Full text of Working Papers (Federal Reserve Bank of Chicago) : Implications of Deregulation for Product Lines and Geographical Markets of Financial Institutions, SM-82-2

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

IMPLICATIONS OF DEREGULATION FOR PRODUCT LINES
AND GEOGRAPHICAL MARKETS OF FINANCIAL INSTITUTIONS




George Kaufman, Larry Mote,
and Harvey Rosenblum

Revised April 5, 1982

Implications of Deregulation for Product Lines
and Geographical Markets of
Financial Institutions

By

George Kaufman,* Larry Mote,** and Harvey Rosenblum**

For presentation at
the 18th Conference on Bank Structure and Competition
Federal Reserve Bank of Chicago
Chicago, Illinois
April 13, 1982

*Loyola University and Federal Reserve Bank of Chicago.
**Federal Reserve Bank of Chicago.




Implications of Deregulation for Product
Lines and Geographical Markets of
Financial Institutions

George Kaufman, Larry Mote, and Harvey Rosenblum*

In his popular 1970 book, Future Shock, Alvin Toffler argued that, while
change had occurred to some degree throughout human history, the mid-20th
century was experiencing an acceleration of change such that adaptation was
proving increasingly difficult, not only for individuals, but also for govern­
ments and other social institutions.

There are few areas of life where this

phenomenon of accelerating change has been more evident than in the markets
for financial services.

While the changes in banking in the 1920s— the rapid

expansion of branch banking; the development of the federal funds market; the
gradual shift of banks into consumer credit, term business lending, and
mortgage lending; and the dramatically enlarged scope of bank securities
underwriting activities— appeared drastic at the time, they pale into
insignificance in comparison with the changes in the past two decades.

A

brief chronological listing of the more important changes includes at least
the following items:

*George Kaufman is Professor of Economics and Finance, Loyola University
of Chicago and consultant to the Federal Reserve Bank of Chicago. Larry Mote
and Harvey Rosenblum each hold the position of Vice President and Economic
Adviser, Federal Reserve Bank of Chicago. The views expressed here are those
of the authors and do not necessarily represent the views of the Federal
Reserve Bank of Chicago or the Federal Reserve System.







2

Large negotiable CDs— 1961
Bank credit cards— 1965
Nationwide bank loan production offices— late 1960s
Entry by bank-originated one-bank holding companies into
nonbanking financial activities and the establishment
of offices across state lines— late 1960s
Expansion by foreign banks in the United States— 1969
NOW accounts offered by Massachusetts mutual savings banks— 1972
Failures of large banks— 1973-74
Money market mutual funds— 1973
Credit union share draft accounts— 1974
National banks' operation of CBCTs— 1974
Telephone transfers to checking accounts— 1975
Interest rate futures trading— 1975
Merrill Lynch Cash Management Account— 1977
Money market certificates at depository institutions— 1978
Adoption by Fed of new reserve-oriented operating procedure— 1979
Depository Institutions Deregulation and Monetary Control Act,
authorizing nationwide NOW accounts, uniform reserve require­
ments, phase-out of Reg Q, new thrift institution powers— 1980
Variable-rate mortgages authorized for national banks— 1981
American Express acquisition of Shearson— 1981
Sears, Roebuck acquisition of Dean Witter— 1981
Interstate mergers of savings and loan associations— 1981
Widespread failures and government-assisted mergers of thrift
institutions— 1982

3

The list is only illustrative; a complete list would have dozens of
entries.

But it does at least suggest how sweeping the recent changes in

financial markets have been.

The House Banking Committee was so impressed by

the scope and magnitude of these changes that it dubbed its recent hearings on
financial reform, Financial Institutions in a Revolutionary Era (FIRE).
Whether these changes really warrant the designation "revolution" is, of
course, open to some skepticism.

Revolutions in the financial sector have

been proclaimed almost weekly for more than a decade.

The most obvious

example is the "whole new ballgame" based on EFT that was first predicted more
than a decade ago.

Despite bold forecasts of an imminent cashless and

checkless society, relatively few payments are made electronically even today;
check volume and currency growth have almost kept pace with the growth in
economic activity.

Nevertheless, the revolution may finally be arriving.

One

reason is that the Federal Reserve is no longer subsidizing the check-based
payments system. Thus, the cost advantages of an electronic system are likely
to become progressively more pronounced with the passage of time.

Another

reason is that cable television and the growing popularity of home computers
are preparing the way for consumer acceptance of in-home electronic banking
using existing television sets and the telephone system.

Once the economics

of these systems catches up with their technology, they could produce a
massive transformation of the financial services industry in a very short
period of time.
If we really are witnessing a revolution, it is still in its early
stages.

The lesson we learn from the history of American business enterprise

is that, in any industry that has undergone a revolution, few of the original
firms remain when it is over.^

Those that survive are typically larger than

they were before the revolution and the number of industry competitors is




4

reduced.

This has been true in manufacturing and transportation as well as in

retail trade.

In some cases, the consolidation has gone well beyond what was

dictated by scale economies, and competition has been unnecessarily impaired.
The fact that the players in the financial system ballgame have not changed
appreciably suggests that it is still not too late to intervene by setting
appropriate ground rules for the future.

It is the purpose of this paper to

analyze the causes of the recent and prospective changes in financial markets,
to speculate on their effects on the product lines and geographic markets of
financial firms over the next decade or so, and to explore their implications
for public policy.
Sources of Change
There have been two primary driving forces behind the recent innovations:
1.

unexpected and abrupt increases in the level and volatility of

interest rates and
2.

major technological improvements in the transmission, processing, and

storage of information.
The impact of these two forces was much more dramatic and severe than it
otherwise might have been because of a third factor— the existence of a
pervasive system of regulations that has limited and distorted the responses
of existing financial institutions and contributed to the emergence of new
ones.

Before analyzing in detail the interaction of these three factors, it

may be useful to describe their major features.
Interest rates.

From the end of World War II to the early 1970s,

interest rates in the United States trended upward but were relatively stable
over short periods.

For example, the 4-6 month prime commercial paper rate,

which stood at .75 percent in 1945, rose to 1.5 percent in 1950, 3.8 percent
in 1960, and 7.7 percent in 1970.



The stability during the years prior to the

5

early 1950s reflected the Fed’s wartime policy of pegging the prices of
Treasury securities.

After the 1951 Accord, movements in rates were moderated

during the remainder of the 1950s by the Fed’s pursuit of a free reserves
strategy and during the 1960s by the Fed’s emphasis on money market
conditions.

With the exception of some relatively rapid, but temporary jumps

during the Korean War and again during the credit crunches of 1966 and 1969,
the increase was gradual.

However, fueled by the inflation resulting from

several years of accelerating monetary growth and from the supply side shocks
produced by the OPEC embargo of late 1973 and the subsequent oil price
increases, interest rates rose to new heights in 1973 and 1974.

They also

embarked on a period of instability not previously experienced in this
century.

The commercial paper rate, which had fallen to 4.7 percent in 1972,

rose to 9.9 percent in 1974, fell back to 5.4 percent in 1976, then climbed to
16.5 percent by the end of 1980 and over 17 percent in 1981.

Although the

recent behavior of interest rates more closely resembles historical experience
prior to the 1930s than did the period of remarkably stable prices and
interest rates between 1930 and 1970,

2

the abruptness of the change after 1972

clearly had some wrenching effects on financial markets and institutions grown
unaccustomed to such volatility.

More recently, the Fedfs adoption of a

reserves-oriented operating procedure has made the short-run volatility of
interest rates even greater.
Technology.

Recent technological improvements in transmitting,

processing, and storing information originated outside the financial industry
and reflect primarily the rapid improvements in the electronic computer.

It

is these developments, more than anything else in the current picture, that
deserve the adjective revolutionary.

The magnitude of the advances in this

area is dramatically illustrated by what has happened to the costs of




6

information processing and transmission.

It is estimated that hardware with

the same capabilities as computers costing a million dollars in the 1950s cost
less than $20 in 1980.

Between the mid 1960s and 1980, the monthly rental

cost of computer memory space declined by a factor of over 50 and the cost of
processing by a factor of over 10.

Over this entire period, computing costs

have declined at an average annual rate of 25 percent, communications costs at
a rate of 11 percent, and memory costs at a rate of 40 percent.
These advances make it possible to transfer funds quickly and cheaply
between accounts and institutions and to maintain appropriate up-to-the
minute, on-line records.

Transfer instructions can be given on-line, pre­

authorized, or keyed by a nplastic card.”

This greatly increases the liquid­

ity of all accounts— -and, ultimately, all assets.

Because fund transfers

among accounts may be keyed by any computer in the network, there is no longer
a need for the transfer agent to be a financial institution.

It is feasible

for a nonfinancial firm operating within a computer network to issue plastic
cards to customers who authorize the firm to withdraw funds from designated
accounts at financial institutions or sell designated assets— e.g., money
market shares, bonds, stocks, and even real estate— and transfer the proceeds
to other accounts specified upon the completion of a transaction.

