders are not banks. The original purpose of many of these
nonbanks was to finance the sale of Its parent's products. However, they have gradually
become expanded their lending activities to a broader array of customers. Unlike banks,
nonbanks are free to provide commercial borrowers with complete Investment banking and
commercial banking services. This strategy has been pursued aggressively by firms like
General Electric and Prudential.

TOP COMMERCIAL LENDERS

(b-

$ Millions

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Federal Reserve Bank of St. Louis

Citicorp

$41,603

$35,939

GMAC

$28,462

Manufacturers Hanover

$27,545

Chase Manhattan

$25,251

Prudential

$27,333

Aetna

$22,681

Security Pacific

$18,828

Chemical

$18,802

TIAA

$17,330

Vanderbilt speech / March 28, 1991 / Page 10

Commercial paper vs. bank loans

But the biggest slngle source of competition for banks has come from the from the commercial
paper market. Between 1976 and 1990 banks share of short term lending declined from nearly
50 percent to a little more than 20 percent. Meanwhile commercial paper's share grew from 38
percent In 1976 to over 80 percent In 1990.

BANK LENDING TO CORPORATIONS
Pen:ent
85

60 '---'-----'--_.__..____._.,____,._____.____,___,__.__,
1976

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Federal Reserve Bank of St. Louis

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Bank lending to corporations

As a result of competition from nonbanks and t e rapid growth of commercial paper, banks
share of tending to nonfinanclal corporations fell from 80 percent In 1976 to 65 percent In 1988.

COMMERCIAL PAPER VS. BANK LOA!'IS FOR LARGE MANUFACTURING FIRMS

... ,
,_ -

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,
\,

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Bankloanslo
' - - • '--"
101al short-1erm debt

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Federal Reserve Bank of St. Louis

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Vanderl>ilt speech/ March 28, 1991 / Page 12

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I 2-

Increased importance of nontraditional activities

On-balance-sheet-estimates of the role of banks as suppliers of credit to nonflnanclal firms,
especially large firms, fall to adequately convey their role In the process.
The traditional credit process had banks Identifying potential borrowers, making a credit
evaluation, funding the loan with bank deposits, and servicing the loan. In the last decade,
several Innovations have made It possible to unbundle this process.
With guarantee products like standby letters of credit and loan commitments, banks stlll
evaluate risk and bear part or all of the risk of a loan whlle leaving someone else to provide the
funding and perform the servicing. With whole loan sales and asset-backed securities, the bank
continues to originate and service the loans, but has others fund the loans and bear the credit
risk.

INCREASED IMPORTANCE OF NONTRADITIONAL ACTIVITIES

Standby letters of credit
Loan commitments
Securitization
Loan sales

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 13

Loan commitment

Borrowers use loan commitments to Insure against llquldlty risk and, to a lesser extent,
changes In credit risk. For example, rating agencies generally require commercial paper Issuers
to obtain a loan commitment from a commercial bank. This guarantees that the commercial
paper Issuer will have access to funds even if the commercial paper market Is temporarily
disrupted, as was the case following the demise of the Penn Central In 1970 {?). With a loan
commitment In place, the commercial paper Issuer wlll be able repay the commercial paper that
comes due even If he Is unable to Issue new commercial paper.
To the extent that the commitment locks In a particular risk spread, It also provides some credit
risk Insurance. However, banks are Increasingly tying the risk spread to usage and to Important
flnanclal ratios.

LOAN COMMITMENT

Borrower

Loan

11111

Lender

11111 . __ _ _ ____,
Repayment

F e ~ ~ ' , ,Loan
Bank

(Issues commitment)

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Federal Reserve Bank of St. Louis

Vanderbilt speech/ March 28, 1991 /Page 14

lSa..

Standby letters of credit require the issuing
bank to fulfill a customer's obligation if
the customer is unable to do so.

Standbys

are often used to guarantee performance of
debt contracts.
Standby letters of credit involve three
parties--the account party, the issuer, and
the beneficiary.

The account party, such as

an issuer of commercial paper or municipal
bonds, obtains a standby letter of credit
from a bank, the issuer, naming the third
party, such as a creditor, beneficiary.

The

standby letter of credit is payable upon
presentation of evidence of default or
nonperformance by the account party.

The

bank is legally bound to pay the beneficiary
if the account party defaults or does not
perform according to some contract whether or
not the bank knows the account party is
unable to repay the bank.

Conservative

estimates based on a survey by the Federal
Reserve indicate that standbys backed at
least .2 percent of debt issued by
nonfinancial corporations in 1980 and at
least 1.8 percent in 1985, the last year the
survey was conducted.

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STANDBY LETTER OF CREDIT

Account party

◄

~
Bank
(Issues SLOC)

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Federal Reserve Bank of St. Louis

Beneficiary

17a..

In order to measure the relative importance
of standby letters of credit and formal loan
commitments, my research staff used a
weighting scheme suggested by the Federal
Reserve Board's proposal for risk-adjusted
capital to factor financial guarantees into
the traditional measures of market shares.
They found that banks' share of total credit
services to nonfinancial corporations grew
between 1975 and 1983.

They also found that

market share measures based solel y on
balance-sheet data underestimate banks' role
in financial intermediation by 5 to 6
percentage points.

These findings suggest

that banks have become more important as
suppliers of credit services to nonfinancial
corporations.

However, their role as

suppliers of funds has not grown as rapidly
as their role as suppliers of guarantees.

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Federal Reserve Bank of St. Louis

IMPACT OF OFF-BAIA'\JCE-SHEET GUARANTEES
Percent
45

With guarantees

({

35
'\

Traditional products only
30

2' ..____,__
1976

_.__...__.__
1978

1980

V'J

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Federal Reserve Bank of St. Louis

_.__...__.__

1982

_.__.___.____,
19&4

1986

Selling loans

Banks have also begun selling large quantities of commercial loans to outside buyers.
Traditionally, commercial banks originated loans and funded them with deposits. Large loans
that exceeded the originating bank's legal lending limit was often syndicated or participated.
But In the early 1980s, some large commercial banks, especially the large ones began to use the
loan sales market to, In effect, underwrite corporate debt.

SELLING LOANS

COMMERCIAL
LOANS

BANK

With recourse

Without recourse

• Assets remain in
organization's balance sheet

• Assets move ott of
0<ganization·s balance sheet

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 17

Ir .

C&I loans sold to nonbanks

At first the buyers were largely other banks, but by 1990 nearly $20 billion In loans was being
purchased by nonbanks - roughly 3 percent of total C&l lendlng by banks. Principal purchasers
of these loans Include a relatively new type of Intermediary - special purpose mutual funds
known as prime rate funds.

C&I LOANS SOLD TO NONBM'KS

Loans sold to nonbanks
15

0
3131/87

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Federal Reserve Bank of St. Louis

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Vanderbilt speech/ March 28, 1991 / Page 18

Commercial banks as well as nonbank firms
also sell assets via the securitization
process.

Securitization, which originated in

the secondary mortgage markets and has since
spread to others, is the pooling and
repackaging of loans into securities, which
are sold to investors.

TURNING LOANS INTO SECURITIES

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Loans an: bundled

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s-=::1&=:iJ

md sold as securities

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Pay-lhroughs
•

Securitin - c o 1 1 debtol>lipiaalofi--

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Federal Reserve Bank of St. Louis

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bo.c.~~d

A s s e t - b o o ~ P:iss-dlroughs
•

Securities - collaenwiod
debt oblig,oiom o f ~

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Soaariry ~ - ,
i.a _.,.,. pool

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~ poaod -111 co"'""""

Commercial banks have been relying rather
heavily on one form of securitization--assetbacked commercial paper--to provide financing
for corporate as well as institutional
customers.

A firm sells receivables of

higher credit quality than that of the
selling firm to a corporation that is
sponsored by the bank and set up for the sole
purpose of issuing commercial paper backed by
the receivables.

Because the commercial

paper is backed by assets of higher credit
quality than that of the firm that sold the
assets, the commercial paper carries a higher
credit rating than the seller and requires a
lower interest rate than would otherwise be
the case.

Of the $29 billion of asset-backed

commercial paper issued, a commercial banking
affiliate provided the vehicle for 83 percent
of the dollar amount issued.

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Federal Reserve Bank of St. Louis

Assets held as asset-backed securities

The process of securitlzation has had a dramatic impact on credit markets. In 1990 37 percent
of residential mortgages had been securitized. Significant though less dramatic Inroads have
been made securitlzlng credit card receivables, trade receivables, and auto loans. Even In the
commercial lending area, securltlzatlon Is beginning to take hold as banks and other Issuers
experiment with various structures for securitlzlng loans to highly leveraged companies.

ASSETS HELD AS ASSET-BACKED SECURITIES

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Federal Reserve Bank of St. Louis

37.0%

0.2%

Resldanllal C,edt catd
mortll"9H reoolvables

Trade
aedt

Auto

loans

Olhe<

Business
oonsume, debt
loans

Vanderbilt speech / March 28, 1991 / Page 20

The changing profitability of commercial banks

The dramatic changes that have occurred In the role of commerclal banks, have been
accompanied by equally dramatic changes in profltablllty. These changes foreshadow suggest
that the nation's largest and smallest banks are destined for some rough sledding in the next
decade.
Between 1980 and 1982, Industry ROA averaged a relatively healthy 69 basis points.
Between 1987 and 1989, Industry ROA averaged only 41 basis points - a decline of roughly 40
percent!
Even after throwing out the energy states of Texas, Oklahoma, Louisiana, Colorado, Wyoming,
and Kansas industry ROA has declined by 1o basis points, a 15 percent decline.
And, while the f lnal results are not yet In, results for 1990 are likely to reinforce this trend,
thanks to losses In New England, the Middle Atlantic states, and the Southeast.

