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A Series of Occasional Papers in Draft Form Prepared by Members'o

CONSEQUENCES OF DEREGULATION
FOR COMM ERCIAL BANKING
George G. Kaufman, Larry R. Mote,
and Harvey Rosenblum

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SM84-3
May 1984

Consequences of Deregulation for Commercial Banking
by

George G. Kaufman
Loyola University and Federal Reserve Bank of Chicago

Larry R. Mote
Federal Reserve Bank of Chicago

Harvey Rosenblum
Federal Reserve Bank of Chicago

A revised and expanded version of a
paper prepared for a joint session of
the American Finance Association and
American Economic Association, San
Francisco, California, December 29,
1983.

The views expressed 1n this paper are the authors' and do not necessarily
represent the views of the Federal Reserve Bank of Chicago or the Federal
Reserve System.

Consequences of Deregulation for Commercial Banking

Over the past two decades the markets for financial services have provided
a fascinating laboratory 1n which to observe the Interplay of market forces,
political responses to periodic crises, and the maneuvering of Interested
parties 1n shaping public policy toward an entire Industry,

In the process, a

regulatory framework put 1n place a half century ago has been partly
dismantled and 1s likely to be modified further, perhaps even more
dramatically, 1n the years to come.

This paper reviews the progress of

deregulation to date, attempts to discern Its Implications for the future
shape of the financial system, 1n particular, commercial banking, and poses
several questions of public policy.

Summary of Recent Developments

The Legacy of the 1930s
The current organizational and regulatory structure of the financial

services Industry, broadly defined, 1s one of the major remaining legacies of
the banking collapse and depression of the 1930s.

In the wake of the failure

of some 9,000 banks, the federal government was understandably under pressure
to take timely actions to forestall a recurrence of financial d1saster--even
1f those actions were based on an Imperfect analysis of the problem and had
undesirable secondary effects.

The popular diagnosis at the time was that the

bank failures had resulted from excessive competition 1n combination with
managerial errors and abuses.

Thus, the Banking Acts of 1933 and 1935

introduced a large array of restrictions on banking designed to shelter banks

both from excessive competition and from the errors and poor judgment of their
own managements.
With the advantage of hindsight and the results of a number of careful
studies of the causes of the depression and the banking crisis completed over
subsequent decades, one can conclude with some confidence that the diagnosis
and cures adopted 1n the 1930s were, for the most part, Incorrect and
Inappropriate.

There was no spontaneous eruption of destructive competition

1n the 1930s (Cox, 1966).

The depression and banking collapse were largely

the consequence of a series of adverse developments abroad and policy mistakes
at home that cumulated 1n the longest, and one of the sharpest, economic
declines 1n our history (see Friedman and Schwartz, 1963).
Whether based on a sound diagnosis or not, the regulatory structure put 1n
place at that time survived largely Intact for half a century.

That 1t caused

relatively few problems during the years Immediately following Its
Introduction was due largely to the fact that much of 1t was nonbinding 1n an
Industry made conservative by the memory of the banking crisis and 1n an
economy characterized by low Inflation and Interest rates.

Some regulations,

Including tightened chartering restrictions and the separation of commercial
and Investment banking, were effective from the start.

But 1t was not until

1957 that an appreciable number of banks were constrained by deposit rate
ceilings, and the problem did not become acute until the mid-1960s, when
sharply rising Interest rates and more aggressive competition for funds
produced a sharp confrontation between regulation and market forces.

The Revival of Competition
The decades of the 1960s and 1970s, respectively, corresponded roughly

with two evolutionary stages in the responses of bank regulators to the
problem posed by increasingly binding regulation.

As we have observed

elsewhere, "the decade of the 1960s began as a period of growing frustration
for commercial bankers; it ended in frustration for financial regulators."
(Kaufman, Mote, and Rosenblum, 1983)

Initially, banks found themselves

increasingly squeezed by deposit rate regulations and restrictions on
activities that hindered them in the pursuit of profitable opportunities.
Their response was to seek ways around the regulatory obstacles.

The result

was the now familiar "regulatory dialectic" in which the regulators responded
by trying to plug every new leak in the dike of regulation as it opened up,
only to find new leaks elsewhere (Kane, 1977).

By the end of the 1960s the

task had become almost hopeless.

Regulatory Adaptation
Regulation in the 1970s, by contrast, was characterized by a policy of

accommodating competition and expansion as far as current law permitted.

Even

so, regulation tended to lag developments in the financial markets, and much
effort was spent simply in bringing regulation de jure into alignment with the
situation de facto.

The states played a leading role in the development of

this new regulatory attitude.

Massachusetts' 1972 authorization of the

offering of NOW accounts by mutual savings banks proved to be a major step
along the road toward deregulation.

Many of the subsequent administrative and

legislative actions taken in the 1970s— the 1974 legislation extending NOW
account powers to commercial banks, savings and loans, and mutual savings

banks 1n all New England states; the authorization of ATMs for national banks
1n the same year; and the authorization of money market certificates 1n
1978--were more visible extensions of a policy trend already established.
The pressures that gradually nudged the regulators toward a more
accommodative stance continued unabated throughout this period.

Foremost

among them were the higher and more volatile Interest fates that caused the
deposit rate ceilings to bind and led to progressively more severe bouts of
disintermediation; the related emergence of new, less stringently regulated
Institutions and Instruments, of which the money market mutual fund 1s the
most prominent example; and technological advances 1n the processes of
collecting, storing, manipulating, and transmitting data, which have
revolutionized cash management and greatly facilitated efforts to circumvent
regulation.
In April 1979, a decision of the U.S. Court of Appeals for the District of
Columbia enjoined depository Institutions from offering NOW accounts or share
drafts and from establishing remote service units— devices by which depository
Institutions had circumvented the prohibition of Interest on demand deposits
and restrictions on branching.

The court ruled that the regulatory agencies

had overstepped their legislative authority 1n authorizing these services.

delaying the effective date of Its order for six months (later extended
another three months), the court effectively set a deadline for congressional
action to avoid the disruptions that compliance with the decision would
otherwise produce.

Pressured by this deadline and by a near-cr1s1s 1n

financial markets 1n the winter of 1979, the Congress enacted the Depository
Institutions Deregulation and Monetary Control Act (DIOMCA) of 1980.

This was

a landmark piece of legislation that Implemented many of the recommendations

made over two decades by a series of study commissions beginning with the
Commission on Honey and Credit in 1960.

01DMCA provided for a phased

elimination of most ceilings on deposit interest rates, authorized depository
Institutions nationwide to offer Interest-bearing NOW accounts or their
equivalent, enlarged the asset powers of thrift Institutions, and preempted
state usury ceilings on certain types of loans.

Only two years later, an

intensification of the distress in the thrift industry led to the enactment of
the Depository Institutions Act of 1982 (Garn-St Germain Act).

Several

provisions of the act authorized emergency powers enlarging the options open
to regulators in dealing with crisis situations, including the possibility of
interstate mergers of closed or financially endangered institutions.

Other

provisions extended and accelerated the process of deregulation, broadening
the asset powers of savings and loan associations and authorizing depository
institutions to offer money market deposit accounts.
Given the absence of any new crisis and the short-term difficulties of
adjusting to the changes already enacted, it is not surprising that no
additional major legislation affecting the financial industry was passed in
1983,

But the Administration introduced a bill that would have greatly

enlarged bank powers to carry on, through a holding company subsidiary:

(1)

securities activities, including full-service securities brokerage,
underwriting

of al1 types of municipal revenue bonds, and the operation of

mutual funds; (2) insurance underwriting and brokerage, and (3) real estate
activities, including investment, development, and brokerage.

However, that

bi11 failed to pass in 1983 and is unlikely to be enacted, except in greatly
modified form, any time in the near future.

Another bill, introduced by

Senator Garn 1n November 1983, also would allow bank holding companies to
offer an expanded 11st of securities activities, Including the underwriting of
mortgage-backed bonds, through securities affiliates.

In addition, 1t would

eliminate the prohibition of Interest on demand deposits, preempt state usury
ceilings on agricultural and business credit, and authorize reciprocal
Interstate banking.

Though approved by the Senate, the Garn bill has met

determined opposition 1n the House from members favoring a more cautious
approach to liberalization of restrictions on bank activities.