The cus­

tomer could indicate at the time of the transaction the date of the transfer
and whether it is to be financed by drawing on an automatic predetermined lin
of credit, by transfering funds from a fixed par value account, or by selling
a variable value asset.

For variable value assets, the customer may need to

receive a periodic statement from the firm, say, monthly or weekly, on the
market value of the asset account and the maximum transfer amount for the
period.

Some of this scenario is already a reality through the use of charge

and debit cards tied to the sale of money market funds.




An even more recent

7

development is Merrill Lynch’s plan to offer credit cards with borrowing
limits tied to customers1 equity in their homes.
assumed to be not too far off.

The rest may reasonably be

The technology is in place; all that remains

necessary is the operational formalities.
The forces of interest rate volatility and information-processing
technology undoubtedly would have produced marked changes in the behavior and
structure of financial institutions even in the absence of antiquated
regulation.

Be that as it may, it has been the continuing tension between

these largely exogenous financial market forces and a set of banking laws and
regulations adopted for reasons possessing varying degrees of validity in the
past, but increasingly inappropriate and ineffectual today, that has produced
the

phenomenal pace of financial change over the past several decades.

These

regulations include restrictions on the assets banks may acquire, capital
requirements, restrictions on interest rates banks may pay on deposits,
restrictions on bank securities activities, restrictions on the activities
bank holding companies may engage in, and the restrictions on the geographic
scope of banks’ operations contained in the 1927 McFadden Act, as amended, and
the Douglas Amendment to the Bank Holding Company Act of 1956.
Regulation of Financial Institutions
In assessing the past role and current relevance of regulation, careful
distinctions must be made between existing regulations based on their origins,
purpose, effectiveness, and desirability, and the effects of eliminating each
major category of regulations must be evaluated within a coherent analytical
framework.

Among the many specific statutes, regulations, and rules that

constitute the regulatory framework within which banks and other financial
institutions operate today, some were adopted for better reasons, or have more




8

rational purposes, or are more effective in achieving those purposes than
others.
Generally speaking, regulation is justified only when there is some
demonstrable failure of the free market to achieve results broadly desired by
the population.
obvious.

There are two primary cases in which such failures are fairly

One is the case of natural monopoly.

When one firm of minimum

efficient size can supply the entire market, there is reason to be concerned
about monopolistic price and output policies, albeit the threat of entry may
constrain the incumbent firm’s ability to exploit its position.

Thus, the

fact that gas pipelines, electric transmission lines, and railroad rights of
way are natural monopolies has been used as justification for their regulation
by public bodies— regulation that often extends beyond the natural monopoly
itself to other activities such as gas production, the operation of railroad
rolling stock, etc., that are not inherently monopolistic. Another case of
market failure occurs when the production of a good or service generates costs
that are borne by parties other than the producers or consumers of that good
or service.

Examples of such external costs are air and water pollution,

noise, nuclear radiation, etc.
Natural monopoly does not appear to be a problem in banking.

Economies

of scale are not such as to limit the number of efficient competitors in the
national market to a very small number.

On the other hand, there is reason

for concern about the state of competition in some highly concentrated local
market areas.
limiting entry.

In part, to be sure, the problem exists because of regulations
Nonetheless, given the insulation from outside competition

conferred on these markets by their distance from other towns and the
discontinuities in entry resulting from the small size of such markets
relative to the minimum efficient size of bank, there might be a case for




9

public intervention to maintain competition even in an otherwise fully
deregulated environment.

Such intervention might possibly be limited to

enforcement of existing antitrust laws.
The most important external cost associated with banking is probably the
incentive depositors had, prior to the introduction of deposit insurance, to
try to withdraw their deposits from a troubled bank before it failed.

In the

aggregate this was self-defeating because it accelerated the closing of some
banks and was actually responsible for the closing of other banks that might
otherwise have survived.

Still, it was rational behavior for the individual

depositor, because his decision to abstain from withdrawing his funds could
not provide any assurance that the bank would remain open.

This negative

externality— without which bank runs would not be a serious problem— was
largely eliminated by the adoption of federal deposit insurance in 1933.
Unfortunately, under the current structure of insurance premiums, deposit
insurance gives rise to a need for supervision to prevent banks from taking
advantage of the incentives it offers for risk-taking.
A recent paper prepared by Carter Golembe for the Treasury Department

3

includes the prevention or cure of these two types of market failure among the
primary objectives of public policy toward the financial system.

Thus,

Golembe lists "a sound, stable system" and "avoidance of concentration of
financial power" as two of the four basic objectives.

The other two, "fair

treatment of customers" and "proper allocation of credit," are less well
defined and offer less of a theoretical economic justification for the
existence of regulation.

Even to the extent that there is agreement that they

are worthy ends, it is not clear that they are better served by regulation
than by unrestrained competition.

Nevertheless, both are firmly embedded in

the series of consumer protection laws adopted since 1968, beginning with the




10

Truth In Lending Act, and in the regulatory and tax provisions that encourage
savings and loan associations to specialize in residential mortgage lending.
To have a legitimate claim to continued existence, a regulation must have
a well-defined purpose measured in terms of its contribution to the
achievement of the free market result or to some other result that enjoys
widespread popular support.

Second, it should be effective— not just in the

narrow legal sense that institutions do not violate its proscriptions, but in
the economic sense that it achieves its intended results.

Third, its benefits

should clearly outweigh its total costs in terms of the costs of compliance by
financial institutions, the costs of administration and enforcement by the
regulator, and any unintended side effects.

If a regulation fails to measure

up to all three of these standards— or if its benefits are so ill-defined that
they cannot even in principle be quantified— there is a strong presumption
that society would be better off without it.
Few existing bank regulations appear to meet these criteria.

However,

the differences between the major categories of regulation in this respect are
large.

To illustrate this, we will briefly consider each of the major

categories of regulations.
Entry restrictions.

In the early days of U.S. history, chartering

restrictions were quite severe, as an act of the state legislature was
necessary to grant a bank charter.

Policy toward entry into banking was

reversed in the late 1830s when most states enacted free banking laws
extending the states’ general incorporation laws to banking.
Following the banking collapse of the 1930s, the Banking Act of 1933
introduced explicit standards for national bank charters and implicitly
restricted state bank entry by the standards it established for granting
federal deposit insurance.




This legislation reflected the widely accepted,

11

but unconfirmed diagnosis that the cause of the collapse was excessive
competition, which was alleged to have led bank managements to behave in an
imprudent fashion.

The prescription adopted was to limit competition by

restricting entry into banking.
Interest rate restrictions.

The same diagnosis led to the prohibition of

certain types of competitive behavior deemed unsound.

For example, the

Banking Act of 1933 prohibited the payment of interest on demand deposits,
authorized the Federal Reserve to regulate the maximum interest rates payable
on time and savings deposits, restricted the types of investment securities
that banks might hold, and prohibited banks from underwriting and trading most
types of securities.

The underlying assumptions of the diagnosis and remedy

were that individual banks, left to their own devices and subject to
unrestricted competition, would behave in such a way as to bring disaster on
themselves, their depositors, and the economy as a whole, and that they must
therefore be sheltered both from competition and from their own poor judgment.
There are at least three basic flaws in this regulatory response of the
1930s.

The first is that it was based on a misdiagnosis.

The evidence simply

does not support the belief that imprudence on the part of individual banks
was the primary, or even a major, cause of the banking collapse.

Rather, in

hindsight, it appears to have been the result of faulty central bank
policy— in particular, the passiveness of the Federal Reserve in the face of
several major bank failures, massive withdrawals of currency, and the
resulting forced liquidation of the banking system.

Once the process of

deterioration got underway, it was exacerbated by the important negative
externality associated with fractional reserve banking discussed above,
namely, the incentive even depositors of well-managed banks have to withdraw
their deposits in the form of currency when prior bank failures have made the




12

public nervous about the safety of banks in general.

Regulation per se did

nothing to remedy this externality.
The second flaw is that regulation went beyond what was necessary to
preserve bank soundness and imposed severe costs on the public by prohibiting
basically desirable types of behavior.

For example, many customers have been

poorly served because entry restrictions kept out more efficient competitors
that could have improved services and lowered prices.

At least in the short

run, legitimate credit demands may have gone unmet because existing banks were
not willing to accept the risks involved in making some types of loans and
alternative sources of credit were few.

Regulation of the interest rates

payable on deposits has had even more obvious pernicious effects.

Particu­

larly in recent decades when inflation has led to sharp increases in market
rates, interest rate ceilings have prevented low income savers with limited
alternatives from enjoying reasonable rates of return on their savings.
The third and fatal flaw is that many regulations simply have not
achieved what they were intended to do.

They have been circumvented in a

variety of ways and have ended up having the net effect simply of raising the
private and social costs of doing the same business.
It is easy, and probably unfair, to criticize harshly actions taken in
desperation and whose mistaken premises are clear only in hindsight.
Nevertheless, it is widely acknowledged today that many of the New Deal
efforts to deal with the Depression and to prevent its reoccurrence were
misguided, and should not be repeated.