CHANGES IN PROFITABILITY - INDUSTRY AVERAGES
Relum on assets (basis points)
80

1980-82

1987-89

All banks

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Federal Reserve Bank of St. Louis

1980-82

1967-89

Tax energy states

Vanderbilt speech / March 28, 1991 / Page 21

The changing pattern of profitability

Very large and very small banks have born the brunt of this decline.
While competition has long forced the nation's largest banks to operate on razor thin margins,
small banks tradltlonally could count on being the most profitable In the Industry
This Is no longer the case.
Today, the small banks are among the least profitable In the nation, having experienced an 80
percent decline In their profitability.
Margins at the nation's largest banks have also been hit. The tidal wave of change that Is
sweeping the Industry has led to a 75 percent decline In ROAs at banks with over $10 billion In
assets.
Least affected by these changes are banks with assets between $100 million and $1 O billion.
These changes In the pattern of profitability suggest that winds of change that buffeted the
Industry during the 1980s will continue to blow during the 1990s. In a free market economy only
the flt and the profitable survive. Many banks both large and small are falling the test and can
be expected to decline In relative Importance over the next decade.
The next logical question Is, "Why are these changes In role and profltablllty occurring?"

CHANGES IN PROFITABILITY
Return on assets
12

0 .0 L - . . . . . . . - - - ' - - - - - - ' - - - - ' - - - - ' - - _ . __
0 -9
10·2•
25..9
50.99
100-300
JOO1,000

__._____,

1,00010 ,000

> 10,000

Asset size (millions of dolars)

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 23

The benefits and costs of regulation

Costs associated with regulation have been an important catalyst for change - particularly In
the highly competitive field of wholesale banking.
Many observers believe that regulation has been Instrumental In moving commercial banks
away from the traditional banking activities of lending and deposit-taking toward newer
activities llke financial guarantees, loan sales, securitlzatlon, and other Investment-banking
services.
Today, banks seem to have a comparative advantage In originating loans but a disadvantage In
funding them. This disadvantage stems from the "regulatory truces" banks must pay In the form
of. ..
federal deposit Insurance premiums that do not vary with risk,
required reserves that do not bear Interest, and
mandatory equity capital requirements that exceed those that would be maintained in the
absence of regulation.
Against these costs, banks must balance the benefits of a bank charter: federal deposit
Insurance and discount window privileges.
These two advantages, especially deposit Insurance, allow high-risk banks to attract deposits at
I

a lower rate than would otherwise be possible given the risks they are taking. However, for lowrisk assets, this lower rate Is offset by relatively large regulatory t~xes.

REGULATION

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Vanderbilt speech / March 28, 1991 / Page 24

Reserve requirements tax

Much of the Innovation during the 1970 was driven by the cost disadvantage created by forcing
banks to Invest a proportion of every dollar deposited In the bank In non-Interest- bearing
reserves at the FED.
The combination of high Interest rates and reserve requirements caused many bank borrowers
to switch to the commercial paper market.I As a result, restructure their funding to reduce
rn!iefVe reqUlrements. Some banks even decided to give up their membership In the Federal
Reserve to escape the reserve requirement. C~ gress responded to the membership problem
by drastically lowering reserve requirements from 1980 to 1986.

As a result of these changes, reserve requirements fell fromr i ,rcent of deposits In 1976 to
1.2 percent of deposits In 1990. Assuming an Interest rate ~

ercent, the reserve

requirement tax would have been roughly 40 basis points In 1976. 44 basis points may not
seem like much but In a business where 80 basis points Is a good ROA and corporate treasurers
are wllllng to run over their own mother to save 12 basis points, It Is enough to move large
amounts of business out of the banks.
By 1990, the reserve requirement tax had fallen to 12 basis points - a fifth of their level In 1976.
With a reduction of this magnitude, banks should have found themselves In stronger position In
providing tradltlonal financial Intermediary services. However, other changes have had the
effect of offsetting the reduction In the regulatory tax.

RESERVE REQUIREMENTS TAX
Basis points (pa< dollar ol assets I
50

Burdensome in the 70s
Reduced between 1980
and 1986 by DIDMCA

Further reduced in 1990
30

Reserve requirements tax

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1976

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

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'84

'86

'88

Vanderl>ilt speech / March 28, 1991 / Page 24

'90

Capital requirements tax

One factor has been the steady Increase In the amount of equity capital that banks regulators
are requiring banks to hold.

The burden that equity capital requirements placed on banks has two components:

ers are reated as expenses and are therefore tax deductible, while
returns to equity holders are treated as Income and are therefore taxable.
The second component. I

ure the burden of equity re ulrements

.!!Je amount of equity that a bank would desire to hold In the absence of regulation and deposit

lnsuranc,e. The fact that money market funds have succeeded by offering shares backed by

c ommercial paper, bank CDs, and treasury securities and that these shares are redeemable at
par on demand suggests that In the absence of regulation the equity requirements for these
types of securities are minimal.
During the Mid 80s, the combination of rising equity capital requirements and Increases in the

effective tax rate on bank Income lead to a big Jump In the capital requirements tax. Our
estimates suggest that the capital requirements burden Increased form a low of 5 basis points In
1981 to a high of 27 basis points In 1985. By 1985, the capital requirement tax accounted for 50
percent of the total regulatory tax, up from 13 percent In 1981.
Tax law changes In 1986 caused this to decline somewhat and today we estimate that capital
requirements Impose a 20 basis point tax on low-risk commercial and consumer lending.

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Federal Reserve Bank of St. Louis

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•fl<'ech / March 28, 1991 / Page 25

Had nothing else changed, regulatory taxes would have fallen from 58 basis points In 197i Po 32
basis points today.

CAPITAL REQUIREMENT TAX
Basis p<>nts (pa< dolar ol assets)

Debt and equity treated
differently for tax purposes
25

Equity capital requirements
for low-risk loans hi9her
than without regulation

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Federal Reserve Bank of St. Louis

Vanderbilt speech/ March 28, 1991 / Page 26

Deposit Insurance premiums

However, the rash of bank failures that began In the early 1980s together with the decision to
ball out uninsured depositors has driven up the Federal Deposit Insurance Corporation's
outlays and driven down their reserves from a high of $18 bllllon to an estimated $8 billion.
As a consequence the premium the FDIC charges banks has gone from 4 basis points In 1976 to
20 basis points today. This premium should be viewed as a tax since It must be paid by all
banks - regardless of their risk.
More worrisome from a bank perspective, Is the fact that premiums may well go higher. Indeed,
the Congressional Budget Office estimates that premiums would need to go up to 40 basis
points to ensure that the fund will have sufficient resources.

DEPOSIT INSURANCE PREMIUMS
Basis points (per dollar ol assets)

so
Not risk-based
Reflects the health
of the FDIC

I
I

I
I
I

I
20

0 '--'---'---'----'---'-----'--'---'----'--.l-J'--'------L-'----'--.i-.J

1976

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

'80

'82

'8-<

Vanderl>ilt speech / March

'86

'88

'90 I 191 &'91 '92

The burden of regulation

The run-up In the capital requirement tax and deposit premiums has largely offset what would
otherwise have been a decline In total regulatory taxes. Today, taxes stand at 50 basis points,
/

down only eight basis poi ols from 1976, The failure of regulators to achieve a greater reductl~ n
In regulatory taxes explains the continued pressures for banks to develop new cheaper ways to

serve customers needs.
If anything this process threatens to accelerate In the 90s. If deposit Insurance premiums were
to go to 40 basis points, total regulatory taxes would rise to 74 basis points. Regulatory taxes
would be nearly double the Industry's current after tax ROA of 41 basis points Implying a tax
rate on Income of nearly 65 percent! Proposals to further Increase the minimum equity capital
requirement will only serve to Increase the pressure on market share and profitability.
Ironically, these changes hit hardest at those assets least likely to cause problems - low-risk
assets.

THE BURDEN OF REGULATION
Basis points {pef dollar ot assets)
70

'----,

' ' .....

Capital requirements lax

'''

----

...........

, , __ .......... __

Reserve requirement tax
0

L-'---'---'---'--'--''------J'------J'------J'------J' - - - - " ~~
'76

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

'78

'80

'82

'84

'86

'88

Vanderbilt speech / March 28, 1991 / Page 30

'90

Pressures on capital during the 80s

Adding to the pressures created by regulatory taxes, during the 80s many banks found
themselves suffering loan losses at the same time that capital requirements were rising.
Reserves for loan losses rose from about .4 percent of loans In 1980, to a high of 2 percent In
1987. As a result of actually charging off losses In 1988, 1989, and 1990; loan loss reserves are
now at about 1.2 percent. However, they are sure to rise sharply In 1991 as with real estate and
LBO loans continue to head south. The principal victims of this decline In asset value have
been the money center banks and regional banks operating In the Southwest and more recently
New England.

PRESSURES ON CAPITAL DURING THE 80s
Loan k>ss reserves as a percent of total loans

2.5

2.0

1.5

1.0

0.5

0.0 L . . _ ~ - - - ' - - - ' - - - ' - - - '1960
·01
112
'83
'84
'85

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Federal Reserve Bank of St. Louis

Vanderbilt speec

....L---'--,....___._--.J
'86

'8 7

'88

, 1991 /Page 31

'89

'90

Implications of poor capital

These losses mean banks have less capital. This forces them to slow their growth and
Increases the risk of dealing with them. Relationship customers, customers purchasing
guarantees, and uninsured depositors all begin to pull back as the banks continued ability to
meet the needs of Its customers are called Into question. Poorly capltallzed banks may also find
themselves slowly closed out of the foreign exchange and Interest rate swap markets.

L\1PLICATIONS OF POOR CAPITAL

Growth slows
Risk increases
Borrowers seek alternatives
Uninsured depositors leave
Guarantees are less attractive
Ability

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Federal Reserve Bank of St. Louis

trade reduced

Vanderbilt speech/ March 28, 1991 / Page 32

Capitalization of money center banks and competitors

All of this wouldn't be so bad for the money center banks If customers didn't have other
alternatives. But, fortunately for the economy and unfortunately for the money centers, better

t of money center banks had market capitalization ratios In excess

'iR-~mr.~1i6 percent of regional banks and 55 percent of large foreign banks had market
capital in excess of 5 percent of assets.

