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The Structure of Our Changing Banking Industry:
Let the Market Decide
Missouri Bankers Association
Senior Bank Management Conference
Acapulco, Mexico
January 12, 1999


he United States is now thoroughly
committed to historic change in the
regulation of its banking industry. In
our nation’s 19th century vision for
the banking industry, reinforced by legislative
changes in the 1930s, government regulation
severely constrained the geographic location of
each bank’s offices and the services it was permitted to provide its customers. Each bank
could maintain offices for accepting deposits in
only one state, and in some states in only one
county. Unit banking states permitted each bank
to maintain only one office. Banks could offer
traditional banking services, including deposits
and loans, but little more. Insurance services
were banned, and securities underwriting was
severely limited. Clearly, law and administrative
regulation have been critical in determining
banking structure in the United States.
When I talk of “banking structure” I intend a
very broad definition of industry characteristics,
including the geographic spread of offices, the
financial products offered and the organizational
forms of banking enterprises. It is not an exaggeration to say that historically the banking industry
has been one of the most comprehensively regulated industries in the country. Financial services,
however, are inherently a pretty competitive business: Many different types of financial firms, and
the public securities markets, offer overlapping
products, and many of the overlaps are so close
that the products are functionally identical or
nearly so. Especially over the last quarter century,
the markets have been deregulating themselves.

Commercial banks, as the most tightly regulated
of all financial firms, have often found themselves
at a competitive disadvantage in an increasingly
diverse and innovative marketplace. It is not surprising that bankers often feel overregulated and
I agree that banks are overregulated. As for
bankers being under-loved, well I probably can’t
do much about that. I am reminded of a summer
job I had during graduate school at a bank in
Wilmington, Delaware, where I grew up. One of
the guys I ate lunch with worked in the auto loan
department and was responsible for repossessing
cars. He wandered around neighborhoods at night
looking for the cars he had to find, and with his
fistful of keys could drive right off. He had some
frightening tales, including some of being shot at.
Perhaps after my speech you can give me some
good ideas about how I can persuade the public
to love the banker who’s repossessing its cars!
Actually, the problem is pretty simple—you
bankers just need to learn how to lend money
without ever having to try hard to collect it!
Anyway, I do want to discuss my views on
where we ought to be headed with banking regulation. A sensible discussion requires some background on how we got to where we are, and what
regulations ought to remain. That’s my first major
My second major theme concerns the probable
future environment for community banks. My
punch line is simple: I believe that community
banks will continue to play an important role in
the U.S. economy. I can’t offer a guarantee, but I


can offer my best guess that large banks and community banks will compete side by side in many
markets, and that community banks will be every
bit as profitable as large banks. I simply cannot
believe that community banks are a dying breed
when Missouri granted 15 new bank charters
over the last three years.
Before I get any further along, let me emphasize that the views I express here are my own;
these regulatory issues are complicated and controversial, and I am not the one to announce official policies of the Federal Reserve System. What
I will do is present my views on trends in banking
and desirable changes in regulation that would
give market forces greater freedom to shape the

The 19th century vision for banking was based
on some basic ideas about the role of banks in
society and the conditions necessary for maintaining a safe and sound banking system. Experience,
particularly the trauma of banking panics and
failures in the 1930s and the Great Depression,
also shaped banking regulation. Many of the ideas
that supported this 19th century vision have been
discredited, and much of these prior regulatory
arrangements has been abandoned. But we still
have more regulatory heritage—regulatory baggage, I think—than we need.
One objective of government policy on banking structure has been to limit the power of large
financial institutions. Throughout the history of
the United States, government policy has been
shaped by a fear that large financial institutions
would exercise excessive economic and political
power. Public policy limited the growth of banks
through restrictions on entry, branching and
Another objective has been to promote lending to small businesses. Our banking regulations
reflect a concern that if market forces determined
banking structure, large banking organizations
would attract deposits at offices located through2