Unfortunately, while the codes

restricting competition adopted by nonfinancial industries under the auspices
of the National Recovery Administration were quickly thrown out by the Supreme
Court on constitutional grounds, the restrictions imposed on banking remain,
nearly a half century after they were first introduced.




13

Portfolio regulation.

The tightened capital and portfolio restrictions

adopted in the 1930s, though reflecting the same diagnosis that led to entry
and interest rate restrictions, had a slightly different rationale.

Their

effects in restricting competition are only incidental; their basic thrust was
to prevent banks from taking excessive risks and to cushion depositors against
whatever losses the bank might suffer.

It is often argued that they are

redundant, on the grounds that much of the danger to depositors’ funds that
they were designed to reduce was eliminated by the introduction of federal
deposit insurance.

(To be sure, some students of banking have insisted that

the role of broadened regulation in preventing bank failures has been
understated, and that of deposit insurance correspondingly exaggerated.)

4

In

any case, and somewhat ironically, one of the most persuasive justifications
for their continued existence today is that the failure to price deposit
insurance to reflect differences in risk provides a powerful incentive to
risk-taking by individual banks.

Thus, regulation is needed to prevent banks

from taking advantage of that incentive.
Curiously, some opponents of deregulation argue that portfolio regulation
is needed because the difficulty of measuring risk accurately dooms any
attempt to devise risk-related deposit insurance premiums.^

A little

reflection will convince one that this difficulty poses as much of a problem
for ongoing regulation as it does for deposit insurance premium setting.

If

we did not know enough about the relationship between portfolio
characteristics and risk to base insurance premiums on risk, we also would not
know enough to regulate bank portfolios— even though it has been done for
years.
Not only do bank examiners carry out detailed analyses of samples of a
bank’s loans and classify them according to their likelihood of repayment,




14

they also look at the quality of its investment securities, excessive
concentrations in any class of loans or securities, the adequacy of capital,
and even the quality of management.
composite rating for the bank.

All of this information is folded into a

Moreover, there are several statutory

provisions— the prohibition of bank ownership of equities, the restriction on
loans to one borrower, the tying of the volume of real estate loans to the
amount of a bank’s capital or time and savings deposits, etc.— that presuppose
that one portfolio configuration involves more risk than another.

The

agencies’ recent attempts to establish early warning systems to identify
problem banks are an even more formal effort to weigh various portfolio
characteristics in arriving at an overall measure of risk.^
While neither these measures nor the examiners’ ratings can discriminate
perfectly between sound and risky banks, both have some predictive power.
More important, both are used in making supervisory decisions to impose
additional reporting burdens on particular banks and in some cases to require
them to modify their behavior in ways that adversely affect current earnings.
The agencies’ willingness to use the ratings in this way contrasts strangely
with their aversion to charging for deposit insurance based on the same type
of judgmental criteria.
Securities activities.

The Glass-Steagall Act’s restrictions on bank

securities underwriting and trading activities had a still different origin
and rationale.

Here the intent was not to protect the banks from entry into

an activity that was considered their sole province, but rather to keep them
out of an activity to avoid what was perceived as a serious conflict of
interest situation affecting the safety of depositors’ funds.

The immediate

impetus was the revelation that a small minority of banks— albeit a
considerably larger percentage of those banks involved in securities




15

activities— had engaged in a number of egregious practices during the late
1920s and 1930s.

In spite of repeated assertions by the large-bank lobby that

the statutory separation of commercial and investment banking is anticom­
petitive, it is not a barrier to entry in the same sense that chartering
restrictions are.

The reason is that, for all potential entrants other than

banks, entry into investment banking per se was left unrestricted.

Of course,

companies engaged in investment banking were also prevented from accepting
deposits.

The only social costs imposed by such a restriction would be the

loss of any informational and transactions economies that might have been
achieved by integrating securities underwriting with banks’ deposit and
lending business.
There is continuing uncertainty regarding the seriousness of the con­
flict-of-interest problem and whether other means short of legal separation
are adequate to deal with it.

g

For example, it is often argued that the

abuses of the 1920s could be prevented simply by applying today’s securities
laws to banks.

In any case, the desirability of the Glass-Steagall restric­

tions remains a strongly debated issue and liberalization is likely to be near
the top of the banking industry’s list of priorities over the next several
years.
Branching restrictions.

Though having profound effects on the nation’s

banking structure, the restrictions on branching by national banks had their
origin in what was virtually an oversight.

Although the National Bank Act did

not even mention branch banking, a provision in it aimed at wildcat banking
was interpreted for the next 60 years as prohibiting national banks from
branching. To be sure, even where branching was permitted it did not really
take off until the 1940s.

Nevertheless, the experience of the Bank of America

in California, as well as the development of multi-state bank holding




16

companies in the West and the Upper Midwest, suggests that some banks would
have taken advantage of broader branching privileges. The unequal treatment of
national banks vis-a-vis state banks with respect to branching was largely
eliminated by the McFadden Act of 1927 and totally eliminated by the Banking
Act of 1933.

However, the growth of the power and political influence of the

independent bankers movement after 1900 had prompted many states to adopt
severely restrictive branching laws by 1930.
It is extremely difficult to find any convincing justification for
branching restrictions in their present form.

Among the reasonable-sounding

arguments that have been advanced for limiting branching are a fear of the
political and economic power of very large banks and concern over
concentration in banking markets.
designed to remedy either problem.

Yet, existing restrictions appear poorly
They restrict the overall size of banking

organizations, if at all, only by confining them geographically to a single
state.

In some lines of business, particularly lending to large corporate

customers, they have little effect.

This explains why, for example,

Continental Bank and First National Bank of Chicago have been able to maintain
their top-ten rankings among U.S. banks despite Illinois1 prohibition of
branching.

The restrictions actually are conducive to local market

concentration insofar as they require a bank's expansion to occur within a
limited area and prevent outside banks from establishing a physical presence
in that area.

To the extent that they limit the geographic scope of a bank’s

lending operations, they force the bank to forego the benefits of reduced risk
through geographic diversification.

By and large, existing branch

restrictions are protectionist, designed to shelter inefficient banks from the
rigors of competition.




17

Prior approval of mergers and acquisitions.

A few regulations are

actually designed to preserve competition in banking.

Included here are the

statutes that require prior approval by one or another federal agency before
banks may merge or bank holding companies may acquire additional banks or
nonbanking firms.

Although elements of protectionism— particularly, the

preservation of small banks— have occasionally crept into decisions, the major
effect of these acts has been to put a heavy burden of proof on the applicant
to demonstrate that any economies of scale or integration or other benefits
that may result from the proposed transaction clearly outweigh any likely
anticompetitive effects resulting from the elimination of existing or
potential competitors.

9

To the extent that these acts actually succeed in preserving or fostering
competition between financial institutions, they are in conflict with the
thrust of most other regulations.^

The conflict is simply illustrated by a

fairly typical, albeit hypothetical, merger case.

A bank in a small, isolated

rural town applies to a regulatory agency for prior approval of its merger
with the only other bank in town.

Because the Bank Merger Act prohibits any

bank merger that would result in a substantial lessening of competition,
absent a showing that the anticompetitive effects are outweighed by the
convenience and needs of the community, the merger is denied.

Presumably the

purpose of the denial is to maintain competition in the local market in
services and prices, including the interest rates paid on passbook savings
deposits and NOW accounts.

However, under existing ceilings established by

the Depository Institutions Deregulation Committee, the maximum rate payable
on either type of account is severely limited— 5% percent at the time this was
written.




18

Regulation begins to bind.

Most of the restrictions adopted in the wake

of the banking collapse were of little cpnsequence during the remainder of the
1930s, the 1940s, and up to the mid 1950s, given the great caution exercised
by those bankers wise enough, or lucky enough, to have survived the
depression.

Even without the prohibition of interest on demand deposits,

banks would not have paid rates in excess of a fraction of a percent in the
late 1930s, while market rates on savings and time deposits remained well
below Regulation Q ceilings until the 1950s.

Similarly, chartering

restrictions had little effect at a time when no one was interested in
entering the banking business and the restrictions on bank securities
activities were not a serious constraint in an era when the securities markets
were uniformly depressed.
Not until the revival of credit demands in the postwar period did most of
the restrictions become severely binding on most institutions.

The degree of

constraint increased moderately year by year as banks gradually became more
aggressive and market interest rates rose.

Up until the early 1960s, the

Federal Reserve generally pursued a policy of raising the ceilings on time
deposits whenever they constrained a significant number of banks.

However,

the accelerating inflation and increases in interest rates after 1965 caused
most of the regulatory shackles to bind, causing bankers considerable
annoyance, if little real pain.
Response to Regulation;

The 1960s

The decade of the 1960s began as a period of growing frustration for
commercial bankers; it ended in frustration for financial regulators.

Caught

between rising loan demands and restrictions on their ability to pay market
rates for deposits and hemmed in by branching restrictions and limitations on
their activities, banks sought out every loophole they could find in the




19

existing web of regulation.

The decade became a contest of wits and wills

between regulator and regulatee.

Not surprisingly, given their greater

potential rewards and the stimulus of competition, the banks tended to stay at
least six months ahead of the regulators.