CAPITALIZATION OF MONEY CENTER BANKS AND COMPETITORS
Foreign
banks

Have nots

Haves

U.S. regional _ _..__.....- ~..
•-----f------banks

U.S. money - - - < N - . - - + - i - - - - - . - : : - - - - - - center banks

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Federal Reserve Bank of St. Louis

6
8
10
12
14
16
Market capiraHzation as a percent of assets

Vanderbilt speech / March 28, 1991 / Page 33

Foreign branch shares of SLOCs and C&I loans

In part because most money center banks have relatively little capital, they have been losing
share to foreign banks. Better capitalized banks - foreign or domestic - face less pressure to
contract lending and are can Issue higher quality guarantees.
B
Between 1980 and 1988, the share of C&l loans held by branches of foreign banks rose fro
percent to 15.6 percent. In the last two years, their share has gone up another 4 percent t 19.6
percent.
The Impact on standby letters of credit has been even more dramatic. With a standby letter of
credit, the beneficiary bears risk that the guarantor will be unable to perform. Therefore he
wants to know that the guarantor Is unlikely to become Insolvent. Between 1980 and 1988
foreign branches' share of SLOC Issuance rose from 1O percent to an astonishing 53 percent.

FOREIGN BRANCH SHARES OF SLOCS Al'ID C&I LOMIS
Pe<C8<i
60

53.0%
50

0
1980

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Federal Reserve Bank of St. Louis

Vande

1984

1968

age 34

? s'

Impact of market capitalization on domestic banking

As a result of capital pressures, money center banks have not only lost business to foreign
banks, they have also lost business to other U.S. banks. In 1980, money center banks
accounted for 19.4 percent of domestic bank deposits. Nine years later, money center banks
accounted for only 15.2 percent of U.S. deposits.
As this chart Illustrates, the banks facing the greatest capital pressure turned In the poorest
growth records. Banks with poor market capitalization grew much more slowly during the 80s
than banks that had high market capitalization.
At the same time that the money center banks began facing capital pressures, two other forces
were working to Increase competition In wholesale banking

IMPACT OF MARKET CAPITALIZATION ON DOMESTIC BANKING
Growth In assets (1980-89)
35

•

• Regional banks
30

• Money center banks

•

•• • •
• • • •
••
• ••••
•• • •
•

...

01-----------..----------5 L,___.__...L......JL-J..-'-~--'--'-'---'-_L--'-'---'-~~~
0

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

•

6
8
10
12
1,
16
Market capitalization as a percent of assets

Vanderbilt speech / March 28, 1991 / Page 35

Japanese banks had a capital windfall

Perhaps the most Important event, from the point of view of the money center banks was the
capital windfall enjoyed by the Japanese banks. Unlike U.S. banks, the major Japanese banks
often purchase equity as well as debt from their customers. In 1984 the Japanese stock market
began a dramatic rally which Increased the market capltallzatlon of Japanese banks ten fold.
With little Incentives to pass the winnings on to their shareholders, the Japanese suddenly
found the depositors willing to provide them with money at extremely favorable rates. As a
result, Japanese banks quadrupled their International assets In a four year period. Much of that
Increase took the form of lending to U.S. corporations. The Introduction of new lending capacity
Into world banking markets had the predictable effect of putting downward pressure on spreads.

I·

JAPANESE BAI'lo'KS HAD A CAPITAL WINDFALL
Index, 1978-100
1,800

,
,,

1,500

Market capitalization '
of Japanese banks , '

1,200

I
I

900

,..
,
,,

600

300

....,,,,

Markel capitalization
ol U.S. banks

0 .____.___.__,___.__.___..____.__

1979

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

"81

'83

'85

_,___-'-__.___,

'87

Vanderbilt speech/ March 28, 1991 /Page 36

'89

Falling underwriting costs added pressure

This downward pressure was aggravated by declines In the cost of raising funds by Issuing
securities. Many of the money centers largest customers viewed securities markets as an
appropriate substitute for bank credit. The deregulation of securities markets and the growing
Importance of the direct placement market dramatically reduced the cost of raising money by
Issuing securities.
Between 1980 and 1989, underwriting fees fell from a llttle less than 4 percent of the offer price
to roughly 1.5 percent of the offer price.

DECLINING UNDERWRITING COSTS PUT PRESSURE ON C&I LENDERS
Percent
5

0 '-------'---'--------'-----'--~--'--~-~~
1980
·s 1
·sz
113
114
·as
'86
111
'88
119

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 37

As a result, loan spreads declined

Greater competition from the Japanese, greater competition from securities markets, and
Increasing regulatory taxes combined to push down the effective spread on low-risk loans from
154 basis points In 1984 to 128 basis points In 1989. Thus at a point when the money centers
needed to rebuild their capital, they were also finding that the fundamental profitability of
traditional banking was being eroded.

CflJ1--U

Q ..

V0 5 (c

?
,

//
,I

&1-~/

AS A RESULT, C&I LOAN SPREADS DECLINED
(Adjusted for regulatory taxes)
154

128

1984

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Federal Reserve Bank of St. Louis

1989

Vanderbilt speech / March 28, 1991 / Page 38

...

Increased competition in retail banking

Retail banking also underwent dramatic changes during the 1980s. Money market funds were
able to capture a large portion of the lucrative retail deposit business. And, at the close of the
decade, major nonbanks like Sears began to make Inroads in the lucrative credit card market.
Technology also played an Important role. The Introduction of ATMs and the spread of shared
networks has dramatically lowered the cost of providing convenient service to customers. This
has undoubtedly led to a dramatic Increase in competition and a further eroded bank
profitablllty.
However, the key factor affecting the structure and profitability of retail banking during the
1980s was unquestionably deregulation

INCREASED COMPETITION IN RETAIL BM'KL.'l'G

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Federal Reserve Bank of St. Louis

Vanderbih speech / March 28, 1991 / Page 39

Deregulation of retail banking

In a free market economy, firms are typically are allowed to locate where they want and sell
whatever products they want at a price of their choosing. In banking on the other hand, state
and federal law traditionally told banks where they could operate, what they could sell, and even
what price they could charge.
At the beginning of the 80s banks were forced to pay small savers rates on deposits that were 5
to 15 percent below market rates, Interstate banking was prohibited, and many states llmlted
banks to operating In a single county or even to operating a single office.
These restrictions protected all banks from competition, but the biggest beneficiaries of this
system were the nation's most Inefficient banks. Interest rate ceilings, branching restrictions,
and prohibitions on Interstate banking all served to protect Inefficient banks from the
competitive Inroads of more efficient banks. Unable to pay higher rates or locate close to
customers, these efficient banks found It difficult to expand their customer base.
By the end of the 80s many of these anticompetitive restrictions had either disappeared or
softened.
At the Federal level, laws allowing regulators to set ceilings on the rates banks paid to
depositors were eliminated. This process began with the passage of DIDMCA In 1980, which set
In motion a six year phaseout of Interest rate ceilings.
At the state level, the near uniform prohibition against Interstate banking crumbled. At the
beginning of the decade Interstate banking was generally prohibited. By the end of the decade,
47 states permitted some from of Interstate banking. 13 of these states require that the acqulrer

DEREGULATION OF RETAIL BAL'lKING

Elimination of Regulation Q
Easing of branching restrictions
Interstate banking

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 40

'f I

come from a particular region - often an adjacent state. The rest permit acquisition on a

nationwide basis or a nationwide reciprocal basis.
29 states also chose to relax restrictions on Intrastate branching. At the beginning of the 1980s,
13 states permitted statewide branching. By the end of the decade, the number had swollen to
34.

The win ners tcorn deregulation were banks with assets between $50 million and $l O blllloo Ill.

assets. Excluding the banks In the energy states, banks In this range actually ~

ame mor~

profitable. These gains appear to have come at the expense of Inefficient and capital deficient
banks.

IMPACT OF DEREGULATION ON PROATABILITY - EX ENERGY STATES
Retu<n on assets
1.2

1980-82
1.0

- - - - - - - - - , .......

0.8

0.6

0 .4

0 .2

0 -9

10-24

25-49

50-99

100-300

300-

1.000-

1,000

10,000

>1 0 ,000

Asset size (minions ol dolars)

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 41

1.(2.

Size and cost control -- the keys to efficiency

Banks can be Inefficient either because they are operating at an Inefficient scale or because
they are poorly managed. Banks with assets of $1 0 million or less have average costs that are
double those for a $1 billion bank. Banks with assets between $25 and $50 million have average
costs that are 25 percent higher. With deregulation, these banks were no longer protected from
their more efficient colleagues that could afford to pay higher rates or provide more service.
Beyond $50 million In assets there are still economies of scale In nonlnterest operating
expense, but they are swamped by variations In efficiency that are the result of differences In
expense control. First Manhattan Consulting Group estimates that average nonlnterest
operating expense at most efficient banks Is 25 percent lower than the average cost of the least
efficient banks. Deregulation Is serving to eliminate Inefficient medium-sized and large banks
both through their acquisition and by competing away their customers.

SIZE A.i.~D COST CONTROL - THE KEYS TO EFFICIENCY
Average <X>SI (peroent)
5

Average

1 ~ - ~ - - ~ - _ . _ __
0-10

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Federal Reserve Bank of St. Louis

10-25

50- 100
25-50
As.et size (minions ol dolla,s)

___,__ __,
100-300

Vanderbilt speech / March 28, 1991 / Page 42

JOO- 1 t,;I,

Cost careless banks suffer

Evidence compiled by First Manhattan Consulting Group leaves little doubt that Inefficient
banks have been hurt by deregulation. Between 1984 and 1988 the stock price of extremely
efficient banks nearly doubled while the stock price of a group of Inefficient banks remained
roughly unchanged.

COS~CARELESSBAi~KSSUFFER
Pe«:ent
300

Cost-<:onscious
250

Stock price 200
performance

6 ,'

150

,...