This

opposition was strengthened by the difficulties experienced by Continental
Bank.

The Current Situation
The financial system 1s still 1n the process of digesting the changes that

have already occurred.

So far as prices paid and charged by depository

Institutions are concerned, deregulation has nearly run Its course.

Only the

Interest rate ceilings on NOW accounts and passbook savings accounts, the
prohibition of Interest on corporate demand deposits— which 1s already largely
nullified by repurchase agreements, Improved cash management, and various
devices for paying Implicit Interest— and state usury laws remain to be
eliminated.

Geographic expansion 1s still restricted by the McFadden Act and

the Douglas Amendment to the Bank Holding Company Act, but these restrictions
have become less and less meaningful as banks have used nonbank subsidiaries
of bank holding companies (Including "nonbank" banks), loan production
offices, Edge Act corporations, toll-free telephone numbers, brokered
certificates of deposit, and other devices to serve customers over wide
areas.

Also, a number of states have liberalized their branching and holding

company laws 1n recent decades, and an Increasing number have removed the
restrictions of the Douglas Amendment and allowed out-of-state bank holding
companies to open new banks or acquire existing banks within their boundaries
(Moulton, 1983).

In most cases Interstate expansion has been on a limited

basis as 1n Delaware, Maryland, and South Dakota or on a reciprocal basis as
1n Georgia, Kentucky, the Carollnas, Utah, New York, and most of the New
England states.
laws.

Only Alaska and Maine have unrestricted Interstate banking

Bank product line restrictions remain pretty much Intact, but are

likely to become the legislative battlegrounds of the future.

Entry Into

banking, at least 1n a de facto sense, has become progressively easier, though
explicit legislative liberalization of bank chartering restrictions has been
undertaken by only a few states.

In sum, although deregulation has made

considerable progress 1n the financial services Industry, 1t still has a long
way to go.

II.

The Shape of the Future:

Product Specialization or Diversification?

One clear consequence of the steps toward deregulation taken so far 1s
that many financial Institutions are free to engage 1n a much broader range of
financial activities than was the case before.

Economic forces, Including any

economies of joint production or consumption, can be expected to play a
greater role 1n the future 1n determining the extent to which Institutions
specialize 1n one or a few services or diversify Into many than they did over
the past 50 years.

Although little direct evidence 1s available on such

complementarities, some Inferences regarding their existence and Importance
can be drawn from observations on the past behavior and success of both
financial and nonflnanclal firms enjoying at least some freedom to choose
their product lines.

The Evidence on Conglomerate Mergers
One source of evidence 1s the conglomerate merger movement among

nonflnanclal firms of the 1950s and 1960s.

United States economic history has

been characterized by several episodes or waves of merger activity.

The first

merger wave 1s generally agreed to have occurred between 1898 and 1902.

This

turn-of-the-century merger movement consisted primarily of horizontal mergers,
1.e., mergers between firms competing 1n the same geographic and product
markets.

Most of these mergers were undertaken to achieve economies of large

scale production and/or monopoly power.

These mergers "transformed many

Industries, formerly characterized by many small and medium-sized firms, Into
those 1n which one or a very few large enterprises occupied leading
positions." (Nelson, 1959)

Economic theory would suggest that of all the

types of mergers that can be undertaken, horizontal mergers, other things
being equal, are most likely to increase the profits of the combined
enterprises.

However, after reviewing four studies of the effects on

profitability of these turn-of-the-century horizontal mergers, one researcher
concluded that "the profitability of firms which undertook substantial amounts
of merger activity 1n the first merger wave was generally no better and
perhaps worse than firms which expanded by Internal means." (Rosenblum, 1972)
The second merger movement, which took place between 1926 and 1930, has
been characterized by Stlgler (1950) as "merger for oligopoly."

The third

wave of merger activity occurred between the early 1950s and 1970.

agreement has been reached on the precise dating of this third merger episode,
partly because a renewed sharp Increase 1n merger activity 1n the late 1970s
has continued up to the present time, and 1t 1s as yet unclear whether the
current merger wave 1s an extension of the 1952-70 merger episode.

Nonetheless, mergers in the post-1950 period have been dominated by
conglomerate merger activity.

In interpreting the intent and impact of

conglomerate mergers, it is necessary to distinguish three types:

product

extension, market extension (geographic), and pure conglomerate mergers.
Product and market extension mergers have some horizontal and vertical
elements; the rationale for pure conglomerate mergers is much less clear.
A number of studies were undertaken in the late 1960s and early 1970s to
determine the profitability of mergers during the third merger wave (Rosenblum
1972; Hogarty, 1970).

These studies concentrated largely but not solely on

pure conglomerate mergers.

Their common finding, despite differing samples

and methodologies, was that the effects of mergers on the combined firm's
profitability, as measured by returns to stockholders, were at best neutral.
The only debate seemed to be "whether mergers have a neutral or negative
impact on profitability." (Hogarty, 1970, p. 384)

These studies also

concluded that, on average, the owners of acquiring firms lost from mergers
while the owners of acquired firms gained--i.e., the key to merger
profitability was the price paid for the acquisition.
This is not to say that pure conglomerate mergers cannot be profitable, at
least in an accounting sense.

Mead (1968) demonstrated that the acquisition

by a firm with a high P/E ratio of a firm with a lower P/E ratio produces an
instantaneous accounting profit.

Such behavior characterized the conglomerate

mergers, but not the horizontal and vertical mergers, studied by Mead during
1967-68.

The widespread use of accounting and tax devices to produce stated

increases in profits for merging firms but not true increases in economic
value led Steiner (1975) to distinguish between pecuniary and real benefits
arising from merger activity, with the former being particularly prevalent in

pure conglomerate mergers.

He concluded that 1t 1s not possible to Identify

any single motive as the major explanation of conglomerate mergers.

Rather,

the historical experience taken as a whole argues for a multiple motivation
model that would Include as arguments such things as:

real economic

efficiencies, market power, growth, tax gains, short-term speculative gains,
Insider gains, and accounting profit gains.

Some combination of these motives

underlies all merger negotiations, and merger activity Increases when the
external climate (antitrust attitudes, Interest rates, etc.) 1s right.

While

not concluding that conglomerate mergers are beneficial to society, Steiner
did not find evidence that they are harmful.
More recently, Brozen (1982 a,b) has argued that conglomerate mergers do
provide economic benefits to society.

He concludes that, "chief among the

many reasons for conglomerate mergers--and the best substantiated
hypothesis— 1s that conglomerates take advantage of opportunities to acquire
poorly managed assets."

According to Brozen, these acquired firms have

returns that are generally below the average for all firms and would either go
out of business eventually or would continue to waste resources through
relatively Inefficient operation or distribution systems.

Acquisition of

these firms results 1n expansion of capacity or maintenance of capacity that
would otherwise contract; therefore, competition or competitive Intensity 1s
greater that 1t otherwise would have been.

Brozen cites some limited evidence

that the effective level of entry and the number of viable competing firms are
enhanced, not decreased, by an antitrust policy that does not Interfere with
conglomerate mergers.
Most recent studies do not separate conglomerate mergers from horizontal,
vertical, product extension, or market extension mergers.

In fact, the only

reason these studies shed any light on the benefits of conglomerate mergers 1s
that the majority of the mergers 1n recent years (and therefore 1n the
samples) were of a conglomerate nature.

In reviewing the literature of the

last decade, Halpern (1983) finds evidence that stockholders of acquired firms
benefit from acquisition but, at best, limited evidence that stockholders of
the acquiring firm derive any benefits.

Jensen and Ruback (1983) report

similar f1nd1ngs--namely, that corporate takeovers generate positive gains for
target firm shareholders— but their review of the literature suggests that
shareholders of acquiring firms do not lose from the merger activity engaged
1n by their management.

Only one study by Lev and Mandelker (1972) found that

acquiring firms tended to be somewhat more profitable than nonmerging firms
within their Industry.
Given the absence of any clear-cut findings that conglomerate merger
activity among Industrial firms provides any real economic gains to
shareholders of the acquiring conglomerate firm, 1t 1s difficult to draw the
Inference that combinations of banks or other financial service providers with
very different business product lines— such as retail department stores,
securities brokerage or underwriting, telecommunications, or 1nsurance--w111
result 1n new firms whose profitability will necessarily outstrip that of
Incumbent specialized financial service providers like commercial banks.