The decade began with Citibank’s

1961 announcement that it would sell negotiable certificates of deposit and
that a major security dealer would make a secondary market in them.

The rapid

growth of these instruments raised great hopes for, and increased reliance on,
the techniques of liability management.
wait for deposits.

No longer did bankers simply sit and

They began to seek them out, paying market interest rates

and competing for them in other ways.

Many bankers came to believe that they

would always be able to buy whatever liquidity they needed.

This notion was

dispelled abruptly in 1966, when, in response to concern over what was
perceived as an inflationary capital spending boom financed by bank loans and
a savings and loan industry suffering from the first in a series of "credit
crunches," the Fed refused to raise the ceiling on large CDs as market rates
rose.
The remainder of the 1960s saw attempt after attempt by the banks to
develop substitute sources of funds not subject to interest rate ceilings or
reserve requirements.

This response is an example of what Professor Edward

Kane has called the "regulatory dialectic".^

Thus, the banks introduced loan

participation certificates, working capital acceptances, small denomination
capital notes, Eurodollar borrowing from overseas branches, and holding
company commercial paper.

Each of these moves was then followed by the Fed,

six months or a year later, redefining the new instrument as a deposit and
subjecting it to interest rate ceilings, reserve requirements, or both*
Blocked from competing on rates, banks tried to compensate by offering
greater convenience, primarily by opening additional branch offices.




Although

20

the existence of such an effect has long been recognized, its magnitude was
not fully appreciated until the publication of a recent study which concluded
that fully two-thirds of the branch offices of California savings and loan
associations in 1978 could be attributed to Regulation Q.

13

Though

specifically addressed to savings and loan association branching, the study is
highly suggestive of what one might expect to find for banking, albeit to a
somewhat lesser degree in view of banks’ lesser dependence on retail deposits.
This is a prime example of the cost-raising effects of efforts to avoid
regulation.
The Saxon era.

Banks also attempted to expand their permissible

activities during the 1960s.

Blocked from underwriting and other securities

activities by the Glass-Steagall Act of 1933 and from many other activities by
the National Banking Act’s limitation of bank activities to ’’such incidental
powers as shall be necessary to carry on the business of banking,” banks began
to look for ways around these prohibitions.
reinterpretation of existing law.

One way around was through the

The Comptroller of the Currency in the

early 1960s, James Saxon, sympathized with the bankers’ desire to enter new
fields and to compete with greater freedom.

A lawyer with more respect for

economic realities than for the niceties of the law, Saxon challenged existing
restrictions on national banks by liberalizing chartering, branching, and
merger restrictions and by unilaterally authorizing national banks to engage
in activities the law had long been interpreted to proscribe.

Among these

activities were data processing, offering commingled agency accounts
(essentially operating a mutual fund), operating travel agencies, and
underwriting municipal revenue bonds.

However, few of Saxon’s challenges to

prior interpretations of existing law held up in court.




21

The one-bank holding company.

Banks also sought to escape their

perceived chains through the device of the one-bank holding company.

Because

companies owning or controlling only one bank were exempt from the
restrictions on activities of bank holding companies established by the Bank
Holding Company Act of 1956, many large banks took the initiative in the late
1960s of organizing their own one-bank holding companies.

Although the bank

itself was still subject to restrictions on its activities, other subsidiaries
of the holding company were free to enter almost any activity, financial or
otherwise, that they wished.

By 1970 over a thousand banks, accounting for

about a third of commercial bank deposits, were owned by one-bank holding
companies.

Many had announced far-reaching plans to enter diverse financial

and nonfinancial businesses.
eliminated.

However, the one-bank exemption was quickly

The Bank Holding Company Act Amendments of 1970 extended the Bank

Holding Company Act to cover one-bank holding companies and redefined
permissible activities of bank holding companies to include only those
"closely related to banking" and whose performance by a bank holding company
subsidiary was in the public interest.
Innovation in the 1960s.

A great deal has been made of the innovative

activity of banks in the 1960s, as if it had produced wondrous advancements in
the financial system.

What it actually did was simply to bring us, de facto,

part of the way back to the situation that existed prior to 1933, at least
with respect to interest paid on deposits.

Although it was certainly

rewarding from the standpoint of the banks, socially it was wasted effort, a
cost that could have been avoided had regulation not been so at odds with
extant market forces.




22

Regulatory Accommodation;

The 1970s

By the early 1970s the consequences of regulations designed to shelter
banks from competition and from their own mistakes were becoming increasingly
evident.

The Hunt Commission focused attention on many of the ills

attributable to the regulatory balkanization of financial markets and called
for an end to restrictions on price competition, enforced specialization, and
geographic barriers.

But decisive legislative action in these directions was

not to come for another decade.
The advent of NOWs and MMFs.

In the meantime, the existing restrictions

on banks created opportunities for other types of institutions.

Stimulated by

rising interest rates associated with accelerating inflation in the face of
unrealistic deposit rate ceilings, other types of depository institutions
began to invade turf previously viewed by banks as their own.

The

introduction of the NOW account by Consumer Savings Bank of Worcester,
Massachusetts, in June 1972 was a momentous event.

Economically, the NOW

account was an interest-bearing checking account, and Massachusetts mutual
savings banks were prohibited from offering demand deposits.

However, the

courts held that the NOW account was simply a savings account offering a
somewhat unusual means of withdrawal.
followed Massachusetts' example.

Savings banks in New Hampshire soon

Money market mutual funds, offering the

small investor a way of participating in high market yields at only a small
cost in terms of safety and liquidity, made their debut in 1973.

By yearend

1981 their assets had risen to the remarkable total of $185 billion.

Though

initially resisting these innovations, regulators and legislators soon began
to accommodate them, partly out of recognition of the ultimate futility of
trying to suppress them and partly because of a belated acknowledgment that
interest rate ceilings are a source of economic mischief.




23

The Fight for Financial Turf:

The 1980s

In the face of these inroads, and given the high and rising rates of
interest on competing financial assets, an end to the prohibition of interest
on consumer demand deposits in the rest of the country was only a matter of
time.

It is ironic that the immediate impetus was supplied by a court ruling

in mid-1979 that held NOW accounts, the similar share draft accounts offered
by credit unions, and remote service units operated by savings and loan
associations to be in violation of existing law.

Though attacked at the time

as representing a step backward, the decision simply affirmed that the law,
wise or not, meant what it said.

To avoid disruption of financial institu­

tions, the court gave the Congress until yearend (later extended three addi­
tional months by the Congress) to consider new legislation before the court's
order was to go into effect.

The urgency of the need to act was heightened by

the difficulties created for financial institutions by soaring interest rates
in the first quarter of 1980.
DIDMCA.

The eventual result was the Depository Institutions Deregulation

and Monetary Control Act of 1980 (DIDMCA), signed into law on March 31.

When

and if all of its provisions are fully implemented, the act will provide great
benefits in the form of a modest improvement in the technical means for
monetary control, more equitable treatment of competing financial institu­
tions, and a greater ability of depository institutions generally to meet the
competition of unregulated competitors and to withstand interest rate fluctua­
tions.

But, because the act left a number of important issues unresolved,

the long war of attrition between banks and other suppliers of financial
services over the division of geographic and product market turf continues
unabated.




24

Geographic restrictions,

De jure geographic restrictions on banks and

other financial institutions remain, although they are slowly giving ground.
The spirit and economic substance, if not the letter, of these restrictions
have been trampled on by bank holding company acquisitions of nonbank
firms— e.g., consumer finance companies and mortgage companies— having offices
in many states, by the opening of Edge Act offices and loan production offices
in major cities throughout the country, by savings and loan branching in
states restricting branching by banks, by the rapid growth of nationwide bank
credit card franchising networks, by the establishment of electronic banking
facilities in locations closed to brick-and-mortar branches, by the use of
computerized cash management services capable of managing a number of widely
dispersed accounts as if they were one account, by national advertising, and
by the growing use of 800 phone numbers to entice customers to deal with
distant financial institutions.

Perhaps the most striking example is provided

by Citicorp, which, through its nonbank subsidiaries and other devices, now
operates 444 out-of-state offices in 39 states (see Table 1).

Manufacturers

Hanover Corporation has even more offices, 471, but is represented in only 30
states.

Even the Continental Bank, in the unit-banking state of Illinois, is

represented in ten states.

The geographic restrictions of the McFadden Act

and the Douglas Amendment to the Bank Holding Company Act remain, but they
have been largely transformed into minor competitive disadvantages for banks
rather than effective impediments to competition in financial services.
Nonbank financial institutions.

The distinctions between traditional

forms of depository and nondepository financial institutions continue to erode
as each tries to expand the scope of its activities.

Commercial banks long

ago became important in consumer and residential mortgage lending, two areas




25

previously the province of small loan companies and savings and loan
associations.

More recently, as we have seen, the inroads have been in the

other direction, as thrift institutions have been granted third-party payment
and consumer and limited commercial lending powers.

But the most dramatic

expansions by financial institutions have been the recent incursions by
nondepository type financial institutions into areas of business where they
were not previously represented.