,
,1

,I /\"'-''

I"-

45% price
difference

A
,__.

Cost-careless I

, ..\

,, '·-

,..,
100
1984

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

1985

1986

1987

Vanderl>ilt speech / March 28, 1991 / Page 43

1988

Change in the 90s

In our view the 80s was only the beginning. We see the coming decade as a period of major
change. Over the next ten years we expect to see three forces at work
•

Continued consolidation within the banking
industry;

•

Entry of banks into new activities as a result of
repeal of Glass Steagall and revision of the Bank
Holding Company Act

•

Deposit insurance reform

CHAJ.'l'GES L'l' THE 90s

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 44

Still too many banks small banks

The deregulation of the 1980s has already resulted In significant Industry consolldatlon.
Between 1980 and 1989, the number of banking organizations declined by 23 percent to 9640.
However, the consolidation has only begun and the number of small banks Is likely to undergo a
rapid decline In the next ten years.
Just how big that decline will be Is still unclear, but we can get some Idea by comparing the
banking structure of California, which has permitted statewide branching since the early 1900s,
with the structure of the rest of the country.
The total population of the U.S. Is 8.5 times that of the state of California. Thus If there are nine
banks with assets of less than $10 million In California we would expect there to be no more
than 77 banks of that size In the U.S. We confine this sort of analysis to banks with under $100
million In assets since this Is where economies of scale are most dramatic. Differences In the
relative Importance of larger banks may be explained as much by historical accident as by
economic forces.
This analysis suggests that 5200 small banks will have disappeared from the U.S. banking
Industry by the time the dust has settled, leaving no more than 4600 banks.

SMALL BANKS - A VA..\lISHING BREED
-olbandngoroa,,izdons
13,000

11,000

9,640

9,000

7,000

5,000

4,600 (upper limil)

3,000 L - - - ' - - - ' ' - - - ' - - - - - - - ' - - - L - - - - - - - ' - ~ - ' - - - - '
1980
'81
'82
'83
'M
'85
'86
'87
'88
'89

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Federal Reserve Bank of St. Louis

Vanderl>ih speech / March 28, 1991 / Page 43

Money centers -- victims of circumstance

The nation's largest banks are also likely to continue their relative decline.
Four factors are driving this decline, decllnlng capital due to declines In collateral values on
commercial real estate loans, a 23 percent decline In new commercial real estate construction,
an anticipated 50 percent decline In new lending to finance highly leveraged transactions, and a
potential 100 percent Increase In regulatory taxes.
Each of these developments Implies that the money center banks will be shrinking - clearly In
relative terms - but perhaps In absolute terms as well.
Salomon Brothers estimates that unless money center banks raise additional capital, they wlll
have to shrink their assets by 30 percent or reduce average costs by 25 percent.
At the same time that capital will be shrinking because of loans that are already on the books,
the money centers wlll also be finding that Important sources of growth during the 1980s will be
drying up as merger- related lending and commercial real estate lending activity dry up.
Spreads on remaining activity may also be squeezed If deposit Insurance premiums rise rapidly.
Another traditlonaliy profitable activity for these banks, credit cards, may also become
squeezed as competition from Sears and AT&T among others drives profits on credit cards
down to more reasonable levels.

MONEY CENTERS - VICTIMS OF CIRCUMSTANCE
$129

(Basis points)
79
(Billions of dollars)

1968

1992

HLTs
down

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Federal Reserve Bank of St. Louis

1968

1992

Commercial
construction down

1968

1992

Regulatory
taxes up

Vanderbilt speech / March 28, 1991 / Page 46

Savings from consolidation

The need for additional capital may well lead money center banks to consider mergers to
achieve cost reductions. Prototypes for this strategy Include the acquisition of Crocker Bank by
Wells Fargo In Callfornla and the acquisition of Irving Trust by Bank of New York In 1988.
Through consolidation of branch networks and other economies Wells was able to achieve an
8% reduction In average costs of the combined firms.
Bank of New York was able to cut Its total costs by roughly 25 percent after Its acquisition of
Irving Trust. Reductions In back-office and corporate lending staff were the key source of
savings In this merger. However, this has yet to Increase profits both because Bank of New
York paid too much and because It has yet to achieve any of the hoped for synergies.
Cost savings of the magnitude achieved by Wells and Bank of New York would be particularly
attractive to money center banks seeking to boost capital from higher earnings.
Whether or not other New York based maoney center banks will be able to achieve similar cost
reductions Is an open question. However, savings from branch consolidation appear less likely
In the New York area than In California. Wells' paring back of the branch network occurred at
the same time that other banks were also cutting back. In contrast, there has been no
lndustrywlde movement toward branch consolidation In New York. It Is Interesting to note that
one thing Bank of New York did not do was cut back Its branch network.

SAVINGS FROM BRANCH CONSOLIDATION
(Number of branches)
1,364

Wells-Crocker merger reflected
a broader trend

1987

1989

Los Angeles county

664

660

No broad trend
in New York
1967
1989
Weslcheste,

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 45

Restrictions on banks likely to ease

While pressures for consolldatlon within the Industry wlll continue unabated, the decade should
also provide banks with an unprecedented opportunity for entering new lines of business.
As a result of 1987 and 1990 reinterpretation of the Glass-Steagall Act by the Federal Reserve,
commercial banks are now allowed to underwrite debt and equity Issue on a llmlted basis.
However, they are generally prohibited from engaging In Insurance activities and from affiliating
with nonflnanclal firms.
These remaining barriers between banking and the rest of the financial services Industry have
been the target of legislative proposals for over a decade. Had It not been for an unfortunate
jurisdictional dispute In Congress, legislation striking down Glass-Steagall would have been
passed In 1987.
Today all the major regulatory agencies agree that removal of barriers between banking and the
rest of the financial services Industry Is desirable. Indeed, the Integration of banking Into the
rest of the financial services Industry has even been given center stage In the Treasury's
banking reform proposals.
It Is conceivable that by the end of the decade most of the prohibitions on bank activities will
eliminated, leaving banks free to create financial supermarkets offering one-stop shopping for
retail and wholesale customers. One key question banks need to ask themselves Is how best to
take advantage of their newfound freedom. Will they choose to buy a presence through
acquisition or build a presence through Internally generated expansion?

RESTRICTIONS ON BANKS LIKELY TO EASE

Investment banking
Insurance
Combinations with commercial firms

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Federal Reserve Bank of St. Louis

Vandeibilt speech / March 28, 1991 / Page 48

High failure rates for acquisitions

The Initial Impulse of most firms will probably to consider a large scale acquisition.
Unfortunately, the strategy of expansion by acquisition often fails. In a 1987 study, Harvard
professor Michael Porter found that 50 percent of acquisitions In related fields were ultimately
divested because of poor profitability. Porter also found that firms ended up divesting 75
percent of acquisitions In unrelated fields.

HIGH FAILURE RATE FOR ACQUISITIONS

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Federal Reserve Bank of St. Louis

75%

Relatedllolds

Urrelated fiekts

Vanderbilt speech / March 28, 1991 / Page 49

Why acquisitions fail

Porter Identifies three hurdles an acquisition must pass for It to be successful.
First, there must be significant synergies between the target firm and the acqulrer. Absent
significant synergies, the acquirer will be unable to offset the loss of competitive advantage
which results from the creation of a larger more sluggish organization.
Second, the profitability of the acquired firm must have firm structural underpinnings which will
ensure Its tong run prosperity. Without a firm foundation to guarantee profitability any
synergies quickly become Irrelevant.
Finally, and most obviously the acqulrer has to be careful not to pay too much.
Porter found that many acquisitions failed at least one of these hurdles.
A detailed examination of the financial services Industry leads me to the conclusion that while
there are synergies, they are often difficult to exploit - particularly at the retail level. This
means that the successful banks will be those that choose to expand their retail activities
through Internal growth rather than large scale acquisitions. On the wholesale side, the
synergies are more compelling. Yet even here, most to expand via acquisitions have not been
successful. This failure Is In part a consequence the competitiveness of these markets and In
part a consequence of the lack of broadbased synergies.

WHY ACQUISITIONS SUCCEED

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Federal Reserve Bank of St. Louis

Vanderl>ilt speech / March 28, 1991 / Page 50

Retail financial services

Retail financial services certainly meet the profitability criterion. Indeed, the provision of
financial services has been the main source of profits in the financial services Industry over the
last decade. Howeyer, It is difficult to build a convincing case that the synergies between the
various segments of the Industry will have a significant impact on profitability. V ~ ' " ' " ~ ~
First of all, the Ingredients for success are very different.
In banking the keys to success are convenience and cost control. This has led banks to build
extensive branch and ATM networks. Customers have contact with that service network at least
52 times a year, primarily to make deposits and get cash.
In the brokerage Industry, the keys to success are personalized service and the targeting of
potential customers. Only 20 percent of households own securities and only 4 percent trade
securities frequently. Since such a small proportion of the population hold securities and
transactions are generally Infrequent and large In value, a dense branch network Is not
particularly valuable outside of a high Income area. Even In these areas, word of mouth may be
much more Important than convenience or name recognition In explaining customer choices.
However, Information on banking activity may be of some use In targeting potential customers.
In Individual Insurance, be It property and casualty or life Insurance, the keys to success are
procedures for screening customers and convincing customers that they should go with your
product. Identifying potential customers Is not particularly difficult since 62 percent of
households purchase Individual life Insurance and 60 percent purchase property Insurance. In
contrast to banking, Insurance customers only have contact with the agent on an Infrequent
i

basis.