Financial Conglomerates
Financial conglomerates have received a great deal of publicity 1n recent

years, largely due to the mergers 1n 1981 between Prudential Life Insurance
and Bache, between American Express and Shearson, and between Sears (which
already owned a large savings and loan association and a major casualty

Insurance company) and both Dean Witter and Coldwell-Banker.

Further

stimulating the public's, the Congress' and regulators' Imaginations were
Sears' establishment of financial centers 1n a number of Its retail stores and
the acquisition or establishment by a number of nonbanklng-based firms of
consumer or "nonbank" banks.

These are Institutions with commercial bank

charters, but which either do not make business loans dr do not not accept
demand deposits, thereby avoiding the necessity for prior approval by the
Federal Reserve under the Bank Holding Company Act, which defines a bank as an
Institution that engages 1n both of those activities.

Besides enabling a

financial conglomerate to engage 1n a combination of activities not permitted
to bank holding companies, such "banks" allow the parent firm to raise funds
by offering federally Insured deposits.

These deposits complement their other

nonbank products, particularly since the Introduction of MMDA accounts that
compete with money market funds.

Before the Comptroller of the Currency, at

the urging of the Federal Reserve, imposed a moratorium on new applications
for national bank charters for such Institutions, nonbank banks had been
acquired, organized, or planned by Prudentlal-Bache, Fidelity, Merrill Lynch,
Dreyfus, Gulf & Western, Dimension Financial Corp., and several other
companies.
The attention centered on these and other comparatively recent
cross-industry mergers, acquisitions, and affiliations has led many to believe
that the Interest of nonbanking-based firms 1n banking 1s of very recent
origin.

However, such a belief 1s false, because nonbanking entitles have

long had a significant presence not only 1n lending to businesses and
households, but 1n many other financial services as well.
began to provide retail credit 1n 1910.

For example, Sears

It has been a major supplier of

Insurance services since it organized Allstate Insurance 1n 1931.

In 1975, 1t

purchased the Empire Savings and Loan Association 1n California, which 1t
renamed Allstate and expanded sharply.

Other nonbanking-based firms have been

Involved 1n providing financial services for a similarly long period of time.
General Motors began its financing operations 1n 1919 and Ford 1n 1928.
General Electric formed Its credit subsidiary to finance refrigerators and
other appliances 1n 1932, diversified Into many types of business financing 1n
the 1960s, and by 1982, virtually none of Its $13.1 billion 1n loans was
related to the financing of GE products.
Roughly a decade ago, Cleveland Christophe (1974) documented the positions
of 11 nonbanking-based firms such as Sears, General Motors, and General
Electric 1n the consumer lending areas traditionally thought to be the domain
of commercial banks and consumer finance companies.

Many of these firms had

earnings from their financial service activities that rivaled those of the
nation's leading bank holding companies.

In 1972, moreover, the dollar amount

of the combined consumer Instalment loans held by three manufacturers (GM,
Ford, and GE) was almost double that of three leading retailers (Sears,
Montgomery Ward, and J.C. Penney) and almost triple that held by the three
largest bank holding companies (BankAmerlca, Citicorp, and Chase Manhattan).
Several studies published recently by the Federal Reserve Bank of Chicago
(Rosenblum and Siegel, 1983; Rosenblum, Siegel, and Pavel, 1983; Rosenblum and
Pavel, 1984) have updated and extended past studies of the extent of overlap
between commercial banks and nondeposit-based firms 1n consumer and business
lending and 1n the generation of depos1t-Hke liabilities.

These studies

examined over 30 nonbanking-based companies and compared them with the top 15

bank holding companies and the consolidated commercial banking system.

Among

the studies' highlights are the following findings:
In 1982, the 32 companies studied had one or more product lines that
overlapped with commercial banks and that gave those firms a
significant regional or nationwide presence 1n one or more banking
services.
In automobile credit, General Motors 1s far and away the largest
lender with over one-fourth of all auto loans outstanding, having
doubled Its share from 13 percent 1n 1978. By contrast, the entire
commercial banking Industry holds 45 percent of domestic auto loans,
down from 60 percent 1n 1978. Since 1979, General Motors and Ford
have dominated the auto lending business, largely as a consequence of
special terms offered to stimulate automobile sales.
Commercial banks are still the dominant business lenders 1n the
country, particularly 1n short-term commercial and Industrial (C&I)
lending. Nonetheless, the 32 nonbanking-based companies studied
Issued combined short-term loans of $42.5 billion 1n 1982, slightly
more than one-fourth the amount of domestic C&I loans of the 15
largest bank holding companies and about 6.6 percent of the total for
all commercial banks. These proportions appear to have changed
little 1n the last 7-8 years.
In commercial mortgage lending, four Insurance-based companies make a
greater volume of commercial mortgage loans than the largest 15 bank
holding companies and about 27 percent as much as the nation's almost
15,000 banks.
The business lease financing market 1s dominated by Industrial
companies. The 15 such companies studied had greater lease
receivables than that of the domestic offices of all Insured U.S.
banks.
Ten of the 32 companies studied have sponsored one or more money
market mutual funds and account for about 38 percent of all money
market fund assets. They clearly compete to some extent with
commercial banks on the deposit side of the balance sheet.
Clearly, the nonbanking-based companies have significant overlaps with
commercial banks.

Ironically, this competition 1s not so much a case of the

nonbanks Invading the territory of the banks as 1t Is the nonbanks trying to
regain markets they abandoned or lost to commercial banks a long time ago.
With the exception of short-term commercial and Industrial lending and the

Issuing of demand deposits, commercial banks are the Johnny-come-lately on the
financial scene.
Despite the prominent examples of success, notably those of Sears, General
Electric, and the major automobile manufacturers, casual and anecdotal
evidence suggests that financial conglomerate combinations may not have been
any more successful, on average, than their nonfinancial counterparts.

The

most dramatic recent example is Baldwin-United, which in 1967 was an old-line
(dating back to 1862) manufacturer of pianos and organs with total assets of
$67 million.

Within a brief 15 years it skyrocketed to a financial

conglomerate with $9.4 billion in assets, including a savings and loan
association, life and property insurance underwriters and brokers, mortgage
banks, and the largest home mortgage insurer in the country, MGIC.

It also

owned a number of commercial banks until the Federal Reserve forced it to
divest itself of them under the Bank Holding Company Act at year-end 1980.
Early in 1983, the company declared insolvency and began to spin off its
subsidiaries.
The stories of most other unsuccessful efforts in putting together
financial conglomerates were less dramatic.

The recent acquisition of

Shearson-Loeb Rhoades was not American Express' first venture into the
brokerage business.

In the early 1970s, it purchased a 25 percent interest in

Donaldson, Lufkin, Jenrette, but spun it off four years later after
experiencing disappointing returns.1

Similarly, the Insurance Company

1
Indeed, American Express has experienced its share of disappointments
in combining with other financial firms. In the 1960s, one of its
subsidiaries was the holder of the watered tanks in the "Great Salad Oil
Scandal" and the press has been reporting difficulties with, and the possible
sale of, its Fireman's Fund Insurance Company. A review of some similar
experiences of other financial conglomerates appeared in the American Banker
(Zweig, 1981).

of North America (INA) purchased the brokerage firms of Blyth & Co. 1n 1970
and Eastman & Co. 1n 1972.

After merging the two Into Blyth Eastman, INA sold

1t to Paine Webber 1n 1979.

Walter Heller, a large finance company, purchased

the American National Bank of Chicago 1n 1973 to expand Its product lines, but
negotiated the bank's sale ten years later after 1t was unable to relieve
Heller's financial pressures.
Itself.

Indeed, Heller 1s 1n the process of liquidating

Conglomerate affiliations between non-f1nanc1al and financial firms

were rarer, many ending with the enactment of the 1970 amendments to the Bank
Holding Company Act, which required companies owning a commercial bank to
divest themselves of most lines of nonflnanclal activity.
No obvious pattern emerges from this experience, 1n the sense that no
particular combinations of activities can be clearly shown to be more
conducive to the achievement of synergies than others.

Rather, 1t would

appear that there 1s no obvious superiority— or 1nfer1or1ty--of financial
services companies associated with conglomerates relative to Independent
companies offering the same services.