Prudential Insurance Company’s acquisition

of Bache combined into a single entity one of the country’s largest
institutional investors and one of its largest brokers and underwriters.

In

view of the fact that such a combination involves the same type of conflict of
interest between investor and underwriter that was proscribed by the
Glass-Steagall Act where banks are involved, it will be interesting to see
whether any legislative response is forthcoming.

Still another example of the

breakdown of traditional functional boundaries is the offering of third party
payment services by money market mutual funds and by Merrill Lynch through its
Cash Management Account (CMA).
Nonfinancial competitors.

The inroads of basically nonfinancial

businesses into the financial area continue.

The examples given at the

beginning of this paper are only some of the more dramatic cases.

As early as

1974 Citibank distributed a study detailing the extensive financial service
activities of such industrial and retailing giants as General Motors, Ford
Motor Company, IT&T, Control Data, Gulf and Western, Westinghouse, Marcor, and
J.C. Penney.

However, as startling as the revelation of these activities was

to some bankers, it is easy to exaggerate their significance.




The simple fact

26

Table 1

Out-of State Offices of 10 Large
Bank Holding Companies

Non-Bank
Subsidiary
Offices

Banking
Offices

Total
Offices

Total
States

Manufacturers Hanover

471

7

478

30

Security Pacific

427

7

434

35 & DC

Citicorp

419

25

444

39 & DC

BankAmerica

360

15

375

40 & DC

Chemical

135

6

141

23

First Chicago

13

14

27

10

Chase

13

4

17

15 & DC

Continental Illinois

9

12

21

10

Bankers Trust

1

8

9

4

J. P. Morgan

1

5

6

4

Source:




Manufacturers Hanover Corporation, The New Reality,
May 14, 1981.

27

is that commercial banking has held its own in most of its major markets over
the past two decades (see Table 2).
Of course, this is subject to change.

While telecommunications,

transportation, and information processing advances have made geographic
expansion possible in ways that would not have been dreamed of 50 or even ten
years ago because of the inefficiencies of coordinating business endeavors
over great distances, these same technological advances pose a threat to the
hegemony of depository institutions in the financial services business.

To

survive and prosper, such institutions not only have to utilize
state-of-the-art credit information processing technology but they also need
to maintain a source of funding that is cheaper than that obtainable by such
nonfinancial information-processing firms as, say, TRW or Dun and Bradstreet.
But the deposit rate deregulation promised by DIDMCA will likely decrease the
cost of funds advantage that depository institutions have enjoyed.

14

If

these narrower spreads were to prevail, any nonbank firm that enjoyed a
comparative advantage in credit information processing could enter the credit
business as a commercial or consumer finance company competing for the loan
customers of present-day depository institutions.
Captive finance companies and other suppliers of trade credit constitute
another source of potential entry.

The larger of these companies can raise

funds in the commercial paper or longer-term capital markets at interest rates
very similar to those paid by banks and bank holding companies.

They

currently have credit information on their customers in their computers and
the marginal cost of adding additional information on these same customers
would seem to be small.

Many of these companies deal with as many clients as

do some of the larger banks in the country; thus, they suffer few economies of




TOTAL PRIVATE FINANCIAL ASSETS, 1945-1980
(Billion dollars)
1978

1979

1980

905.5
845.4
18.8
391.9
134.8
43.3
311.1
171.9
120.4

1002.9
936.3
18.9
459.2
147.3
51.6
339.8
178.3
132.5

1146.8
1056.0
20.6
523.6
158.2
58.4
378.3
198.3
153 c9

1274.5
1161.4
25.2
579.3
163.3
61.9
420.4
222.0
169.7

1386.7
1244.7
29.5
629.8
171.5
69.2
469.8
286.8
198.1

77.3
99.1
14.0
43.0

93.9
111.2
9.8
46.5

113.2
133.8
7.2
45.5

133.9
157.5
6.8
46.1

154.9
184.5
6.7
51.8

180.1
198.6
5.8
63.7

3.7
18.5
2111.6

3.7
26.8
2370.8

3.9
27.7
2642.9

10.8
28.0
3000.6

45.2
28.2
3362.4

74.4
33.5
3768.0

1950

1955

1960

1965

1970

1975

1976

143.8

147.8

185.1

228.3
224.2

340.7
335.0

8.7
17.0
.4
43.9
2.8
2.7

16.9
22.4
.9
62.6
6.7
5.0

37.7
31.3
2.4
87.9
18.3
10.7

71.5
41.0
6.3
115.8
38.1
19.7

129.6
59.1
11.0
154.2
73.6
34.1

504.9
448.9
3.0
176.2
79.3
18.0
200.9
110.4
60.3

834.3
786.0
12.8
338.2
121.1
31.1
279.7
146.8
104.8

6.9
4.3

12.6
9.3

21.0
17.1

26.2
27.6

36.5
44.7

1.3

3.3

7.8

17.0

35.2

49.9
64.0
3.9
46.8

4.9
236.7

4.0
291.5

5.9
425.2

6.7
598.2

10.3
929.0

16.2
1330.8

(Percent of total)
60.8%
Commercial Banking
(U.S. Banks)
(
(Domestic Affiliates)
(
3.7
Savings and Loan Associations
7.2
Mutual Savings Banks
.2
Credit Unions
18.5
Life Insurance Companies
1.2
Private Pension Funds
1.1
State and Local Government
Employee Retirement Funds
2.9
Other Insurance Companies
1.8
Finance Companies
Real Estate Investment Trusts
Open-End Investment Companies
.5
(Mutual Funds)
Money Market Mutual Funds
Security Brokers and Dealers
2.1
TOTAL
100.0%
Trade Credit Nonfin Firms
(Billion dollars)
% of Total TPFA
% of Commercial Banks
Source:




20.6
8.7
14.3

37.9%
36.7
.2
13.2
6.0
1.4
15.1
8.3
4.5

39.5%
37.2
.6
16.0
5.7
1.5
13.2
7.0
5.0

38.2%
35.7
.8
16.5
5.7
1.8
13.1
7.3
5.1

37.9%
35.4
.7
17.4
5.6
2.0
12.9
6.7
5.0

38.2%
35.2
.7
17.4
5.3
1.9
12.6
6.6
5.1

37.9%
34.5
.7
17.2
4.9
1.8
12.5
6.6
5.0

36.8%
33.0 )
.8 )
16.7
4.6
1.8
12.5
7.6
5.3

3.8

3.7
4.8
.3
3.5

3.7
4.7
.7
2.0

4.0
4.7
.4
2.0

4.3
5.1
.3
1.7

4.5
5.2
.2
1.5

4.6
5.5
.2
1.5

4.8
5.3
.2
1.7

1.1
100.0%

1.1
100.0%

1.2
100.0%

.2
.9
100.02

.2
1.1
100.0%

.1
1.0
100.0%

.4
.9
100.0%

1.3
.8
100.0%

81.4
13.6
35.7

119.5
12.9
35.0

189.1
14.2
37.4

249.6
11.8
29.9

50.7%

43.5%

38.2%
37.5

36.7%
36.1

5.8
7.7
.3
21.5
2.3
1.7

8.9
7.4
.6
20.7
4.3
2.5

12.0
6.9
1.1
19.4
6.4
3.3

14.0
6.4
1.2
16.6
7.9
3.7

4.3
3.2

4.9
4.0

4.4
4.6

3.9
4.8

1.1

1.8

2.8

1.4
100.0%

1.4
100.0%

44.4
15.2
30.0

67.6
15.9
3(>.3

Board of Governors of the Federal Reserve System, Flow of Funds

2.0
.9
100.0%

460.8
12.2
33.2

Table 2

Commercial Banking
(U.S. Banks)
(Domestic Affiliates)
Savings and Loan Associations
Mutual Savings Banks
Credit Unions
Life Insurance Companies
Private Pension Funds
State and Local Government
Employee Retirement Funds
Other Insurance Companies
Finance Companies
Real Estate Investment Trusts
Open-End Investment Companies
(Mutual Funds)
Money Market Mutual Funds
Security Brokers and Dealers
TOTAL

1977

1945

29

scale disadvantages vis a vis their bank competitors.

General Electric Credit

Corporation is one very successful example of a captive finance company that
has expanded its business to include financing not related to its parent’s
products.^
The volatility of interest rates may be another important factor
impacting depository institutions’ share of the credit-granting pie.
Beginning in the 1930s banks became more active in fixed-rate term lending.

16

This practice continued until the early 1970s when interest rate volatility
increased markedly and banks began passing forward to their commercial and
industrial customers the risks associated with the more volatile cost of
funds.
Banks of all sizes have been very successful, on the whole, in avoiding
the perils of interest rate risk.^

Rather than bear this risk, many banks

have shifted this risk forward, particularly to their business customers, many
of whom may not have been in as good a position as the bank to absorb this
risk.

Eventually, this could result in banks losing some business credit

market share to suppliers of trade credit, which is typically offered at what
appear to the borrower to be fixed rates.