RETAIL FINAi"\;CIAL SERVICES

Conducive to long run profltablllty, but. ..
Ingredients for success differ
Banking - convenience and economies of scale
Brokerage - personal service and customer identification
Individual insurance - screening customers and hard sell

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

Vanderbilt speech/ March 28, 1991 / Page 51

Marketing synergies limited

Clearly the potential for economies of scope In the physical distribution of financial services Is
limited. However, being active In many financial products may enhance the bank's ability to
earn additional revenues from Its banking customers.
For Instance, account balance Information could be used to target actual and potential
purchasers of annuities and brokerage services. Information on securities holdings and life
Insurance purchases can be used to target potential trust customers and vice versa. Also,
Information on mortgage originations can be used to target potential purchasers of property
Insurance.
However, It is worth noting that most of these synergies flow one way, from banking services to
other services. Banks are unlikely to sell more banking services to their nonbank customers.
What they may be able to do Is market nonbank services to bank customers at lower cost. This
means that the best that the bank can hope for Is that It will not lose the nonbank customers It
acquires. That Is hardly the sort of upside that success stories are made of.

MARKETu~G SYNERGIES LIMITED
69%

Banking

(Percent of households)

~Ii

Brokerage
Property

Individual
Insurance

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Federal Reserve Bank of St. Louis

Insurance

Vanderbilt speech / March 28, 1991 / Page 52

160%

The retail track record

During the 70s and 80s, many firms attempted to Implement the financial supermarket strategy
by acquiring major presences In Insurance, securities brokerage, real estate, and banking.
The best that can be said Is that the experiments have not succeeded. In many cases they have
clearly failed.
Consider Sear's experiment with its flnanclal centers. Building on Its success In retail credit
and Insurance Sears set out to become a full service provider of financial services. By 1983 it
had acquired Dean Witter, a major retail brokerage house, Coldwell Banker, a major real estate
broker, and acquired several S&Ls in Southern California.
After some experimentation, Sears adopted the one-stop In-store financial center as Its model
for marketing Insurance, securities, real estate, and bank deposits. Sears began Implementing
the strategy in 1983 (?). At the same time Sears attempted to distribute Its products through Its
S&L branch system In Southern California. At the experiments peak, Sears had over 300 Instore financial centers.
By 1989 It was clear that the strategy, as conceived, was not working. In that year, it reduced
the number of In-store centers from 300 to 100, eliminated the Coldwell Banker part of the
center, and sold off the commercial real estate activities of Coldwell Banker. In the preceding
year Sears sold off all Its brick and mortar branches In Southern California.
Where Sears has succeeded, synergies appear to have played a relatively small role. The
Discover card Is a straightforward extension of Sears' private label credit card activities and

THE RETAIL TRACK RECORD

Many experiments have failed
American Express

---

Sears Financial Centers
Discount brokerage

(""" / , . ,
_ f i I"'
~ ~ c.J)v

"'----=._ •

5 ,..c) JC.!.

\5~c...U

https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 53

p
J

_~
"-("

Sears' relative success with Dean Witter appears to be the result of old-fashioned consenltliive
management, not the exploitation of synergies.
American Express has faced similar problems with Its financial supermarket strategy. It has
divested Its Insurance company, pumped over $1 billion Into Its Investment banking subsidiary,
Shearson, and failed to cross market Investment products effectively. At a recent conference
the only benefit that American Express was able to cite from Its 15 year experiment was a
reduced cycllcallty of earnings.
Even discount brokerage has proven to be a rocky road. After acquiring Charles Schwab In
198x Bank of America spun It off again 1987. According to Schwab, only 2-3 percent of Bank of
America's customers were potential customers for discount brokerage. In Schwab's view, the
synergies from being associated with Bank of America did not outweigh the reduced freedom of
action and Increased Inertia.
The failure of these experiments suggests that large -scale acquisitions are not best the way to
achieve synergies In the retail side of the financial services Industry.

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 54

Wholesale services

The prospects for synergies on the wholesale side seem brighter. But, even here, the ability to
at hleve these synergies through large-scale acquisitions Is debatable.
One problem Is that In the wholesale market, profltablllty can easily disappear. This Is
particularly true In underwriting. Large customers are footloose and deal oriented. Much of the
expertise resides with Individuals and Is not the property of the firms they work for. This means
that the loss of a few key people can threaten a firm's position in the market.
Another problem Is that underwriting for Fortune 500 customers is likely to be no less
competitive than lending to Fortune 500 customers. In addition, new players have been eroding
the dominance of the largest underwriters. The share of equity underwritten by large U.S. firms
has fallen form 88% In 1980 to 62 % In 1989. As a result of this Increased competition, gross
spreads have fallen by half In the last ten years.
Clearly this Is an environment that will be unforgiving of mistakes.

UNDERWRITING IS COMPETITIVE

Expertise and customers are footloose
Leaders are losing share
Profitability has declined

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Vandcrl>ih speech/ March 28, 1991 / Page 53

But banks have certain advantages

In contrast to the retail part of the market, however, banks bring some very clear advantages to
the underwriting game. Prior to a firm going public the bank may know more about the
condition of the firm than any other financial market participant. This Information can be used
to do a better Job of pricing new Issue.
Banks also come to the underwriting business with a fair amount of experience In pricing debt
Issues. This means that start up costs In underwriting debt wlll be relatively low.

BUT BAi'IKS HAVE CERTAIN ADVANTAGES

Unique information
Experience in underwriting debt

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Federal Reserve Bank of St. Louis

Vandetbilt speech / March 28, 1991 / Page 56

Trading securities

~hen It comes to trading securities the prospects seem l e s s ~ There are few barriers to
entry for market making. All you need Is a lot of money. Moreover, much of a bank's
Informational advantage evaporates once a security has been Issued. Even If the bank has
inside information, Insider trading laws would prevent It from trading on the Information without
revealing It to the public as a whole.

TRADING SECURITIES

No barriers to entry
Hard to use inside information

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Federal Reserve Bank of St. Louis

Vanderbill speech / March 28, 1991 / Page 57

C,6

The wholesale track record

~ To date, attempts to build a profitable wholesale Investment banking business through ✓

acqµls!Uon have failed. The acquisitions of Bache, Kidder Peabody, and Shearson by Prudential, General Electric, and American Express respectively have proven disastrous. Each
of these acquisitions has suffered heavy losses and required large Injections of capital.
Admittedly the years following the 1987 Crash have been tough on all Investment banks, but the
Investment banks with the richest parents seem to have suffered the deepest losses. Ironically
these three firms were widely viewed as among the best managed In the Industry prior to their
acquisition.
Cltlcorp's wholesale financial supermarket strategy also seem to be floundering. Cltcorp has
either tried to sell or has been forced to gut each of Its three strategic acquisitions which were
designed to secure It a place In wholesale Investment banking. Quotron, an electronic quotation
•
service, AMBAC, an Insurer of municipal securities, and Scrimgeor-Vlckers, a London-based
Investment bank have all turned out to be disappointments. The only success for Citicorp has
been Its home-grown domestic underwriting and private placement businesses.
Finally, many U.S. banks have been forced to sell either sell or shrink major British securities
dealers acquired after the U.K. ovrrhauled Its securities laws to permit bank entry Into securities
i
trading.

THE WHOLESALE TRACK RECORD

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Acquisitions have been costly
Prudential - Bache
GE - Kidder Peabody

Citicorp - Scrimgeor Vickers
The Big Bang

Vanderbilt speech / March 28, 1991 / Page 58

The wholesale track record

In contrast to the abysmal performance of acquisition-based strategies, strategies based on
building a presence In Investment banking do seem to be showing some success. Two U.S.
banks, J.P. Morgan and Bankers Trust have become Important players In the Investment
banking field solely by using their corporate relationships as the base. Only three years after
receiving the power to underwrite securities, Morgan Is already the 13th largest corporate debt
underwriter In the U.S. up from 26th In 1989. Other banks have made Important Inroads In this
area with Citicorp ranked 14th, Chemical ranked 19th, and Bankers Trust ranked 20th.
In the field of private placement, where banks have been able to compete unfettered, Morgan Is
third and closing In on the number two spot, Citicorp sixth, Chase Is tenth, and Bankers Trust Is
eleventh. In total, banks account for 34 percent of privately placed securities, up from 25
percent In 1987.

THE \VH0LESALE TRACK RECORD

Success through internal growth
J.P Morgan
Bankers Trust
Private placement

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Vanderbilt speech / March 28, 1991 / Page 59

Implications for future structure

The experience to date of banks and nonbank financial firms suggests that synergies between
various financial services are most readily achieved In the wholesale segment of the market.
Because the synergies are limited and the wholesale market is extremely competitive,
acquisition appears to be an Inefficient way for banks to take advantage of their superior
Information. Given the rather specific nature of the synergies, many of the lines of business of
the acquired firm would need to be spun off perhaps Jeopardizing other Important synergies.
This makes a strategy of expansion by acquisition expensive. In contrast, build-It-yourself
strategies for expanding Into Investment banking seem to be yielding some success.
The poor performance of large scale consolidations between firms In different parts of the
financial services Industry suggests that the 90s will be characterized by a gradual Intermingling
of various activities rather than a rapid creation of financial conglomerates.

IMPLICATIONS FOR FUTURE STRUCTURE

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Federal Reserve Bank of St. Louis

Biggest successes on the wholesale side
Internal expansion the best bet
Other countries no guide

Vandetbilt speech / March 28, 1991 / Page (i()

Regulatory reform

Banks are not the only ones that must adjust to the emergence of a new more competitive
financial services Industry. Regulators also have some Important decisions to make about how
best to regulate the Industry.

REGULATORY REFOR.L\11

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 61

A bad decade for deposit insurance

One particularly troublesome Issue Is deposit Insurance. The Federal Savings and Loan
Insurance fund finished the 1980s with a deficit of $200 billion - $2100 for each household In the
U.S. While bureaucratic Ineptitude Is largely responsible for the size of the S&L bailout, It also
raises serious Issues about the regulation of banks that engage In a wide array of nontraditional
activities.
On the banking side, the Bank Insurance Fund, whose health was once beyond question, Is
clearly headed for a very serious liquidity problem and possibly an Insolvency problem. The
failure to control losses at BIF Is making extraordlnarlly high deposit Insurance premiums a real
possibility.