Success or fa1lure*appears to be much

more a function of the particular managements and competitive situations of
the Individual firms.

On reflection, this 1s not surprising, since a

conglomerate that allowed complete operating autonomy to Its subsidiaries
should be able to duplicate the performance of a collection of Independent
firms.

Any stronger conclusions about the effects of conglomeration must

await more detailed and systematic examinations of the Internal organization
and managerial styles of a number of financial conglomerates.
C.

Bank Holding Companies
Commercial banks can enter many financial activities directly or through

the establishment of a bank subsidiary.

To enter activities permitted under

the Bank Holding Company Act, but not permissible for banks per se, they must
form a bank holding company subsidiary.

But, even for holding companies,

activities must "be so closely related to banking . . . as to be a proper
Incident thereto."

Some states grant broader powers to state banks than the

federal government does to national banks or to bank holding companies.
Although similar restrictions apply to multi-association savings and loan
(SLA) holding companies as to commercial bank holding companies, singleassociation holding companies have considerably broader powers.

Recently,

commercial banks and savings and loan associations have been permitted under
the same holding company umbrella, but still only on a very restrictive
basis.

Except for the Glass-Steagall Act's prohibition on deposit-taking

activities by securities firms, most firms other than commercial banks and
savings and loan associations are not restricted as to the types of financial
activities 1n which they may engage.
How successful have commercial banks been 1n diversifying their services?
In terms of numbers, 1t appears very successful.

A recent survey reported

that, 1n 1982, 139 bank holding companies operated some 5,5€0 nonbank offices
in states other than the ones 1n which they were headquartered.

Of these,

4,442 were finance company offices, 584 were mortgage banking offices, and the
remaining 474 were offices of other types of nonbank subsidiaries of bank
holding companies (Whitehead, 1983).

The services offered by the largest

number of these offices were finance company-type services, followed by
Insurance agency activities for smaller companies, underwriting credit life,
loan servicing, mortgage banking, and community-type Investments.

addition, of course, these holding companies operate many additional 1n-stite
affiliates.

However, little hard research has been conducted on how

profitable these operations have been.

The fragmentary research that has been

completed casts doubts on the success of these ventures 1n Increasing profits
or decreasing risk.
Two studies reported that mortgage banks affiliated with bank holding
companies 1n the mid-1970s were both less profitable and slower growing than
their Independent counterparts (Talley, 1976; Rhoades, 1975).

Two other

studies reported that bank-aff1l1ated finance companies were also less
profitable, but expanded more rapidly than independent finance companies
(Talley, 1976; Rhoades and Boczar, 1977).

Similarly, bank-aff1Hated

equipment leasing firms were less profitable than their Independent
counterparts (Rhoades, 1980).

Despite these experiences, however, commercial

banking was one of the more profitable Industries 1n the 1970s (Ford, 1982;
Kaufman, Mote, and Rosenblum, 1983b).
Nor have commercial bank holding companies appeared to be any more
successful 1n reducing their overall risk through affiliation with nonbank
activities (Boyd, Hanweck, and P1thyachar1yakul, 1980).

The conclusions of

all of these studies, however, are limited by the restrictions on the types of
nonbank activities bank holding companies may conduct (Stover, 1982).

Risk

reduction requires not only entry Into different activities but entry Into
activities whose Income flow 1s not highly correlated with the bank's Income
flow.

While the available evidence on the success of commercial bank product

diversification 1n reducing risk or Increasing profitability 1s not
encouraging, the final word awaits more rigorous research results.

Increased

authority to enter Into additional areas may permit bank holding companies to
search out activities whose Income flows are less positively correlated with,
or Independent of, their current Income flow.

But 1t should be kept 1n mind

that the potential risk reduction from diversification by banks 1s ultimately
limited by the fact that the typical bank already holds a highly diversified
asset portfolio, albeit consisting almost entirely of debt securities.

Foreign Experience
A largely untapped source of useful Information on the likely effects of

further deregulation 1s the experience of other countries with less
restrictive regulation of financial Institutions.

Any conclusions based on

International comparisons must be drawn with great caution and some
skepticism, given the Importance of cultural and other nonquantlf1ab!e
variables 1n affecting the outcomes of similar policies 1n different
countries.

Nevertheless, there are some broad lessons to be derived from

foreign experience that would appear to have relevance 1n virtually any
country.
One fairly clear generalization that can be drawn from other countries'
experience 1s that, freed of legal constraints or administrative pressures,
many of the larger banks would diversify further than has been the case 1n the
United States (Goodman and Kumekawa, 1984).

Such diversification would

Include a variety of Investment banking functions, Including underwriting of
corporate securities and the purchase of equity Interests 1n nonflnanclal
firms, both of which violate traditional U.S. beliefs about appropriate
banking activities.

The strongest argument that this would occur under

deregulation 1s that 1n West Germany, where 1t 1s permitted, such "universal
banking" 1s 1n fact practiced, albeit primarily by the largest banks. Both
U.S. and Japanese banks engaged 1n underwriting until prohibited from doing
so, the former by the Glass-Steagall Act of 1933 and the latter by legislation

adopted during the U.S. occupation.

Moreover, 1n England, where Informal

regulation by the Bank of England had effectively separated commercial and
merchant banking, the relaxation of that separation since 1971 has resulted 1n
the rapid entry by the major clearing banks Into securities underwriting and
Investment management (Daskln and Marquardt, 1983).
Of course, the mere fact that banks would choose to' diversify 1f free to
do so does not demonstrate the desirability of that diversification from a
social standpoint.

It has frequently been argued that combining lending,

underwriting, and equity ownership 1n the same Institution will lead to
reduced competition, undue risks to depositors, conflicts of Interest, and
undue Influence on the policies of customers.

In response to such concerns,

the Minister of Finance of the Federal Republic of Germany 1n 1974 appointed a
special commission--known as the Gessler Commission after Its cha1rman--to
Investigate German universal banking.

The final report of the commission,

Issued in May 1979, failed to find strong evidence of any of these adverse
effects.

The few reforms the commission did recommend were largely of a

prophylactic nature, designed to prevent abuses from occurring rather than to
correct any observed abuses (Kruemmel, 1980).

The U.S. experience before 1930

which led to a different conclusion and, ultimately, to the legal separation
of commercial and Investment banking, has been Increasingly questioned 1n
recent years as banks have pushed for revision of the Glass-Steagall Act.

appears that the appropriateness of restrictions on banks' product lines, and
particularly securities activities, will be among the hottest Issues of
financial regulation for some time to come.

Conclusions
The evidence appears unequivocal that deregulation of product line

restrictions will result 1n considerable diversification by commercial banks
(depending on the degree of deregulation) Into services previously prohibited
to them, as well as further expansion by nonbanking-based firms Into
additional financial services currently prohibited to them.

However, the

mixed success of both financial and nonflnanclal conglomerates, the apparently
poor performance of nonbank subsidiaries of bank holding companies, and the
varying degrees of specialization by financial Institutions even in a country
like West Germany that Imposes few product restrictions on banks all argue
that there will continue to be a highly diverse set of financial Institutions
after deregulation.

III.

The Shape of the Future:

Size and Geographic Scope

Economies of Scale
A lowering of entry and geographic barriers would allow the number, size

distribution, and geographic scope of financial Institutions to be determined
much more by market forces, Including the relationship of efficiency to bank
size and organizational characteristics and customer preferences regarding
price, quality of service, and convenience, than 1s the case today.

There 1s

a considerable literature on economies of size and organization that should
offer some guidance.

Unfortunately, much of 1t has not been designed to

answer the questions that need to be asked.

For example, one of the key

questions 1s the relative Importance of plant and firm economies of scale 1n
banking.

Plant economies result from the expansion 1n size of a single plant

or office of a bank.

If all the operating economies 1n banking are limited to

the plant level, an alternative reason would have to be found for expecting
multi-office firms to predominate.

One possibility 1s that there are

convenience advantages to customers 1n being able to do business with the same
bank at more than one location--which must be distinguished from the added
convenience of having more and, on average, more conveniently located banking
offices In a given market, whether operated by the same bank or not.

To the

extent that the size of the local market places limits on the growth of a
single plant, or banking office, very large unit banks would be found only 1n
the largest, most densely populated markets.