The use of bank credit relative to

trade credit for short-term financing purposes has not changed appreciably as
interest rate volatility has risen; however, for small businesses, trade
credit is the most widely used source of credit, both in terms of the
percentage of firms utilizing it as a credit source^ and in dollar volume.^
These facts take on increasing significance when one realizes that it is small
firms that have experienced the greatest employment growth over the last
decade and that this trend is expected to continue.

20

To the extent that

these firms desire fixed-rate loans, banks must offer them the credit terms




30

that they desire or other credit suppliers (finance companies, leasing
companies, trade credit, etc.) may find an opportunity to fill this void.
None of this is to say that banks need fear for their survival.

Customer

turnover in any industry is a fact of life and banks have dealt successfully
with this problem for many years.

As William F. Ford, President of the
/
Federal Reserve Bank of Atlanta, concluded in a recent speech to a banking
audience:
When you stop to think about it, the reason
businesses want to get into banking markets
business looks good to them. You have been
in earning profits, and you have been doing

all these other kinds of
is quite simple. Your
doing better than ttj^y have
it for a long time.

Banking has been a profitable industry over the last 15 years.

Earnings

growth averaged (at an annual rate) 18 percent during 1966-70, 10 percent
during 1971-75, and 19 percent during the 1976-80 period.

22

Return on capital

as measured by the ratio of net income to total capital was significantly
higher in the 1970s than in either the 1950s or 1960s, and higher in the last
three years of the 1970s than in any other three-year period (see Table 3).
The ratio of net income to total bank assets was also higher in the 1970s than
in the previous two decades, but somewhat lower in the second half of the
decade than in the first.

This strength could be interpreted as showing that

banking was profitable because of its highly regulated environment, but this
would probably be the wrong conclusion as the regulatory walls have been
crumbling at a very rapid pace.
The playing field.

The public has little or no vested interest in the

outcome of the battles over the division of the financial market turf.

It is

concerned primarily, and probably exclusively, with receiving the best service
possible and, for any given quality of service, the lowest price.

Questions

as to whether there is a "level playing field" or whether competition is




31

Table 3
Profitability of Insured
Commercial Banks: 1952-1980

Total Assets
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980




0.55
0.55
0.68
0.57
0.58
0.64
0.75
0.63
0.81
0.79
0.73
0.72
0.70
0.70
0.69
0.74
0.72
0.84
0.89
0.87
0.83
0.85
0.81
0.78
0.70
0.71
0.77
0.81
0.80

Net Income as Percent of
Total Capital
Equity Capital
8.07
7.93
9.50
7.90
7.82
8.30
9.60
7.94
10.02
9.37
8.83
8.86
8.65
8.73
8.70
9.56
9.70
11.48
11.89
11.85
11.60
12.14
11.89
11.19
10.66
10.93
11.96
13.01
12.85

Annual Report, various issues.

10.14
10.31
11.98
12.37
12.39
12.25
12.86
12.53
11.75
11.41
11.72
12.80
13.89
13.66

32

"fair" are likely to leave the public cold; harm to a competitor is not the
same thing as harm to competition. Moreover, efforts to establish "fairness11
by legislation or regulation often result in ossification and inefficiency.
This has certainly been the case with the Interstate Commerce Commission’s
efforts to maintain fair competition between rail, barge, and truck
transportation.
Ideally, the many proposals for legislative and regulatory changes
currently under consideration should be evaluated on their merits, with little
regard for whether they enhance or detract from some particular narrowly
»
defined industry's competitive position vis a vis its competitors. Of course,
legislators cannot ignore the political reality of well-organized industry
lobbies.

But to the extent that they condition further deregulation on their

ability to achieve a multi-industry consensus, they may simply be encouraging
the vultures to agree on a division of the public carcass.
Product and Geographical Lines of the Financial Industry of the Future
In attempting to peer into the future of the financial services industry,
it is probably wise not to assume that it will consist of the same, familiar
types of institutions that we know today.

As Almarin Phillips pointed out

recently in testimony before the House Banking Committee,
It is not ordained that all or most commercial banks, savings and loan
associations, mutual savings banks, credit unions, insurance companies,
investment bankers and others of the old forms of financial institutions
will persist. It is more clearly ordained that they will not.
Predicting the future configuration of the financial services industry
requires two preliminary steps.

First, one must make some assumptions about

the future pace and direction of technological development, both of which are
largely independent of developments in the financial sector, and also about
the extent and form of deregulation and the level and volatility of interest
rates, which are not.




In the nature of things, these can be no more than

33

educated guesses.

Second, one needs an analytical framework, filled in as

much as possible with estimates of the magnitudes of relevant parameters, in
order to be able to calculate the consequences of the assumptions.
Assumptions.

It would appear reasonable to assume that technological

advances in information processing and transmission will continue in the
future.

More importantly, the rate of adoption of existing technology is

likely to accelerate as the bugs in existing equipment are remedied and as the
public gradually comes to accept— and is given market incentives to
accept— new ways of doing things.
Deregulation appears to have a certain amount of momentum at this time
and is likely to go somewhat further before the pendulum begins to swing in
the other direction.

To be sure, a large number of thrift institution fail­

ures might dampen the prospects for major additional steps toward deregulation
over the next year or so.

Ironically, just as the decades-long campaign for

financial deregulation is bearing fruit, we are experiencing a recurrence,
hopefully on a milder scale, of the conditions responsible for the imposition
of regulations in the 1930s.

If the difficulties currently being experienced

by financial institutions can be kept to manageable proportions, and if market
interest rates do not rise again sharply between now and 1986, there still
appears to be a fairly good chance that the following steps toward
deregulation will be taken:
*The phase-out of Regulation Q ceilings on time deposits will continue
under the current six-year timetable.
*The asset powers of thrifts will be further enlarged.
*The Glass-Steagall Act will be relaxed at least enough to allow the
underwriting by banks of all municipal revenue bonds and the management
by bank trust departments of commingled agency accounts.
*The few remaining functional distinctions between different types of
depository institutions will be destroyed by mergers of commercial banks
and thrift institutions.




34

^Interstate commercial deposit banking may soon be allowed de jure as
well as de facto.
*The attitude of regulators toward entry will be further relaxed.
^Regulation of bank lending and investment policies will become
progressively less detailed and restrictive, particularly if risk-related
deposit insurance premiums are adopted.
*Prior approval for mergers and acquisitions will be more perfunctory and
liberal.
In all probability, the relaxation of geographic restrictions will take
the form of an easing of the Douglas Amendment to allow interstate acquisi­
tions of banks by bank holding companies, perhaps followed by regional full
service interstate branching on a reciprocal basis.

NCNB’s announcement of

its planned acquisition of Gulfstream Banks in Florida is just one more step
in this process.

The branching issue may be forced by the problems currently

being experienced by the savings and loan industry.

The recent acquisition of

Farmers and Mechanics Savings Bank of Minneapolis by Marquette National Bank
and of Fidelity Mutual Savings by First Interstate Bank of Washington are
probably just the first in a series of commercial bank-thrift institution
mergers.

In those cases where thrift institutions now enjoy broader branching

privileges than banks, such mergers effectively constitute an instant liber­
alization of branching restrictions.

If such mergers are permitted on an

interstate basis, as may occur if there are insufficient in-state bidders to
rescue all the failing thrift institutions, they will do even more to break
down geographical barriers.

That many in the banking industry foresee a

lowering of the barriers to interstate banking is strongly suggested by the
recent rush by bank holding companies to acquire less-than-controlling
interests in out-of-state banks.
The analytical framework.

Projecting the consequences of these assumed

developments in technology and regulation requires one to take into account a




35

number of important facts and relationships.

For example, it must include

what is known about how output varies with the amounts of various inputs and
how cost varies with the output of a given financial service.

A key question

is the degree to which there are complementarities or interaction effects
between the production of one financial service and another— e.g., is it
cheaper or otherwise more efficient to produce underwriting services and
investment services jointly rather than separately?

Unfortunately, our

knowledge of such effects is extremely fragmentary.
Equally important are empirical estimates of the relationships between
the demands for various services and customers1 incomes, the prices of the
services in question, and the prices of substitutes.

It is essential to take

account of the geographical distribution of demand and any complementarities
on the demand side between different services— e.g., how much value do
consumers place on full-service banking or, more generally, on being able to
obtain more than one service at the same place?
Our task in the remainder of this paper is to use our assumptions about
future regulatory developments, together with what is known about demand,
cost, and other behavioral relationships, as the basis for projecting the
future configuration of the financial system, particularly with respect to the
geographic markets and product lines of financial firms.

This necessarily

involves us in making educated guesses about the number and size distribution
of financial firms, the number and locations of their branch offices, and
their degree of specialization or diversification.

We then offer a few

comments on the public policy issues raised by the transition to a deregulated
environment.
Branching.

In predicting the branching patterns of the future it is

useful to keep in mind that, when an institution is constrained by more than




36

one regulation, these regulations may interact to produce results differing
from what might otherwise be expected.

For example, it is certain that, if

left wholly free to compete as they wished, some banks would choose to branch
into geographical areas beyond where they are permitted to go today.

But

total deregulation might not produce a net increase in the number of branches
operated by some banks, for at least two reasons.