out the nation and lend these funds in financial
centers. Local businesses, so the argument went,
would be starved of the credit they needed to
prosper. People in communities throughout the
nation viewed branching by large banking organizations as a threat to the economic health of
their local economies. An objective of government
regulation of bank structure was to create a banking industry composed largely of small banks
that would lend to small businesses located in
their communities.
The government also attempted to make banks
safe by restricting competition among banks.
Government restricted entry into banking in the
early 1930s in an effort to limit the number of
bank failures. Under this policy, government
agencies often denied applications for charters
because new banks might have adverse effects
on the profits of existing banks located in their
same communities, undermining their viability.
The government also attempted to restrict competition among banks through ceiling interest
rates on deposits, including a ceiling rate of zero
on demand deposits.
Government has limited the services offered
by banks and the types of firms with which banks
affiliated to limit the possibility that losses on
loans and investments would cause banks to fail.
For instance, reducing the risk of bank failure was
one of the objectives of the federal government in
separating investment and commercial banking
in the 1930s.
The role of the government in regulating the
banking industry in the past reflects the policymakers’ understanding of banking, and the balance
of political forces in our federal and state legislatures, at the time regulations were imposed. However, it is important to recognize that tremendous
intellectual development in the understanding of
banking has taken place in recent decades. Astute
observers, both academics and practitioners,
believe that many of the propositions justifying
regulation historically are false. Consider the
restrictions the government imposed on bank
competition in the 1930s. Economists today generally agree that the large number of bank failures
in the 1930s did not result from excessive com-

The Structure of Our Changing Banking Industry: Let the Market Decide

petition. Research has undermined the view that
restrictions on competition are necessary to preserve the stability of the banking industry. In addition, research has not supported the argument
that the securities underwriting activities of
banking organizations caused bank failures and
the Great Depression.
Government regulation of banking structure
has been relaxed substantially since World War II.
Nevertheless, the recent federal law that mandated
nationwide interstate banking has some features
that reflect the history of public policy in shaping
banking structure. This legislation, enacted in
1994, requires banking organizations with offices
in more than one state to meet standards for lending funds in the states where they attract deposits.
This provision reflects a fear that large branch
banks will starve small businesses of credit by
using deposits received through their branches to
lend in financial centers. In addition, this legislation sets limits on the shares of banking deposits
that can be controlled by any one organization in
a state and in the nation. These limits reflect the
fear of a concentration of financial power. Thus,
ideas that shaped our 19th century vision of bank
regulation continue to shape banking legislation

If we have abandoned the 19th century vision
of banking, if not all its residue, where are we
headed? What is the new vision for the role of
banks in society? Does the government continue
to have compelling reasons to support banking
services with deposit insurance and other elements of the financial safety net for the banking
industry? Will the encroachment of nonbanking
firms into the activities of banks continue until
there is no clear distinction between banks and
other providers of financial services? Do community banks have an important role in the financial
system in the future? If we want to preserve an
important role for community banks, do we need
to establish new barriers to competition from
larger banks and from other providers of finan-

cial services? To discuss these issues, we must
consider bank regulation as a whole, rather than
focus separately on the parts implemented by
the Federal Reserve or other bank regulatory
I do not have a detailed blueprint for the
future or a specific proposal to promote. I do have
some basic principles that shape my thinking
about these issues, however, and these principles
lead me to some conclusions.
The first principle is that the government
continues to have a compelling reason to support
banking services with deposit insurance and other
elements of the financial safety net. This principle
is based on the fact that banks serve two important
purposes in our economy: They provide credit to
borrowers who do not have direct access to credit
in the securities markets and, even more importantly, they process payment orders for their
depositors. Experience indicates that major disruptions in these lending and payments functions
cause disruptions in economic activity.
The second principle is that, while maintaining deposit insurance and the financial safety net
for banks, we should rely on market forces rather
than regulation as much as possible to shape the
structure of the banking industry. Attempts to
preserve the roles of particular types of banks,
like community banks, through regulation would
not be in the public interest. Such regulations
would interfere with the public’s ability to freely
choose its providers of financial services, and in
our highly competitive economy, would eventually be self-defeating for banks themselves.
Why do I say “self-defeating?” Consider the
example of the prohibition of interest on demand
deposits and Regulation Q interest rate ceilings.
Bankers welcomed these regulations when they
were introduced in the 1930s, because interestrate constraints held down the cost of funds to
banks. But when Reg. Q ceilings were extended
to thrifts in the 1960s, ceiling rates were set higher
for thrifts than for banks, leaving banks at a competitive disadvantage. And in the 1970s, both
banks and thrifts were at a disadvantage relative
to money market mutual funds, which could offer
rates on checkable accounts without regulatory