If there are significant

economies at the firm level— perhaps because certain functions like personnel,
accounting, and the establishment of broad management policies are centralized
at the head off1ce--then operating efficiency will also favor larger banks
with many branches.
Disagreement 1n results exists 1n the literature on economies of scale at
both the plant and firm level 1n banking.

However, there has been a steady

Improvement over the past two decades 1n the measures of output, choice of
functional form, and specification of branching effects.
better conceived studies appear to agree that:

The more recent and

(1) there are significant

economies of scale to be achieved by output expansion at the plant level for
very small banking offices, (2) these tend to be exhausted as the office
reaches a size between $10 million and $100 million 1n deposits, after which
costs remain flat or begin to rise; and (3) economies of multiplant (branch)
operation appear to be negligible (Benston, Hanweck, and Humphrey, 1982).
On the basis of a reading of these results, several authors have concluded
that the

dismantling of barriers to Interstate branching would have a

relatively small impact on the U.S. banking structure, except possibly on
banks 1n the smallest size class, and that there would continue to be a large
number of banks of diverse sizes and branching configurations.

As Richard

Nelson (1983) recently stated this conclusion,". . .the broad elements of U.S
banking structure have been determined more by underlying supply and demand
factors than by branching regulations...

The major objection one might raise to such a conclusion 1s that 1t 1s
based exclusively on operating efficiency.

As Indicated above, 1f customers

value being able to transact business with their bank at more than one
location, multi-office banking might proliferate despite the absence of
operating economies.

Nelson considered this force for consolidation but

concluded that 1t would probably be confined to large urban areas.

Additional

possibilities, mentioned by Alton Gilbert (1983) 1n a recent survey of the
bank cost literature, are that branching may enable a bank to reduce risk by
broadening the geographic diversification of Its loan portfolio and/or sources
of funds and that greater size at the level of the firm may enable the bank to
reduce the transactions costs required to manage its reserve position.

If any

or all of these factors were Important, overall efficiency would require banks
larger than would be justified simply on the basis of operating economies.
Moreover, the fact that cost curves have been found to be relatively flat
beyond the point of minimum average cost and that there may be some economies
of scope 1s consistent with a wide range of efficient bank sizes.
Still another largely unanswered question 1s the effect of technological
progress, particularly 1n data processing, on the optimal size of bank.

has often been assumed that such change would greatly Increase the minimum
size of bank needed for efficient operation.

This might have been true a

couple of decades ago, when the use of a computer required a major Investment
well beyond the capabilities of most small banks— although the possibility of
purchasing services from an outside firm means that the existence of economies
of scale 1n computer operation need not Imply economies of scale 1n banking.
In any case, recent trends have been mostly 1n the opposite direction with the
development of time sharing and smaller and less expensive computers with
Increasingly greater capabilities (Metzker, 1982; Kaufman, Mote, and
Rosenblum, 1983).

Effects of Liberalizing State Laws
Some useful Insights Into the effects of geographical deregulation on

banking structure can be gained by looking at the results 1n states that have
liberalized their branching or multibank holding company laws.

An early study

of this type by Bernard Shull (1972) examined the experience of banks in New
York and Virginia after both states liberalized their branching and multibank
holding company laws 1n the early 1960s.

Several peculiarities of the revised

laws must be kept 1n mind 1n judging the results of the study.

First,

although both states eventually moved to statewide branching, branching 1n New
York was Initially confined to the banking district— of which there were nine
1n the state--w1th1n which the head office of the bank was located.

Virginia

allowed statewide branching, but only by merger, and encouraged statewide
expansion by the holding company route.

Shull observed the following

statewide effects after the laws were changed:

the rate of consolidation

Increased, concentration Increased, and the number of banking organizations
declined.

At the local market level, however, the results were quite

different.

There was no systematic effect on the number of banking

organizations and, on balance, concentration declined slightly.
Other studies have found even less evidence of changes 1n concentration
due to bank holding company expansion.

In recent decades, concentration 1n

banking declined at the national level, was virtually unchanged at the state
level, and, with many exceptions 1n Individual markets, declined at the local
level (Savage, 1982).

To be sure, the number of banking organizations

statewide has declined In most states liberalizing their branching and holding
company laws, but this 1s of significance only to the degree that such
theories of mutual forebearance as the "linked oligopoly" theory are valid.
So far this has not been demonstrated (Whitehead, 1978).

At the local market

level, there 1s no apparent relationship between state holding company laws
and concentration (Rhoades, 1978).

Foreign Experience
As 1n the case of product diversification, the experience of foreign

banking systems subject to varying degrees of regulation can tell us something
about the likely consequences of removing geographic restrictions.

It 1s

generally known that the banking systems of most other modern industrial
countries are much more highly concentrated than that of the United States.
Many have only a handful of banks of any consequence.

In virtually all of

these countries, the major banks operate nationwide branching systems.
Consequently, it 1s tempting to conclude that removal of geographic
restrictions 1n the United States would lead to a banking structure similar to
those of other Industrial countries.

However, such a conclusion ignores several important differences.

One is

the sheer size of the U.S. banking system, which means that even with banks of
comparable absolute size to those abroad, the concentration level would be
considerably lower.

Secondly, the large average bank size and high

concentration levels typical of most foreign banking systems are only partly
due to liberal branching laws.

In many cases, as in Japan, they are

exacerbated by restrictive chartering policies and systematic encouragement of
mergers (Wallich and Wallich, 1976).

In Italy, the banking laws of 1926 and

1936, by encouraging consolidations and closings, reduced the number of banks
from 4,000 in 1926 to 1,432 in 1945 and the number of branches from 12,000 to
6,889 (Alhadeff, 1968).

Similar policies pursued by the Conseil National du

Credit in France reduced the number of deposit banks from 361 1n 1946 to 233
in 1964, while allowing some increase in the number of branches.

Even more

dramatic results were achieved by a restrictive chartering policy combined
with a liberal merger policy in Canada, where the number of domestically
chartered banks declined from 51 in 1875 to 11 today.

Of these, five have

nationwide branching systems and rank among the 65 largest banks in the world
(Pozdena and Sullivan, 1982).

Thus, the high levels of banking concentration

in other countries are as much a reflection of regulation as is the extreme
atomization of U.S. banking.

A banking structure determined entirely by

market forces would probably lie between these extremes.

The Experience with Food Retailing
Banking, defined broadly to include other depository institutions like

savings and loan associations and savings banks, is among the few industries
in which the extent of branching has been restricted.

Food retailing is

another Industry that was once subject to concerted efforts to restrict
multi-office operations.

Because these efforts failed, the subsequent

experience of food retailing may provide some Indication of what can be
expected to occur 1n banking 1f branching restrictions were removed.
The first grocery stores were general stores that sold clothing, hardware,
and general merchandise 1n addition to food.

These were followed by specialty

stores that restricted themselves to food or, even further, to particular
types of foods such as meat or groceries.

In the 1920s, chain grocery stores

expanded rapidly and supermarkets developed from both Independent and chain
stores.

A&P was the first and the leader among, first, chain stores and,

then, supermarkets.

It opened with one store 1n New York City 1n 1859.

1900, 1t operated 200 stores throughout the country; 1n 1910, 372 stores; 1n
1920, 4,621; and 1n 1930, 15,737 stores, Its peak number.
quickly followed.

Other chains

In 1930, Kroger had over 5,000 stores and American, First

National, and Safeway over 2,000 stores each (See Lebhar, 1959; Markin, 1968;
and Mueller and Garolan, 1961).
The expansion of the chain stores was accompanied by severe price cutting
that put local, Independent stores under great financial pressure and drove
many out of business.

By the 1920s, the "menace" of chain stores was brought

to the attention of state legislatures and the Congress, and bills were
Introduced to limit the number of stores operated by any one company and to
Impose a progressive tax on multiple stores.

By 1933, more than 500

ant1-cha1n store bills had been Introduced 1n state legislatures and some 20
had been enacted (Lebhar, pp. 118-136).

In 1928, the Senate requested the

Federal Trade Commission to make a thorough study of chain store operations.

The reasons enumerated 1n the Senate resolution read much like those
traditionally used against Interstate banking.