A BAD DECADE FOR DEPOSIT INSURANCE

Thrifts bounced a $200 billion check
BIF is bust - or at least illiquid

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 62

Losses rival depression levels

To put the problem In some sort of historical perspective, the losses suffered by the two
Insurance funds during the 1980s rival the losses to depositors during the 1920s and 1930s.
This should suggest that something Is not quite right since losses In massive losses In the 30s
were driven by a 30 percent reduction In GNP. During the sos GNP rose 28 percent.

LOSSES RIVAL DEPRESSION LEVELS
losses as a percent cl all deposits
2.•

1.8

I
I
1.2

Vanderbilt speech / March 28, 1991 / Page 63

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Federal Reserve Bank of St. Louis

Depository institutions are subject to a
unique system of government regulations and
safeguards.

If regulation and the mispricing

of these safeguards give banks an unwarranted
advantage in raising funds, then an expansion
of bank powers may put firms not associated
with banks at an unwarranted competitive
disadvantag9, lead banks to take greater
risks, increase the costs of providing the
safeguards, and adversely affect the rest of
the economy.

MISPLACED GOVERNMENT SAFEGUARDS

Unwarrented advantage in raising funds
Greater bank risk
Increased cost of providing sardguards
Adverse economic effects

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There seems to be a broad consensus that some
degree of public intervention is necessary to
the safe and efficient functioning of the
banking system.

Perhaps the most critical

form of intervention is the provision of
reserves . to the banking system during periods
of stress.

As the Federal Reserve reaffirmed

during the stock market crash in October
1987, it stands

ready to provide liquidity

to the financial system as a whole through
open market operations.

However, it has long

been believed that a safe and efficient
banking system depends on providing banks and
their depositors with a safety net consisting
of a number of additional safeguards.

These

safeguards include lending to banks on a
collateralized basis through the Federal
Reserve's discount window, providing flatrate federal deposit insurance, and
guaranteeing funds sent or received through
the Federal Reserve's electronic payments
system.
SAFETY NET

Federal deposit insurance
Discount window
Guaranteed payments system

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Without a system of controls, . these
safeguards could be offered only at
considerable expense to banks and/or
ta:{payers ..

The ability to examine banks and

sell or close them when they are found to be
insolvent permits these costs to be reduced.
More frequent and precise examinations reduce
the loss that can occur before the bank
be sold or closed.

can

The smaller the loss, the

smaller the amount that must be paid by the
deposit insurance agency.

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Federal Reserve Bank of St. Louis

..,

The need to reform the current safety net
guarantees and the associated regulatory
activities is clear.

Admittedly, the safety

net has enabled the American banking system
to function smoothly despite runs on several
banks, uncertainty about the solvency of
banks with significant concentrations of
Latin American debt, the insolvency of a
third of the nation's thrifts, and the
insolvency of many commercial banks in the
Southwest.

However, it is becoming clear

that through relatively minor refinements the
cost of the safety net could be significantly
reduced with little or no sacrifice of
stability.

Instead the refinements would

result in a more efficient, market-dri ve n
environment.

APPROPRIATENESS OF CURRENT SAFETY NET

Enabled U.S. banking system to function smoothly
Minor low-cost modifications would increase efficiency

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Federal Reserve Bank of St. Louis

______ .....

-----

Under the current system, the deposit insurer
is often bearing risk that should be borne by
the private sector.

Deposit insurance, in

its current form, creates an excessive degree
of "moral hazard" by encouraging bankers to
take excessive risk.

This moral hazard

arises because insured depositors do not
demand interest rates commensurate with bank
risks and because bank regulators do not
demand higher capital levels from riskier
banks.

This gives banks a comparative

advantage in holding many types of high-risk
assets.

This failure to control risk was

pervasive among insolvent S&Ls where attempts
to take additional risk initially boosted
their stock prices, but ultimately caused
many firms to dissipate most of their equity.
While the "end-of-game" behavior of insolvent
thrift institutions provides the most
egregious manifestation of the moral hazard
problem, there are other more subtle and
widespread undesirable eff9cts on bank
behavior .
In the absence of deposit insuranc9, banks
would have to pay higher deposit rates as the
riskiness of their loan portfolios increased,

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Federal Reserve Bank of St. Louis

because depositors would require a higher
return to compensate them for the greater
probability of default.

Bank loan rates, in

turn, would rise as banks passed their
increased funding costs along to borrowers.
Under flat-rate deposit insurance, however,
depositors have no incentive to monitor their
banks closely and deposit rates are largely
unaffected by the riskiness of bank asset
portfolios.

Competition forces banks to

reflect in their loan rates the risk
insensitivity of their funding costs that
results from the current system of deposit
insurance and capital regulation.

Because

banks can charge lower risk premiums on risky
loans, other financial intermediaries are at
a competitive disadvantage in the market for
high-risk assets and these assets have become
an increasingly important component of bank
portfolios.

This process seemst to be

playing out in the banking industry where a
significant proportion of the 50 largest
banks have increased their riskiness without
commensuratelf in-.:reasiw~r U1eir equi t:.y.
leaves the FDIC holding the bag.

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Federal Reserve Bank of St. Louis

This

-------------------------.S7.b .

FLAT-RATE DEPOSIT INSURANCE

Moral hazard problem on part of bankers
Depositors have no incentive to monitor banks
Banks given comparative advantage in market
for high-risk assets

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Federal Reserve Bank of St. Louis

58a.

Restrictions on bank activities serve to
contain the impact of the safety net to those
activities that banks can undertake directly.
If the safety net is not properly priced--a
notion almost universally accepted--then
removing the restrictions on bank activities
will have serious negative consequences.
First, the insurance fund's exposure to risk
may expand in ways that its founders did not
intend and that cannot be justified by public
policy considerations.

This may put a strain

on the fund and lead to further distortions
of risk/return tradeoffs in the economy.
Second, the expansion of the safety net
raises the possibility that nonbanks will be
subjected to unfair competition from banks.
Finally, the extension of the safety net to
an even wider array of activities is
fundamentally inconsistent with a free market
economy.
If these outcomes are to be avoided, either
the mispricing of the safety net must be
corre<::ted or new activities m1_1st b":'
undertaken in such a way that they do not
benefit from the safety net.

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Federal Reserve Bank of St. Louis

RELAXATION OF RESTRICTIONS

Insurance fund's e:<:posure expanded
Nonbanks subject to unfair competition
Extention of safety net inconsistent with
free market economy

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Federal Reserve Bank of St. Louis

Not all the concerns resulting from expanded
bank powers are related to the mispricing of
the safety net.

Proposals to expand

powers

force one to reexamine the role that banks
should play in the economy.

Should banks be

confined · to a particular set of activities or
should they be free to choose the composition
of their portfolios?

Do we need to preserve

banking's traditional role in the
intermediation process, or do we simply need
to ensure that banks are operate& in a safe
and sound fashion?

Do we need to continue

the traditional separation of banking and
commerce?

ANKS' ROLE IN ECONOMY

Who decides?
Preserve "traditional" role?

Ensure safety?
Separate commerce and banking?

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Federal Reserve Bank of St. Louis

The issues discussed above have been
addressed in a number of proposals formulated
by legislators, regulators, academicians, and
industry groups.

The following chart

summarizes the major features of several of
these proposals.

What I would like to do in

the time remaining is share with you my
proposal for restructuring regulation.

A COMPARISON OF MAJOR PROPOSALS

New financial
powers granted
Commingling of banking
and commerce

Riegle
Proposal

Gonzalez
Proposal

Treasury
Proposal

FDIC
Proposal

BenstonKaufman
Proposal

Narrow
Bank
Proposal

Nooe

None

Unlimtted

Yes

Yes
No

New powers for
Banks

Yes

Subsidiaries of banks

Yes

Alfdiates of banks

Yes

?
No

Holding company a
source of strength

Yes

Consolidated
oversight

Yes

Restrict coverage

Yes

Earty intervention

Yes

Encouraged

Yes

Risk-based premiums

Yes

Maybe

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Federal Reserve Bank of St. Louis

61
AN ALTERNATIVE RESTRUCTURING PLAN:
PROPOSAL

THE JrRB-CHICAGO

The development of a new regulatory structure
for the banking industry in the United States
requires a comprehensive understanding of the
forces at work in the industry.

Although

government intervention in the industry may
be considered necessary for safety purposes,
as discussed earlier, it can also create
inconsistent and inappropriate incentives.
Ideally, any new proposal should attempt to
limit these distortions.

A piecemeal

approach to changing the regulatory structure
is likely to have unintended consequences due
to the interrelationships between different
aspects of the current system.

It is

probably also more expensive and time
consuming to implement change in this fashion
since regulatory "gaps" will likely occur
which will have to be readdressed.

NEW REGULATORY STRUCTURE

Comprehensive understanding of banking industry
Limit distortions caused by regulation
Piecemeal approach inefficient

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Federal Reserve Bank of St. Louis

,,.

Princip1es for Restructuring Bank
Regu1ation

The regulatory system must be able to
accommodate an e~panded range of activities
for banking organizations.

~e;e~al

__,1

irrepressible forces are at work to increase
the range and scope of activities in which
banks engage.

The rapid innovation of new

financial products in the past 20 years has
typically kept the regulatory process one
step behind the industry.

In _,,,,..., _,'

--J~gned banking system
should allow for fair competition between
regulated firms and their peers.

Government

interference in the competitive position of
the industry should be limited to cases in
which clear public interests are at issue.
The stability of the banking system is a
legitimate concern of public policy; the

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Federal Reserve Bank of St. Louis

survival of individual components is not.
The stability of any individual component of
the system is important only insofar as it is
necessary to maintain the satisfactory
operation of the system.
The mispricing of the "safety net" needs to
be corrected.

Those who derive the benefit

from the service should pay the cost of their
proportionate benefit.