constraint. In a rapidly changing marketplace,
Regulation Q became a regulatory albatross instead
of a regulatory protection for banks.
The biggest challenge in reconciling the
safety net for banking services and market forces
involves the powers of banks and the encroachment of nonbank providers of financial services
on the turf of banks. One way the government
might respond to this encroachment would be to
extend bank supervision, regulation and the
financial safety net to these nonbank firms. If
lending and the operation of the payments system are important in maintaining a stable economy, why limit supervision and regulation and
the safety net to banks? Why not treat all firms
that lend or provide any payments services as
Although there is a certain logic to the call
for extending government regulation over all
financial firms, I am convinced that doing so
would be highly undesirable for several reasons.
First, the government’s commitment to support
the banking system through deposit insurance
would be extended to a larger share of the private
sector, and the government would expand its role
as supervisor and regulator. Government guarantees would become vastly larger than they are
today, as would the risks to the taxpayer. Second,
given the intimate connections between financial
and nonfinancial activities in our enterprise system, we would risk never-ending extensions of
government control far beyond financial activities per se.
Another approach to reforming bank regulation would involve narrowing the safety net by
placing greater restrictions on the types of services
that banks may offer, and tighter restrictions on
the risk that banks may assume. This approach,
I am convinced, is not a viable option over the
long run because of competition from nonbank
firms. Banks subject to continuing tight government regulation would lose their share of the
business to nonbank competitors. In time, the
most important lenders and providers of payments
services would operate beyond the jurisdiction
of government supervisors, leaving the economy
vulnerable to the types of shocks that led to the

development of our system of bank supervision
and regulation and the safety net in the first place.
I believe that we can avoid either of these
undesirable outcomes by maintaining government
supervision and regulation and the safety net for
banks, while giving market forces a greater role
in shaping the structure of the banking industry.
If government policies are consistent with the
basic objective of maintaining financial stability,
we can rely on market forces to shape the structure of the banking industry in a way that is efficient and socially desirable. The topic that
requires the greatest thought is regulation of
bank powers and the affiliation of banks with
nonbank firms. I suspect that we will be living
with uneasy compromises on this matter for a
long time. Quite frankly, if I had a brilliant solution, I’d love to offer it. But I don’t.

I’ll now turn to some remarks on the likely
direction of banking markets in the future. I do
not believe that community banks will need special protection in order to thrive. Experience indicates that community banks can and do operate
successfully in the same geographic markets, and
in many of the same product markets, as much
larger banking organizations. Community banks
have some important advantages, including opportunities for their customers to have personal relationships with top decision-makers, and ability
to compete without the challenge of coordinating
the activities of large numbers of employees.
While we do not yet have a complete blueprint for a new vision for banking regulation,
and therefore do not have a firm idea about how
regulation will shape the future of banking, we
can gain some valuable insight into the forces
that shape the banking industry by examining
how regulation and market forces shaped the
banking industry in the past. If we go back to the
period before 1980, the banking industry of many
states consisted of many small banks, each with
one or at most a few offices. There were a few