For example:

Whereas these chain stores now control a substantial
proportion of the distribution of certain commodities 1n certain
cities, are rapidly Increasing this proportion of control 1n
these and other cities, and are beginning to extend this system
of merchandising Into country districts as well; and
Whereas the continuance of the growth of chain-store
distribution and the consolidation of such chain stores may
result 1n the development of monopolistic organizations 1n
certain lines of retail distribution; and . . .
Whereas, 1n consequence, the extent to which such
consolidations are now, or should be made, amenable to the
jurisdiction of the Federal antitrust laws 1s a matter of
serious concern to the public: . . .(U.S. Congress, Senate,
1934, pp. 1-2).
Before 1t was completed 1n 1934, the study Involved a series of 33 reports,
examining every conceivable aspect of chain-store operations.

The Commission

concluded that 1f the trend of the previous 20 years continued, monopoly 1n
some lines of chain-store merchandising would result.

Although 1t recognized

some advantages to chain-store operations, the Commission recommended a number
of changes strengthening the Clayton and Federal Trade Commission Acts (U.S.
Congress, Senate, 1934, pp. 85-97).

In 1933, Representative Wright Patman

(later a vocal advocate of small banks and persistent critic of the Federal
Reserve) Introduced a bill that Imposed a severe tax on the number of stores
multiplied by the number of states 1n which the chain operated.

If enacted,

this bill would have effectively forced the closure of Interstate chain stores
and severely restricted Intrastate chains.

Although 1t gathered substantial

support, this and subsequent bills were not enacted.

Possibly 1n part because

of this opposition and 1n part because of the Depression, the relative growth
of chain stores slowed.

By 1939, they accounted for 37 percent of all retail

grocery sales, slightly less than the percentage 1n 1929.

After World War II, the opposition to chain stores declined significantly
and their Importance Increased.

By 1958, the proportion of retail grocery

sales accounted for by chain stores had climbed to 43 percent.
leveled off.

Thereafter, 1t

Increased demand for convenience and personal service associated

with rising Incomes, as well as the development of purchasing cooperatives and
franchise operations, has enabled Independently owned food stores to maintain
a substantial portion of the market.

To the extent that the experience of

retailing 1s relevant to banking, 1t suggests that geographic deregulation may
be compatible with the continued existence of a large number of banks of
varying size.

This conclusion 1s buttressed by the resurgence In the

chartering of unit banks 1n California, Oregon, and other western states after
years of domination by a few giant banks with statewide branching systems.

IV.

Deregulation and the Safety of the System

Deregulating a previously regulated Industry Involves changing— at times,
quite abruptly- the rules of the game under which management, owners, and
labor have been playing.

Moreover, as 1s evident from the recent experiences

of the airline, securities brokerage (after the demise of fixed commissions),
trucking, and telephone industries, these changes may also be disruptive for
consumers.

Not only do prices change more frequently, but the number of

different prices for apparently similar services Increases greatly--although,
on average, they tend to be lower than before deregulation.
One of the ongoing problems 1n aligning costs and prices 1n the breakup of
American Telephone and Telegraph may have an Interesting counterpart In the
deregulation of banking.

As 1s well-known, AT&T subsidized local telephone

service by overpricing long distance service.

As competition 1n the latter

service forced reductions 1n price, the attempt to Increase prices on local
service and eliminate the long-standing subsidy was met with political
opposition.

Minimum local telephone service at a low price was viewed as a

necessity 1n the public Interest, a so-called "lifeline" service.

The

Inability to Increase prices on local service as much as necessary to align
with costs could reduce AT&T's ability to reduce prices on long lines
sufficiently to meet competition and protect Its market share against firms
not burdened with underpriced local service.
Similarly, studies have suggested that the prohibition against cash
Interest payments on demand deposits has subsidized smaller depositors.

Interest rates on transactions accounts are deregulated, Including the removal
of the prohibition of explicit Interest on demand deposits, 1t appears
reasonable to expect that the sharpest Increases will be on charges to small
depositors.

This may well bring forth an outcry that minimum checking

accounts at low prices are a public necessity and lead to restrictions on
service charges that may Impair the ability of banks to Increase Interest
rates on larger accounts to meet the competition from nonbank firms not
burdened with smaller accounts.
Another likely consequence of the Increased competition resulting from
deregulation 1s that certain services and even complete firms may disappear.
Indeed, exit of Individual firms through either merger or closure appears to
be a characteristic of deregulation 1n many Industries.

Such exit need not,

however, Imply a reduction 1n the overall number of firms 1n the Industry, as
the entry of new firms— which 1s frequently the cause of the exit— could
offset or even more than offset the number of leaving firms.

This has been

true 1n the airlines Industry, which has more airlines today than before

deregulation.

It may also be true in the securities brokerage industry, which

underwent price deregulation earlier.

In 1975, fixed minimum commissions on

security transactions conducted on the New York Stock Exchange~-the security
industry's Regulation Q--were removed.

The number of firms that were both

members of the New York Stock Exchange and were conducting business with the
public, the firms most directly affected by this change, declined in that year
and also in the next two.

It is difficult to tell whether the reduction was

attributable solely to the ending of fixed commissions and the subsequent
reductions in commissions, because the number of firms had also declined
sharply in 1973, the first year the New York Stock Exchange reported this
breakdown.

Since 1977, the number of firms has increased, but remains below

the 1975 number.

The number of security firms registered with the National

Association of Security Dealers (NASD), which includes almost every investment
banking firm, also declined from 1974 through 1977 but has increased since
then to well above its previous peak.

Thus, although deregulation may have

resulted in a decline in the number of brokerage firms, most or possibly even
all of the decline was only temporary.
This may not prove to be the case in banking.

Although entry was

restricted under regulation, prohibitions against branch offices and
geographical restrictions on branch offices in states where they were
permitted resulted in the coexistence of more banking firms than are likely to
exist in equilibrium in the absence of such restrictions.

Thus, unlike in

many other deregulated industries, geographic deregulation should lead to a
sharp reduction in the number of banks and even more so in the total number of
financial institutions, if accompanied by further deregulation of product
lines.

But even if the number of firms in an industry declines following

deregulation, the resulting churning of firms increases the competitive
intensity of the industry, which is a major objective of deregulation.

Market

shares are reallocated both among existing firms and among old and new firms.
In addition, if deregulation is successful in achieving increased efficiency,
the size of the market may be enlarged.
i

Deregulation of commercial*banking has*the same objective as the

deregulation of nther Industrles-^namely,1to increase efficiency and reduce
the cost of services to consumers--and may be expected. ceteris paribus, to
result in increased entry of new banks and other institutions offering
bank-like s e r v i c e s B u t entry increases the likelihood of exit by existing
banks that suffer losses from increased competition:

A key question is

whether* tinder what circumstances, and in what form bank regulators and publ'ic
policy should permit exit to otcUri

The Key Role of Exit

;

Exitplays a key role in any competitive industry:

It is the ultimate

stick that complements the carrot of profits*in disciplining firms to serve *
the public interest.

However, it is effective in fulfilling this purpose only

to the degree that it provides *the*proper incentives to*the owners* of the
exiting firms;

To do this; it must piinish^Stockholders for the managerial

errors, inefficiencies, or excessive risk-taking that Were ultimately
responsible for the exit;

Or, in cases where the exit Was due to a^shfft in

demand or sometother exogenous*development that resulted in excess capacity■■•■■■•in
the industry; *1t must signal to others that the industry-ls not a prime
prospect for new entry and that resources could be put to better use ;
elsewhere;* What must be avoided,-If exit^1s to serve its disciplinary

function, 1s for existing ownership and management to be "balled out" by some
form of government subs1dy--d1scount window borrowing at below-market rates
and/or federally assisted mergers— that allows them to escape the consequences
of failure.

Barriers to Exit
In banking, unfortunately, the nature of regulation has often worked to

prevent exit from performing Its Intended function.

Regulation of banking has

differed 1n a fundamental way from that of most other regulated Industries, 1n
that the well-being of the overall banking system was believed to be dependent
on the financial health of every Individual bank.

Consequently, bank

regulation has been directed primarily toward preventing or containing bank
failures.

However, the adoption of federal deposit insurance 1n 1933 greatly

reduced the likelihood of contagious bank failures.