In the first place, some

branches opened by expanding banks would simply displace existing branches of
other banks, either through acquisition or through their elimination by
competition.

Second, as we have already seen, many banks have opened more

branches, within the area in which they are allowed to branch, than they would
operate in the absence of interest rate restrictions.
In a deregulated environment they might find it more efficient to compete
for deposits by paying a higher rate, avoiding some operating costs by closing
down some existing branches.

Indeed, money market funds have demonstrated

clearly that it is possible to collect funds from throughout the country with
only one office and an 800 telephone number if market rates are paid.

The

demand for brick-and mortar branches is likely to be affected even more
dramatically as point-of-sale payment systems and, ultimately, in-home banking
become realities.

For all of these reasons, we project a substantial absolute

decline in the number of conventional branches over the next decade.

To the

extent that they are permitted, the larger banks will establish full-service
branches in the major financial centers and many of the regional centers.

But

massive expansion of retail-oriented branches is highly unlikely.
Consolidation and number of firms.

What we know of economies of scale in

banking, the experience of other countries permitting nationwide branching,
and the changes that have occurred in individual states that have liberalized
branching all point toward a considerable amount of consolidation if existing




37

barriers to interstate banking are dropped.

As we know, the banking struc­

tures of all other major industrial nations are much more concentrated than
that of the United States; most have only a handful of banks, each with an
extensive system of branches.

To be sure, it appears likely that consolid­

ation in those countries has gone well beyond what is required for efficiency,
as is strongly indicated by the success of American banks in competing against
the established giant British banks in London,

Nevertheless, there are

important size economies still unrealized by many small and medium-sized banks
in the United States.
When states have liberalized their branching laws, the results almost
invariably have been increases in the rate of consolidation and increased
statewide concentration.

Thus, New York and Virginia, both of which libera­

lized their branching and holding company laws in the early 1960s, both
experienced declines in the number of banking organizations over the ensuing
decade of 20-40 percent and both experienced increases in statewide concentration.

24

.(Both also experienced net declines in concentration at the crucial

local market level and essentially no change in the number of potential
entrants into local markets.)

If carefully monitored and controlled,

consolidation need not have anticompetitive consequences.
But even under the assumption that branching restrictions are totally
eliminated, there would continue to exist a large number, perhaps several
thousand, smaller, retail-oriented banking or thrift institutions.
basically two reasons for expecting this.

There are

First, there is a genuine demand

for the type of personal service that only a small, locally oriented insti­
tution can give.

This explains why many mom-and-pop businesses continue to do

well in the era of the supermarket; it may also explain why new unit banks are
still being established and are thriving in statewide branching states such as




38

California and Oregon.

Second, the economies of scale in many retail banking

activities, in particular consumer and mortgage lending, are simply not that
great.

Once an institution reaches an asset size of $50-$100 million, there

appears to be little additional cost advantage to be gained by another dou­
bling in the scale of these functions.

Such institutions will not, of course,

be able to compete seriously in the national and international corporate
lending markets.
Diversification.

The advantages of being able to buy your stocks where

you buy your socks (or hold your checking account) are probably greatly
overrated.

It is doubtful whether many stock market investors have complained

of the inconvenience of not being able to buy and sell stocks through their
banks.

The main attraction of the Cash Management Account, which at first

glance might seem to depend on economies of joint consumption, is really
related to economies of joint production.

It enables a product to be

offered— ready access to a larger line of credit than is currently available
with a bank credit card— that is possible only because of the investment
account maintained by the customer at Merrill Lynch.

However, the convenience

of one-stop banking has been shown to be of major importance in determining
where consumers hold their savings accounts,

25

and the advantage to the

customer of being able to obtain all, or most, financial services from a
single source may become more important in the future.
Very little is really known about the existence or magnitude of economies
of joint production of various financial services.
case of the CMA account is clear.

That there are some in the

There also would appear to be fairly

important complementarities in the granting of various kinds of credit; e.g.,
a bankTs experience gained by extending consumer credit to a customer is
clearly useful in deciding whether to make him a mortgage loan.




In at least

39

one area where there might be important informational economies to be gained
by combining activities— commercial lending and management of trust
investments— the potentials for abuse are so great that public policy actively
discourages the realization of such economies.
However, the recent advances in information-processing technology are
rapidly eroding much of the cost advantage enjoyed by established lenders,
thereby destroying the associated advantages to borrowers and, hence, their
interest in maintaining such relationships.

Assuming only that in-home

banking terminals do not take the form of proprietary installations by a
single financial firm— thereby excluding other competitors until the customer
decides to terminate his entire relationship with the installing firm— there
is likely to be a great deal more "shopping around” by customers on the
computer terminal for the best terms available on individual financial services.

26

Thus, specialized firms offering only a limited number of services

wil'l still be able to compete on the basis of price and quality with the large
financial conglomerates.
Although the Citicorps, Manny Hannies, and Merrill Lynches may try to
offer every financial service under one roof— we might end up with, say, 25 or
so fully integrated, national financial conglomerates— the managements of many
other institutions will choose to specialize.

This may be either from weak­

ness— for example, it is not clear that many savings and loan associations are
prepared to move from the rather simple business of accepting passbook savings
and making mortgage loans to operating department stores of finance— or from
strength, in the sense that some managements may be convinced that they can
perform a narrow range of functions better than anyone else.
However, it is doubtful that thrift institutions, in particular, will be
quite as narrowly specialized as they have been in the past.




The new NOW

40

account, consumer lending, and limited trust account powers granted them by
DIDMCA have already moved them in the direction of becoming family banking
institutions.

Further liberalization on the asset side is likely to move them

further in that direction.

But it should be recognized that adoption of

either of the two major reform bills currently under consideration— the Garn
bill and the regulators1 bill— will do nothing to end the tax preferences that
have been a major force pushing thrift institutions to specialize in resi­
dential lending.
It might be observed that these much-heralded asset powers are likely to
prove less useful to the thrifts in surviving in a volatile interest rate
environment than the variable-rate mortgage powers that they are still
learning to use.

Transition problems aside, they permit the same shortening

of asset durations without either start-up costs or the need to compete with
other established suppliers of the new services.

The shifting of interest

rate risk to the borrower that such mortgages entail may not be as serious a
problem as it has been painted to be.

Although the typical homebuyer is

probably less able to predict interest rate movements than the professional
managers of lending institutions, this is generally counterbalanced by the
fact that the market value of the mortgaged property rises with increases in
the mortgage rate.

(However, this hedge will not work when the increase in

interest rates is not attributable to expectations of increased inflation,
i.e., when the real rate of interest increases.)

In the past, it was

extremely difficult to translate the increase in the homeowner’s equity into
improved cash flow.

However, the recent expansion in lenders’ willingness to

make second mortgages, as well as such developments as Merrill Lynch’s new
plan to extend lines of credit based on the borrower’s equity in his home,




41

promises to increase the availability of this hedging possibility in the
future as variable rate mortgages grow in importance.
As for the banking industry’s role in the financial system of the future,
we believe that the question is somewhat out of place.

In the past, the

unique attributes and capabilities that distinguished banking as a welldefined industry were largely the product of regulation.

With the demise of

these artificial barriers, the notion of banking as a separate and distinct
industry will slowly but inexorably disappear.

Although its full implications

have only begun to seep into the consciousness of those who labor in the
financial marketplace, the Depository Institutions Deregulation and Monetary
Control Act was a fateful step into a largely unknown, but certainly very
different, competitive environment.
Public Policy
The public policy questions raised by these hypothetical developments are
many, varied, and important.

Although one of our key theses is that much of

the change we have been seeing is inevitable and that regulation must, and in
fact does, adapt itself to that change, this point can be pushed too far.

The

argument of !,inevitabilityn is easily abused, as when it is argued that a
particular change, though highly undesirable in and of itself, should be
adopted because of its "inevitability."

In other words, if the ship is going

to sink anyway, let’s blow a hole in the side to get it over with.

The

arguments of some financial industry lobbyists that such and such law should
be changed now because it must inevitably be changed someday are examples of
this particular brand of sophistry.
We reject such a simplistic notion of inevitability.

Although we ac­

knowledge that, to be effective, regulations must be predicated on a realistic
idea of how market forces work and must be designed so as to minimize evasion,




42

we would not argue that they have no effect whatever on the economic outcome
or that they can never play a constructive role in shaping firms’ responses to
market forces.
One very real concern that attends the prospective dismantling of geo­
graphical barriers is whether the ensuing consolidation movement will result
in excessive concentration, both in specific markets and in the aggregate, and
whether existing antitrust laws are adequate to prevent such a development.
The Sherman and Clayton Acts were designed to deal with horizontal restraints
on competition and there does not appear to be any good reason why they cannot
serve to prevent mergers that would result in excessive concentration in
specific markets in the financial sector.

Several important cases in the

1960s settled the question of whether they apply to commercial banking.

Thus,

one may question whether prior approval under such special legislation as the
Bank Merger Act will be necessary in the future.
The effectiveness of the antitrust laws, however, depends to a large
degree on how they are applied; antitrust has always been one of the more
arcane and fuzzy areas of the law, particularly when applied to financial
institutions, and its administrators have considerable discretion in choosing
which cases to prosecute.