The Structure of Our Changing Banking Industry: Let the Market Decide

relatively large banks, though they would not be
considered large by today’s standards.
Although regulations have been a major force
shaping the structure of the banking industry,
they have not been uniform across states or over
time, and we can use that fact to provide insight
into the industry structure that will emerge as
market forces play an increasingly greater role in
shaping the banking industry.
Missouri, historically a unit-banking state,
had a total of 497 banking organizations in 1980,
and the five largest accounted for 45 percent of
assets. But in a banking industry shaped primarily
by market forces, would the large banks drive all
of the relatively small banks out of business? We
know that a lot of consolidation would take place;
it already has. The issue is whether all community
banks would be forced to consolidate. The best
evidence we have on this question is the experience in states that have permitted statewide
branching for many years. Consider four of the
states that permitted statewide branching prior to
1980: two in the West (California and Idaho) and
two in the East (Maryland and North Carolina).
The average share of banking assets at the five
largest banking organizations in these states in
1980 was 74 percent. How many banking organizations operated in these states in 1980? Here are
the numbers:
• California


• Idaho


• Maryland


• North Carolina 79
These figures indicate that many community
banks operated in the same markets as banks with
far-flung branch systems.
Why do community banks do so well? You
know the answers better than I do. Some customers prefer small banks because they have
personal relationships with top decision-makers
in such banks, whereas it would not be possible
for them to have relationships with the top decision-makers at larger banks. Relatively small banks
may be more efficient than larger banks in delivering some services. Small banks are likely to

have closer ties to their communities, yielding
advantages in assessing credit risk. Of course, only
large banks with large amounts of capital can
make the large loans required by some borrowers,
but that fact does not mean that huge banks will
be more efficient than small banks in making large
numbers of individually small loans.
Allowing market forces to shape the banking
industry will not be the end of the community
bank. This examination of banking structure in
the past indicates, lifting constraints on the operation of market forces leads to the emergence of
large banking organizations with many branches
but does not eliminate the relatively small community bank.

How would we implement a policy of letting
market forces shape the structure of the banking
industry? Because of the importance of entry into
an industry for determining its structure, the best
place to begin this discussion is with the granting
of charters. Under deposit insurance and other
elements of the financial safety net for the banking
industry, it is reasonable for the government to
set standards for granting charters. These standards include checks on the backgrounds of bank
organizers, to prevent granting charters to criminals. These standards also require a minimum
level of capital for new banks. Under my approach
of letting the market decide, these would be the
only standards for granting charters. All applicants
who qualify would receive charters.
The government would permit banks to open
branches anywhere they want. Government agencies, including the Fed, would approve banking
mergers and acquisitions unless they reduced
competition or the financial strength of the banks
involved in the mergers and acquisitions. As long
as new organizations were relatively free to enter
into banking, most mergers could be permitted
without concern that banks could gain market
power through mergers.


Finally, limits on the percentage of deposits
in a state or in the nation held with any one bank
are inconsistent with letting market forces shape
banking structure. We do not need to limit the
market power of banks through such regulations.
Competition is a more effective tool for limiting
such power. Any bank that attempted to raise
interest rates on loans, raise service charges or
reduce the interest rates it pays on deposits would
lose business to its competitors. I would eliminate
the limits on the percentage of deposits at any
one bank as unnecessary and undesirable limits
on the freedom of market forces to shape the banking industry. This program for letting the market
decide would not have adverse effects on the
safety and soundness of the banking system provided that regulators enforce effective capital
requirements, as is necessary to sustain the deposit
insurance system.
My bottom line is simple. Small firms are
prospering across the entire U.S. industrial landscape. In only a handful of industries are large
firms increasing their market share because of
compelling economies of scale. Banking is no
different in this respect from the typical U.S.
industry. Although large banks are growing as
artificial branching and line-of-business restrictions are swept away, small banks are prospering
when they are well managed and when they select
the proper market niches. A banker’s life is certainly more intense than it used to be in the old,
highly regulated days, but the rewards for entrepreneurial bankers and their customers are to be
celebrated rather than bemoaned. I for one am
only too happy to break out the champagne!

I especially want to thank Alton Gilbert of the
research department of the Federal Reserve Bank
of St. Louis for extensive assistance. A number of
other colleagues provided very helpful comments.