As a result, 1t can be

argued that some positive rate of bank failure 1s not only acceptable, but
optimal (Tusslng, 1967; Rosenblum, 1976).
Although the Introduction of FDIC Insurance broke the linkage from the
failure of an Individual Institution to the endangerment of the system as a
whole, bank regulators often appear to act as 1f this linkage still existed.
Only rarely has the FDIC forced an Insolvent bank to liquidate and then
generally only 1f the bank was small and located 1n a unit banking state so
that merger with a nearby solvent bank was difficult.

Most Insolvent banks

are merged with solvent banks (purchases and assumptions).

Through this

device, all depositors, Including uninsured depositors, and general creditors

are generally made whole.

Likewise, the Federal Reserve has periodically

provided exceptional assistance to large banks to maintain them solvent either
as separate entitles or as merger partners.

The Fed has publicly stated Its

fears that Insolvency of large banks would endanger the system as a whole.

the aftermath of the Penn Square failure, 1t assisted 1n constructing a safety
net of large banks under the Seattle-First until Its acquisition by
BankAmerlca Corp. and provided liberal assistance to the Continental Illinois
National Bank while a permanent rescue plan was being worked out.
Such procedures are Inconsistent with the therapeutic and disciplinary
roles of exit.

If the regulators remain reluctant to see exit by closure,

then 1t 1s likely that they will act to offset some of the Implications of
deregulation of prices, products, and geographic location that has been or 1s
being enacted by the Congress by constructing a safety net under, at least,
3
larger Individual banks.
One of the reasons for regulators' reluctance to move quickly to
deregulate banking derives from a basic flaw 1n the current system of federal
deposit Insurance.

Because present Insurance premiums are scaled

2S1m1larly, the FSLIC has recently stated that an advantage of
financially assisted mergers 1s that "The assisted merger not only protects
insured depositors, but uninsured depositors and general creditors as well."
See Edward 3. McGuIrk (1983).
3At least one former regulator, however, believes that bank failure 1s
Important for deregulation and efficiency. Thomas Vartanian, a former general
counsel of the Federal Home Loan Bank Board, argued:
"Without failure there 1s not going to be any ability to
succeed. Otherwise, we will be regulated back to the
mediocrity that has been the hallmark of financial
Institutions and that business over the last fifty years."
(Fitzgerald, 1983)

proportionately to the bank's total domestic deposits, deposit Insurance
encourages banks to move out on their risk preference functions by permitting
them to acquire Insured deposits at the risk-free rate--regardless of the risk
assumed by the bank.

There are several ways that the salutary effects of

market discipline can be reintroduced.

One of these 1s to scale the Insurance

premiums to risk 1n the same manner as the market would' have done 1n the
absence of federal Insurance, thereby discouraging excessive risk-taking
(Blerwag and Kaufman, 1983).

Absent risk-related deposit Insurance premiums

or capital requirements, the Insuring agency must rely on other means to
control its risk exposure.

It does so by examining and regulating banks.

the extent that these activities are Inconsistent with the objectives of
deregulation, complete deregulation requires the Introduction of
risk-sensitive Insurance premiums.
Achievement of the socially beneficial effects of exit 1s not Inconsistent
with the sale of a failed bank's assets to other existing banks, so long as
the previous stockholders bear the consequences of failure and the purchasers
are not direct competitors.

To some degree the FD1C has managed to achieve

the benefits of exit 1n Its management of purchases and assumptions.

However,

the benefits have been limited by the extremely restricted group of
Institutions allowed to bid for the failed bank's assets.

Existing geographic

and product line restrictions have often limited bidding to similar
Institutions competing 1n the same market.

For example, the Bank Holding

Company Act prohibits the sale of a bank to a steel company or retail grocery
cha1n--1.e., pure conglomerate acquisitions are forbidden.

Many product and

market extension affiliations are barred by the Glass-Steagal1 Act and other
laws such as those barring Insurance companies from owning full-service

banks.

These restrictions have been eased to some degree by the emergency

merger provisions of the Garn-St Germain Act.

But their complete elimination

to allow a more open bidding procedure would do much to dissipate any possible
anticompetitive effects of such forced mergers with existing Institutions, as
well as assuring that the assets were obtained by the owners willing to pay
the most for them and, presumably, best able to manage them.
Although a merger with a financial Institution not currently competing 1n
the same market 1s probably the Ideal solution for many falling banks, this 1s
not to say that such firms should never be bought out by direct competitors or
that liquidation 1s Inherently preferable to that alternative.

If Brozen

(1982a) 1s correct that limitations on exit alternatives reduce entry, then
the banking business has probably been less competitive than 1t would have
been with more liberal exit alternatives.

Furthermore, continued exit

restrictions will probably reduce competitive Intensity 1n the future by
further limiting entry.

Alternative Forms of Entry and Exit
Failure and merger are not the only forms that exit can take.

form 1s voluntary liquidation.

Another

A business firm that 1s earning a positive but

Inadequate return can choose to voluntarily liquidate 1f 1t cannot find
another firm to acquire 1t.
off.

Liquidators are called 1n and assets auctioned

However, as 1n the case of mergers arranged by regulators, the number of

potential bidders 1s limited by existing restrictions on conglomerate and
product and market extension mergers.
In order to aid Institutions searching for a legally acceptable buyer, the
state of Indiana has recently passed a law which allows a bank, savings bank,

or bank holding company to petition the state banking commissioner to arrange
a merger and sets standards by which certain normal geographic and other
4
restrictions (such as county-wide branching) might be waived.
This allows
a greater range of potential purchasers to bid on the bank than would
otherwise be the case.

These procedures can be used when the cap1tal-to-asset

ratio falls below 3 percent, 1.e., when returns are low but capital 1s still
positive.

If other states follow Indiana's example, then many "voluntary"

liquidations may be avoided.
Finally, entry and exit can occur on a more limited scale that does not
entail the disappearance of an entire firm.

A bank can abandon one of its

many product lines that 1s not profitable, or a new firm or branch of an
existing firm can enter a market by offering a single product or narrow range
of related products such as consumer loans.

A hallmark of deregulated

Industries 1s the entrance of new tiers of specialized firms that offer narrow
ranges of products:

one tier that provides low cost, no frills service such

as People Express 1n the airline business and a second tier that specializes
1n high value added services tailored to the Individual needs of particular
customers or segments of customers (Bleeke and Goodrich, 1981).
There is a critical need to pay full attention to the wide range of forms
that entry and exit may exhibit; otherwise Inappropriate public policy
decisions will follow.

The Inherent product and geographic market overlaps

between financial Institutions of different types and between financial and
nonflnanclal firms cannot be Ignored.

As shown 1n Section II.B., the markets

of bank and nonbank firms already overlap considerably and some members of

^Senate Enrolled Act No. 232, Indiana Code. IC 28-1-7.2.

each group have begun to explore new ways to offer some part of the other
group's products.

For example, Dreyfus has acquired a "consumer" bank to

expand the range of services it can offer to its existing customer base of
mutual fund shareholders; Sears is capitalizing on the traffic volume in its
retail stores to offer a group of financial services; a Kansas-based company,
Dimension, has been formed with the intent of opening over 30 consumer banks
in about a dozen states; and loan production offices and itinerant lending
officers provide well-known examples of how new entry has occurred in business
lending.
These new production and delivery systems may usefully be described as
"mutants."

A mutant, unlike a hybrid, connotes a strong element of randomness

or unpredictability of outcome.

Making forecasts regarding future mutations

is more difficult than making forecasts about hybrids, which are usually
designed, as opposed to occurring by chance.

An example of a mutant is

provided by the linkage of Paine Webber, a large brokerage firm, with a
nationwide network of bank-owned automated teller machines run by MasterCard
International that will allow Paine Webber's customers to draw cash from their
cash management accounts.

Although these forms of entry need not always

involve a change in the number of banks (or S&Ls and other depository
institutions), the competitive environment following such entry is changed
nonetheless.
Not all mutants survive.

Many of the new organizational forms of

financial service providers will not do well but a few may displace some of
the existing organizational types.

For some period, both the mutants and the

full-service, old-line commercial banks will exist side-by-side, just as

horse-drawn carriages and automobiles shared the same city streets and country
roads for over 30 years.
Some of the mutants that do not survive may be sufficiently strong for a
short period of time to cause the demise of many old-Hne, full-service banks,
only to be themselves eliminated by a new mutant.

As an example, suppose that

a new delivery system for certain banking services- say, the supermarket-owned
cash dispensing (or more sophisticated electronic teller) machine -offers
greater convenience and thus gains widespread acceptance.