One would be ill-

advised to e~~tend product powers without
first correcting problems inherent in the
existing safety net.
Bank supervision is necessary, but is it not
a complete substitute for the incentives of a
coherent and comprehensive regulatory system.
Since the presence of some government
guarantee is likely to be a part of any bank
regulatory structure, the supervisory agents
have a legitimate and vital interest in
having current, verifiable, and in-depth
knowledge of the various firms for which they
are accountable.

However, this knowledge

cannot substitute for a coherent and
comprehensive regulatory system that provides
adequate incentives and/or penalties to
motivate appropriate behavior on the part of

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Federal Reserve Bank of St. Louis

the participants.

In the presence of

significantly mispriced incentives,
supervision alone is inadequate.

Sufficient

supervision can only work wehn combined with
a regulatory structure that imposes the
proper incentives on market participants.
Better failure resolution alternatives are
necessary to limit excessive risk-taking.
Since imposition of losses on uninsured
depositors at a large bank in the current
financial environment raises the spectre of
deposit "runs" and disruptions of cre d it
relationships at other banks, regulators have
been unwilling to risk this event and instead
have had the insurance fund bear the l o sses.
We believe this choice has led to the
distortion of the risk/return relationship in
the marketplace by allowing the privatization
of the rewards and the nationalization of the
losses resulting from business decisions of
the firm.

While the regulators' choices seem

rational in the conte::t of minimizino
immediate c0sts o r risk s t o the sys t e m, they
may in fact be increasing the industr y 's
overall appetite for risk and may actually be
more costly in the long run.

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Federal Reserve Bank of St. Louis

A better

methodology of failure resolution would help
balance the long-run and short-run interests
of the industry.
Corporate separateness--a legal barrier that
separate~ the bank from the operations of
nonbank affiliates--is necessary but not
sufficient to limit risk to the insured
entity.

In many cases, enforcement of

corporate separateness appears to be the best
means to separate risks from the insured
portion of the firm, while allowing the
remainder of the firm to incur such risks.
However, the walls of corporate separateness
are most effective when private creditor bear
the costs of breaking them down.

Another key

to effective corporate separateness is being
able to separate the bank from the rest of
the holding company without totally
eliminating the synergies resulting from
jointness.
Principles for regulatory reform
Accomodata e~pandad range of activities for
banking firms

Foster fair competition between bank and
non.bank financial serrices providers
Endeavor for system stability,
not survival of individual firms
Price safety net appropriately
Supervision necessary but
not a substitute for regulation
Batter failure resolutions to limit
e~cessi~• risk-taking

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Coroor1ta seoarateness necassar-1 but not
su~!iciant to limit risk e~posure of banks

The Federal Reserve System bears ultimate
responsibility for the stability of the
financial system.

The discount window and

open market operations are critical in times
of financial stress.

Therefore, the Federal

Reserve System needs to have, at the very
least, ready access to information on the
condition of depository institutions and
other major components of the financial
system.

It needs to have an ongoing

supervisory role in the regulatory
environment.

ROLE OF FEDERAL RESERVE SYSTEM

Ultimately responsible for financial system
Needs ready access to infonnation
Needs on-going supervisory role

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Federal Reserve Bank of St. Louis

67
Structure of the Chicago Proposai

Numerous means to reprice the-safety net have
been proposed, including lowering the level
of deposits insured, imposing risk-based
insurance premiums, forcing additional
disclosure, imposing explicit penalty rates
on discount window borrowings, and
eliminating finality on FedWire.

Each of

these alternatives has been thoroughly
discussed and each has specific merits worth
pursuing.

However, for various reasons, they

have not been adopted.

My recommendations

partially substitute for these alternatives
but will not preclude their future adoption.
They are simply viable alternatives that may
be more easily implement~d than some of these
previously discussed alternatives.
Recommendations to resolve safety net
concerns include:
•

Implement a comprehensive riskbased capital plan.

• Require banks to maintain rati o s
of subordinated debt, to risk
assets, and equity to risk assets
of at least four percent.

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Federal Reserve Bank of St. Louis

•

Impose additional restrictions on
bank risk-taking.

CHICAGO PROPOSAL

Implement a comprehensive rish-based capital plan

Require banks to maintain subordinated
debt-to-assets and =:)
~ -~q~ity-to-assets ratios of at least 4 percent

Impose ·restriction on bank risk-taking

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Federal Reserve Bank of St. Louis

69
Risk-based capita1

Capital serves a vital role in providing
stability to the banking system.

It is the

first cushion available to absorb losses and
serves to reassure debtholders that they will
be repai?·

The appetite for risk of the

capital investors has the greatest direct
influence over the risk profile of the firm.
In today's system a large proportion of debt
financing of banks, particularly larger
banks, is either explicitly or implicitly
guaranteed by the federal regulatory
agencies.

The resulting cost of such

financing is not as sensitive to the
riskiness of the firm as it would be in the
absence of these guarantees.
Risk-based capital proposals address this
issue by attempting to set minimum capital
levels according to the risk profile of the
individual firm.

While we believe that such

a system is likely to be imperfect because of
the compromises necessary to gain acceptance,
it is an important first step in limiting the
implicit subsidies in the federal safety net.
The U.S. regulators' response to the Basle
proposal for international convergence of
capital standards is an important step in

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Federal Reserve Bank of St. Louis

this direction and ideally th~t proposal
would be implemented within the broader
context of the restructuring proposed here.
If e1~perience indicates that the Basle
proposal . provides insufficient improvement
over the current system, then further
modifications may be necessary within the
framework of that agreement.

Important

factors in this determination are whether the
practice of supporting large depositors can
be changed and whether the market discipline
provided is sufficient to alter behavior.

RISK-BASED CAPTIAL

Sets minimum capital levels commensurate with
riskiness of banking firm

Imperfect, but step in right direction
Further modifications may be necessary

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71
Subordinated debt cushion

The second recommendation requires banks to
maintain minimum ratios of subordinated debt
to risk assets and equity to risk assets.
Recommendations that banks be required to
issue subordinated debt have been made in the
past; most notably by Professor Paul M.
Horwitz.

This can be accomplished by a minor

modification to the current U.S. risk-based
capital proposal mentioned above.

Instead of

requiring the bank to hold eight percent
capital, it is proposed that the allowance
made for supplemental capital instruments be
slightly revised to require a minimum of four
percent subordinated debt to risk assets
ratio, along with a four percent equity
requirement.

Obviously, additional levels of

supplemental capital over and above that
amount could and probably would be held.

order to qualify, the subordinated debt
instruments would have to possess covenants
or characteristics which would produce the
followinq series of events:

SUBORDINATED DEBT CUSHION

Minor modifications to current risk-based
capital guidelines
Require 4 percent subordinated debt-to-assets mtio

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Federal Reserve Bank of St. Louis

Subordinated debt needs to possess
certain charJctcristics

•

Dividends, growth and ~eposit
rates must be restricted when core
equity falls below an agreed upon
level; that level not less than two
percent of risk assets.

•

Bank ownership would be converted
to the subordinated debtholders
following a judicial or regulatory
determination of insolvency.

•

Cr e ditors would be converted to
common shareholders of the "new"
entity according to rules specified
in the debt covenants.

•

Warrants would be distributed to
the former common shareholders
according to a formula also
specified in the debt covenants.
These warrants would be exercisable
if the value of the assets exceeded
the amount of the liabilities (less
any new investment by the new
r::ommon shareholders) by m0re than
one p~rcent within the first two
years after the finding of
technical insolvency.

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Federal Reserve Bank of St. Louis

This

provision protects the common
shareholders against capricious
findings of insolvency by the
regulators or the courts.
T~e newly restructured bank would
be required to raise new
subordinated debt, find an
acquiror, or put itself into
liquidation within one year.
•

These bonds should have
maturities of no less than five
years with the issues being
staggered to insure that no more
than 20 percent, and no less than
10 percent, mature within any one
year.

•

Small banks could be allowed
alternative means to meet the debt
requirement.

Subordinated debt characteri:itics
Oi·ridend:, r~stricted wnen core equit.;· fall:,
below a certain level
Bank ownersnip convert:, tot.he subordinated
debt.holders upon in:,olvency
credit.ors convert t.o common shareholders o! -new entity
warrant:, di:itribut.ed t.o former common shareholder:,
"~ew" bank would be required t.o raise ~ew _subordinat.ed
debt, find an acquiror or liquidate wit.~in a year
Subordinated debt issued with :itaqgerinq mat.urit.ie:i
o! five year:, or more

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These provisions provide several advantages.
They create a class of creditor that is
specifically available to bear the risk of
loss.

The regulatory agents need not be

concerned about a run on other banks by large
groups

0£

depositors because these depositors

recognize that they are protected by the
presence of the subordinated debtholders.
Unlike creditors of corporations reorganized
under Chapter 11, these creditors would truly
be subordinated.

They would not be able to

bargain for improvements in their position by
refusing to approve the reorganization plan
because banks are not subject to bankruptcy
laws.

The creation of this class of debtors

would enable the insurance fund to eliminate
implicit coverage of all deposits of large
banks.

Insurance would still be important to

cover deposits under $100,000, but the
subordinated debt would now act as the
protection for the remaining uninsured
depositors.

However, if the debtholders are

also wiped out--a possibility •.:.-nly in the
event that asset values fall much quicker
than has occurred in the past--then the
uninsured depositors would bear additional
losses.

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Federal Reserve Bank of St. Louis

The relatively long and staggered

terms of these instruments would help to
prevent such an event from causing additional
runs and liquidity drains at other
institutions.

Uninsured depositors would

still have a cushion and, again, debtholders
would be · unable to run.

It is important to

note in this context that the banking
regulators would retain their powers to force
closure of the bank once capital is
e:~hausted, but the eJdstence of subordinated
debt makes this power less important than it
is currently.
The debt provision would also permit earlier
resolution of bank problems than is currently
possible.

Currently, fearing the legal

consequences of closing a solvent
institution, regulators wait until all
uncertainty concerning a bank's solvency is
eliminated.