These machines

could lead to the demise of many banking firms as customers find that they can
use distant banks both for many of their day-to-day transactions and for
less-often-used banking services, such as major loans.

But this new delivery

system may Itself be displaced by a more efficient network--say, between a
communication company and a bank--wh1ch will allow a customer the convenience
of performing the same set or a large subset of these transactions at home.
Note that the supermarket-turned-distributor of banking services need not
go out of business in such an event.

When transaction volume and fees fall

off sufficiently that the floorspace devoted to teller machines could earn a
higher return from providing milk or canned goods, then banking services will
be eliminated but the supermarket remains 1n business.

And again, the simple

availability of a better delivery system, say 1n the home, will not
Immediately eliminate the supermarket delivery system.

Today's "computer

hacker" 1s comfortable doing business with an ATM; but he or she may be
uncomfortable doing business with the third or fourth generation of ATM
devices.

But the children of today's young adults may feel perfectly at home

with the new financial service delivery systems of that future era.

Human

generations do not correspond one-for-one with machine generations and this

factor should have a bearing on the financial structure of the future.

turn, entry and exit patterns will be Influenced by this evolutionary
process.

Unfortunately, each set of demographics (human and machine) contains

elements that cannot be forecast with a reasonably acceptable degree of
precision.

Remaining Policy Issues

Local Market Concentration and Competition
Deregulation of pricing, branching, and entry will do much to move

commercial banking toward the status of other, essentially unregulated
Industries.

This prospect raises a number of public policy concerns.

One of

the most persistent of these concerns 1s that regarding the appropriate merger
and acquisition policy, 1f any, to apply to the financial services Industry.
This 1s a subset of the broader question whether there 1s a need for an
antitrust policy governing mergers, acquisitions, and pricing agreements
generally.

The traditional view has been that there 1s a need for such a

policy, given the potential for overt or tacit collusion 1n highly
concentrated markets.

This need has been considered greatest 1n the presence

of Imperfect and asymmetrically distributed Information, natural barriers to
entry (Including discontinuities due to large minimum optimal scale relative
to the size of the market), and asymmetries between the costs of merging two
existing firms and establishing a new one to enter the market.
However, recent empirical research and developments 1n the theory of
industrial organization have raised serious questions about the viability of
the traditional view.

The evidence suggests that many Instances of high

concentration are the result of superior performance rather than a source of
anticompetitive effects.

Renewed Interest 1n the role of entry conditions has

led to the development of the theory of "contestable" markets, 1n which the
existing number and size distribution of firms play a much less prominent role
1n determining performance (Baumol, Panzar, and W1ll1g, 1982).

Finally, 1t

has been argued that the broadening of markets that 1s accompanying
deregulation and technological change should reduce concern about the effects
of mergers and acquisitions even when traditional antitrust criteria are used
1n evaluating their competitive effects.

The validity of these new results

and theories should be scrutinized closely before deregulation proceeds much
further because their acceptance and embodiment 1n policy are likely to have
extremely 1mportant--and, perhaps, Irreversible--effects on the financial
structure of the future.

Conflicts of Interest
The conflicts of Interest that attend the combination of lending,

underwriting, and Investment management activities are a perennial concern of
students of banking.

Although anecdotal evidence exists that such conflicts

are real, their aggregate importance can only be guessed at.

Hence, there 1s

little basis for assigning a value to the potential costs that must be weighed
against any benefits to be derived from combining these act1v1t1es--benef1ts
which are themselves largely conjectural.
The continued operation by banks of trust departments has long been an
anomaly 1n an Industry governed by the Glass-Steagall Act, since the conflicts
of Interest Inherent 1n that arrangement appear to be every bit as serious as
those between lending and underwriting.

On the other hand, careful

examination of experience with supervision of trust operations may shed some
useful light on whether supervision and regulation are sufficient to prevent
the abuse of such conflicts of Interest or whether enforced separation 1s the
only effective solution.

Aggregate Concentration
Whatever the evidence Indicates regarding the effects of consolidation and

diversification on competition, efficiency, and the management of conflicts of
Interest, many observers of Industrial structure will continue to have serious
misgivings about the desirability of a heavily concentrated banking system
modeled after that of Canada, England, or Germany.

Fear and dislike of size

for Its own sake have a long history 1n the United States and are not easily
assuaged by (often exaggerated) claims for the Importance of economies of
scale and scope.

The seriousness of the danger that a few mammoth firms might

dictate government policy or corrupt the political process overrides 1n many
people's minds the reassurances of others that no evidence of such Influence
1s to be found.

The public will be called upon to decide whether, despite

potential losses 1n competition and efficiency, 1t would prefer to retain
constraints on Individual Institutions' geographic expansion and product lines
that guarantee the survival of a large number of small firms.

It does little

good to dismiss such attitudes as Reflecting uninformed populism; what 1s
needed 1s more convincing evidence that what would be given up 1s worth more
than what would be preserved.

Separation of Banking and Commerce
The fear of market power abetted by the government through Its chartering

powers, reinforced by concerns regarding potential conflicts of Interest and
their Implications for the fair and efficient allocation of credit, underlies
the long Anglo-Saxon tradition of separation of banking and commerce (Shull,
1983).

Whatever the wisdom of such a policy, Its continuance presupposes a

fairly clear demarcation between those activities that constitute banking and
those that do not.

However, the technological changes of the past few

decades, combined with the resurgence of firms like Sears and General Motors
Into some bank-like services, necessitate a reexamination of the perennial
Issue of how to define a bank (D1 Clemente, 1983).

One could, as the 64th

American Assembly (1983) did 1n Its recommendations for reform of the
financial services Industry, demarcate the line more or less arbitrarily as
falling between those firms that offer governmentally Insured deposits and
those that don't.

As stated 1n the American Assembly's first recommendation:

Institutions that accept governmentally Insured
deposits should not be able to provide directly, or
though affiliates, services other than financial
services and services closely related thereto.
Among other things, this would prevent firms from
using low-cost effectively government I.O.U.s for
financing their activities 1n competition with firms
lacking access to such low-cost funds and without
paying an Interest rate commensurate with the
riskiness of the activity.
Conversely, Institutions that provide nonflnanclally
related services or products, directly or through
affiliates, should riot be able to own or control
Institutions that accept governmentally Insured
deposits.
Unfortunately, this approach leaves undefined what 1s meant by "financial
services and services closely related thereto."

Moreover, efforts to 11st the

services that banks may appropriately engage 1n run the risk of being rendered
obsolete by technological or competitive developments.

What 1s needed 1s a

more general statement of the broad principles underlying the separation of
banking and commerce that can be applied to the situation as 1t exists at any
particular time.

Ideally, these principles would be derived from a rigorous

analysis of the social costs and benefits associated with various possible
combinations of activities.

IV. Conclusions

In light of the very dramatic changes 1n the economic, financial, and
technical environments since the time most banking regulations were initially
Imposed and the belief (at least up to the time of the Continental Bank
troubles) that the Industry-wide solvency problem has been solved,
deregulation has been advocated as a means to permit the financial system to
operate more efficiently.
for commercial banks?

What will be the net consequences of deregulation

As we have discussed 1n this paper, they are

far-reaching and highly complex.

The evidence strongly suggests that

deregulation of product line restrictions will result 1n considerable
diversification by commercial banks Into services previously prohibited to
them, as well as further expansion by nonbanking-based firms Into additional
financial services.

However, the evidence on the performance of financial and

nonfinanclal conglomerates, the experience of nonbank subsidiaries of bank
holding companies, and the varying degrees of specialization by financial
Institutions 1n countries with few product restrictions on banks suggest that
there will continue to be a highly diverse set of financial Institutions 1n
terms of both size and degree of product diversification after deregulation.

The evidence from studies of plant and firm economies of scale and scope,
the experience of states I1beral1z1ang their branching and holding company
laws, and foreign experience all suggest that geographic deregulation will
result 1n some degree of consolidation of the banking Industry.

These changes

may be smaller than 1s often predicted, because much deregulation has already
been accomplished, de facto. 1f not de lure. While further deregulation may
cause near-term problems for consumers, inefficient bank managements, and
policymakers, 1n the long run 1t will benefit well-managed banks and, 1n
particular, their customers.

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