By providing a group of private

parties the incentives and the ability to
petition for a finding of insolvency, as well
as protecting the current shareholders
against an improper finding of insol~ency,
the current proposal eliminates the need to
wait until the bank's value falls completely
below the "questionable zone of solvency."

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qr;

The pricing of subordinated debt instruments
would obviously be very sensitive to the risk
profile of the bank.

While the amount of

discipline this would exert is uncertain, it
should be substantial.

It would also

encourage the bank to maintain higher equity
levels.

The precise level would depend on

the tradeoff between paying the subordinated
debtholders more because of the low equity
cushion protecting them and paying these
creditors less with a higher equit y level.
The e;=act equilibrium point would be the
le v el of debt and equity that minimizes the
bank's average cost of capital.

Ad~antage3 of 3ubordinated debt cu3hion
Probability of bank run i3 3mall
Subordinated debtholder3 are truely 3 ubordinate
..Ulow in3urance fund to eliminate implicit coverage
of all depo3it3 of large bank 3
Early re3olution of bank failure 3
Market di3cipline

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77Q

Bank risk-taking

The third recommendation is that additional
restrictions be placed on bank risk-taking.
When a holding company is insolvent, it has
incentives to require even its solvent banks
to take on more risk in order to generate
additional income that can be upstreamed to
the parent.

The bank may be able to change

its risk profile and earn (lose) substantial
amounts of money before subordinated
creditors or regulators realize what has
happened.

In order to avoid this problem,

when a holding company's solvency is
questionable the bank's primary regulator
must enter into a memorandum of understanding
with the bank stipulating that no dramatic
changes in the bank's risk profile will be
undertaken until its parent has regained
solvency.
The combination of the above provisions would
allow the marketplace to impose the proper
incentives on bank managers, and would allow
regulators to intervene when ne~d~d without
mitigating the effect of market dis~ipline.

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BANK RISK-TAKING

When banking firm's solvency is questionable,
no dramatic changes in bank's risk profile
Bank powers restricted to direct credit
and related activities
Nonbanking financial activities conducted by
holding company affiliates of bank
Nonfinancial activities prohibited

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78
Bank powers

It is recommended that bank powers be
restricted to direct credit and related
activities as opposed to market making and
trading activities.

This provision would

allow the bank affiliate to offer what are
essentially traditional bank services.

As a

result, some of the larger banking
organizations would be required to move some
services currently housed at the bank to a
nonbank affiliate.

For most banks no changes

would be required.
Non-banking financial activities would be
permitted in the holding company affiliates
of the bank.

Nonfinancial activities

would

remain prohibited for any portion of the
holding company.

As new financial activities

are approved through either new legislation
or the regulatory process, they would be
housed in nonbank subsidiaries of the bank
holding company.
Three firewalls seem particularly important.
First, lending by a bank t o its n0 nbank
affiliates would be limited to 20 percent of
the bank's capital .

Second, a bank would

have to demonstrate its capability to operate

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Federal Reserve Bank of St. Louis

separately from the rest of the holding
company.

And third, the Board of Directors

of the bank would have to be separate from
the Board of the holding company.
By placing firewalls between the banks and
the rest of the holding company, increased
powers may be safely granted to holding
company subsidiaries.

IMPORTANT FIREWALLS

Limit lending by a bank to nonbank affiliates
to 20 percent of bank· s capital
Require bank to demonstrate capability to
operate separately from the
rest of the holding company
Require separate Boards of Directors for bank and
bank holding company

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Firewalls are common in banking, insurance,
and the investment banking industries and are
frequently employed by bondholders in
unregulated industries.
firewalls to work?

But can we count on

I believe so.

Recent

developments in investment banking provide
incontrovertible proof that firewalls can
work.

The recent collapse of Drexel Burnham Lambert
provides an e1tcellent example of firewalls at
work.

Only Drexel's broker/dealer subsidiary

was subject to regulation.

SEC regulation

placed restrictions on transactions between
the broker/dealer and the rest of the firm.
In addition, the broker dealer's activities
were subject to restrictions, and risk-based
capital requirements.

Because of these

firewalls, the broker/dealer and its
creditors were insulated from the financial
meltdown of the parent, allowing its business
to be wound down in an orderly fashion.
Another good e::ample of firewalls in action
comes fr0m the Chapter 11 re0rganization of
Campeau.

Campeau has three subsidiaries that

were acquired through an LBO transaction
Allied Department Stores, Federated

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Federal Reserve Bank of St. Louis

Department Stores, and Ralph's Grocery
Stores.

After, Campeau announced that it was

filing for protection under Chapter 11,
Allied and Federated junk bonds were trading
at 10 cents on the dollar, while Ralph's junk
bonds were trading at 98 cents on the dollar.
Allied and Federated bondholders have a big
incentive to feather their own pockets.

Yet

Ralph's bondholders don't appear to be
concerned.

Apparently the legal firewalls

created by bond covenants and bankruptcy
provide considerable protection.

DO FIREWALLS WORK?

•

Dreicel Burnham Lambert - broker/dealer insulated
Campeau - Ralph's Grocery Stores insulated

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Federal Reserve Bank of St. Louis

But the question is not whether firewalls can
work but how can we get them to work in
banking.

The key is making sure that someone

in the market has an incentive to seek the
enforcement of firewall protections.

Our

proposal ' meets this requirement by seeking
the creation of subordinated creditors.
Clearly firewalls are a useful tool for
limiting the array of services covered by the
safety net.

However, the benefits of

limiting the safety net must be balanced
against the cost savings resulting from
multiproduct production and marketing.

The

recommended breakdown of permissible product
offerings is designed to allow for product
synergies but not at the cost of e1~panding
the safety net.

CAN FIREWALLS WORK IN BANKING

Subordinated debtholders will enforce firewalls

Balance benefits of firewalls against
efficiency loss of multiproduct
production and marketing

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Federal Reserve Bank of St. Louis

83
Supervisory and reguiatory issues

Throughout the discussion of the new
restructuring proposal we have emphasized the
need to limit the activities of the bank, its
interaction with affiliates, and the
influence of the safety net.

While market

forces play an important role in enforcing
these limitations, supervision is required to
protect against violations.

Although the

package of services this proposal would
permit the holding company to provide
encompasses various financial service lines,
it should not be necessary to create a "super
regulator" to regulate all aspects of the
organization's activity.

Rather, a well-

defined allocation of regulatory
responsibility, combined with cooperation
between government agencies, should be
adequate.
It is our belief that "consolidated
oversight" should be the responsibil~ty of
the Federal Reserve System.

The · role of the

Federal Reserve System as the l~nder of last
resort and as the entity with the legislated
purpose of maintaining a liquid transaction
medium requires the Federal Reserve to have

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Federal Reserve Bank of St. Louis

an ongoing involvement in the regulatory
process.

SUPERVISORY ISSUES

"Super regulator" not necessary

Well-defined allocation of
regulatory responsibility and
intergovernmental cooperation

Consolidated oversight responsibility of Fed

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Federal Reserve Bank of St. Louis

Summary and conslusions

1980 marks a major dividing line for the U.S. banking system. The passage of legislation
phasing out Interest rate celllngs marked the beginning of a wave of regulatory reform. Other
major milestones of the 80s Included llberallzatlon of Intrastate branching laws, the Introduction
of Interstate banking, an easing of Glass-Steagall restrictions, and the adoption of more
rigorous and more realistic capital standards.
As we enter the second decade of reform two major tasks have yet to be completed - an
overhaul of the system of safety and soundess regulation and comprehensive legislation
remove legal barriers between banking and the rest of the financial services Industry. If
problems related to to the extension of the federal safety net are not to be exacerbated,
significant changes In the current regualtory strucuture should be Implemented prior to allowing
expanded powers.
The pressures to address this unfinished regulatory businesss will continue to grow. The
profits that can be earned from traditional wholesale banking services are eroding and the costs
of our Inefficient approach to dealing with capital deficient banks Is ballooning. I believe that
meaningful legislation Is likely to be adopted sometime In the next two or three years.
By the beginning of the next century, the number of firms In the banking Industry wlll have
declined to 4600 or less. Traditional wholesale banking will continue to decline In Importance.
The lines between banking and other parts of the financial services industry will be
disappearing, but most financial services firms will have very clear specialties. Financial
supermarkets will be t~e exception rather than the rule.

IN CONCLUSION ...

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Current bank regulatory structure is outmoded
Bank profits from traditional activities have fallen
Bank management incentives are distorted
Bank closures are complex and expensive
Broader array of banking services are efficient
Chica90 proposal relies on market discipline to reduce
d1stort1ons from safety net mispricing

Vanderbilt speech / March 28, 1991 / Page 62

••

{o l

If we adopt a restructuring proposal along the lines of the Chicago proposal, market discip'lfne
will be restored and bank closure policy wlll be Improved. With these changes, the dramatic and
costly rescues of the 80s should become a thing of the past.

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Federal Reserve Bank of St. Louis

Vanderbilt speech / March 28, 1991 / Page 63

YOU ARE THE POLICYMAKER
1. What role do you think banks should play in the economy?
2. What powers should they and shouldn't they have?
3. Would you make any legal distinction between banks and
their nonbank affiliates (i.e. would you erect "firewalls")?
4. What powers should nonbank affiliates of banks have?
5. Who would regulate banking firms? One regulator?
Various regulators according to function?
6. Would you change the deposit insurance system?

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Federal Reserve Bank of St. Louis

•

Would you reduce coverage from the
current $100,000 per account?

•

Would you institute a risk-based
deposit insurance system?

•

Would you explicitly and implicitly not
insure all liabilities? How?

YOU ARE A BANKER
1. How do you prepare to compete in a deregulated industry?
2. How do the growth of securitization and long term financing
affect your long run profitability?
3. What kind of banks do you acquire?
4. How tough do you want regulators to be
on poorly capitalized banks?
5. How do you respond to growing number of competitors
that are falling on hard times?
6. How much capital do you hold?
7. What kind of deposit insurance system is best for you?

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