Deregulation undoubtedly will lead to both a

broadening of the actual geographic and product markets within which financial
institutions compete and a broadening of the approximations of those markets
used by the agencies and the Antitrust Division in evaluating the competitive
effects of acquisitions.

Conceivably, however, the broadening of the defini­

tions could be carried beyond what the facts would warrant, and acquisitions
could be allowed that are seriously anticompetitive.

This is made more likely

by the fact that, with markets in flux and new competitive realities emerging,
great uncertainty will attend the market delineation process in the years




43

immediately ahead.

The limited resources of the Antitrust Division and the

typically long lag between the filing of an antitrust case and its resolution
in the courts raise additional questions regarding the adequacy of relying
completely on the antitrust laws to prevent anticompetitive mergers in fin­
ancial markets, particularly during the transition to full interstate banking.
Much also depends on economic conditions in the years ahead.

If interest

rates remain high and volatile, and many financial institutions find them­
selves in serious trouble, the anticompetitive effects of acquisitions may be
relegated to a position of secondary importance.

This is already evident in

the virtual neglect of the competitive implications of recent mergers of large
thrift institutions in New York and Chicago.
Perhaps of even more concern, the issue of aggregate concentration may
become a serious problem for the first time.

However crudely, the restric­

tions on interstate banking made it difficult for a very few firms to dominate
the entire financial system, and thereby to wield undue political influence.
When these restrictions are gone, that danger will become more real.

Insofar

as the antitrust laws reach primarily horizontal mergers, and not the market
extension mergers between different types of institutions or between similar
institutions in different geographical markets that are certain to be the
prevalent type in the future, they are not equipped to deal with the
problem.

27

Conceivably, such mergers could be attacked under the antitrust

laws using the potential competition doctrine, but the burden of proof on the
prosecution in such cases is extremely heavy.

28

An alternative approach to

the case-by-case analysis of competitive effects would be to impose a global
limit on the number of offices a financial firm might have nationally or a
prohibition on further acquisitions once its share of a given market exceeded
a given level.




The reality and seriousness of the problem of aggregate

44

concentration in the financial sector and, therefore, the necessity and
appropriateness of such solutions are, of course, open to some doubt.

But a

failure to give the problem full consideration now could be the cause for
serious regret later.
A similar point can be made regarding the potential conflict of interest
problem associated with allowing lenders to underwrite securities.

The

argument that banks should be allowed to underwrite municipal revenue bonds
because securities firms are beginning to offer bank-like services is at best
somewhat specious.

It fails to address the evils the Glass-Steagall Act was

designed to prevent and could equally well be used as an argument for
drastically limiting the transactions characteristics of money market fund
shares.

Moreover, the effects of combining underwriting and banking on the

overall risk incurred by the bank are still largely unknown.

As previously

indicated, the entry barrier imposed by Glass-Steagall is very different from
those posed by chartering or branching restrictions, and the resulting
restraint on competition considerably less.

Unless there are very few firms

other than banks capable of entering the investment banking industry, the
exclusion of banks should have little effect on the competitiveness or the
efficiency of underwriting municipal revenue bonds.

In the absence of any

compelling evidence demonstrating the efficiency of combining the two
activities, it would appear unwise to eliminate this protection.
In closing, we would like to add our voices to those urging that much
more attention be given to the adoption of risk-related federal deposit
insurance premiums.

The importance of this reform, which would constitute a

major step toward greater reliance on price incentives to guide financial
institutions’ decision-making, has not been adequately appreciated.

The

compatibility of such a scheme with a freer and more competitive financial




45

environment more than outweighs the alleged difficulties of its implementation.

29

The very technological developments in information-processing that

are propelling the changes in financial markets would contribute greatly to
its feasibility.

Indeed, without this change, it is unlikely that

deregulation in the financial services industry will ever achieve its enormous
potential.




FOOTNOTES

*Alfred D. Chandler, Jr., The Visible Hand; The Managerial Revolution In
American Business (Cambridge: Harvard University Press, 1977).
2

See John H. Wood, "Interest Rates and Inflation," Economic Perspectives,
Federal Reserve Bank of Chicago (May/June 1981), pp. 3-12.
3
"Policy Recommendations for the Comprehensive Deregulation of Major
Financial Institutions and Markets," September 11, 1981.
4
For example, see Raymond P. Kent, "Dual Banking Between the Two World
Wars," in Banking and Monetary Studies (Homewood, Illinois: Richard D. Irwin,
1963), pp. 61-63.
^See, e.g., John H. Kareken, "Deregulating Commercial Banks: The
Watchword Should be Caution," Quarterly Review, Federal Reserve Bank of
Minneapolis (Spring/Summer 1981), pp. 1-5.
g
These classifications have been shown to possess some ability to predict
defaults. See, e.g., Hsui-Kwang Wu, "New Evidence on The Accuracy of Bank
Examiner Loan Criticisms: An Intertemporal Cross-Section Analysis,"
Proceedings of a Conference on Bank Structure and Competition, Federal Reserve
Bank of Chicago, 1979, pp. 121-45.
^See, for example, Leon Korobow, David P. Stuhr, and Daniel Martin, "A
Nationwide Test of Early Warning Research in Banking," Quarterly Review,
Federal Reserve Bank of New York (Autumn 1977).
g

See, e.g., "Alternative Views on Regulating Conflicts of Interest in The
Financial Firm," in Issues in Financial Regulation, edited by Franklin R.
Edwards (New York: McGraw-Hill, 1979), pp. 123-75.
9
Strictly speaking, there is no specific mention of economies of scale in
the Bank Merger Act or in Section 3 of the Bank Holding Company Act which
deals with acquisitions of banks. Nor is economies of scale a legal defense
under the Sherman Act or Clayton Act, although it may be a legitimate economic
defense.
(See O.E. Williamson, "Economies as An Antitrust Defense: The
Welfare Tradeoffs, American Economic Review, vol. 58 (March 1968), pp. 18-36.
Only under Section 4(c)(8) of the Bank Holding Company Act, which applies to
acquisitions of nonbank companies, is economies of scale a legitimate pffset
to anticompetitive effects. Section 4(c)(8) states that "the Board shall
consider whether its performance [of a nonbanking activity] by an affiliate of
a holding company can reasonably be expected to produce benefits to the
public, such as greater convenience, increased competition, or gains in
efficiency, that outweigh possible adverse effects, such as undue
concentration of resources, decreased or unfair competition, conflicts of
interests, or unsound banking practices." Under Section 3, convenience and
needs of the community, financial and managerial resources, and future
prospects of the banks involved are the only offsets to anticompetitive
effects.




2

The Bank Holding Company Act is one of the few banking regulations to
have been subjected to a cost-benefit analysis. It is doubtful that many
others could stand up as well under such close scrutiny. See Harvey
Rosenblum, "A Cost-Benefit Analysis of the Bank Holding Company Act of 1956” ,
in Proceedings of a Conference on Bank Structure and Competition, Federal
Reserve Bank of Chicago, 1978, pp. 61-98.
^ See Edward J. Kane, ,fGood Intentions and Unintended Evil: The Case
Against Selective Credit Controls,11 Journal of Money, Credit, and Banking,
vol. 9 (February 1977), pp. 55-69 and "Accelerating Inflation, Technological
Innovation, and the Decreasing Effectiveness of Banking Regulation," Journal
of Finance, vol. 36 (May 1981), pp. 355-67.
12

Peter R. Lloyd-Davies, "The Effect of Deposit Rate Ceilings upon the
Density of Bank Locations", in Proceedings of a Conference on Bank Structure
and Competition, Federal Reserve Bank of Chicago, 1977, pp. 1-18.
13
Kristine Chase, "Interest Rate Deregulation, Branching, and Competition
in the Savings and Loan Industry, Federal Home Loan Bank Board Journal, vol.
14 (November 1981), pp. 2-6.
14
With the complete phaseout of Regulation Q, banks will have to offer
rates competitive with money market mutual funds. Banks should have a cost
advantage resulting from federal deposit insurance. Based on casual
observation of the minimum spreads between top quality private sector and U.S.
Government debt with similar maturity and liquidity— for example money market
funds of the same sponsor that invest in private vs. Treasury money market
instruments, it is estimated that this cost advantage will typically be less
than one percentage point.
^General Electric Credit Corporation’s commercial receivables grew at an
18.7 percent annual rate between 1975 and third-quarter 1980. Its net income
grew at an 18.2 percent annual rate over this same period. During this time,
"the type and brand of products financed and the credit granted have been
significantly diversified, and products of companies other than General
Electric now constitute the major portion of the products financed." Moody’s
Bond Survey, February 16, 1981, p. 2747, emphasis added.
16

Randall C. Merris, "Business Loans at Large Commercial Banks: Policies
and Practices," Economic Perspectives, Federal Reserve Bank of Chicago
(November/December 1979), pp. 15-23; see especially pp. 17-19.
^Mark Flannery, "How Do Changes in Market Interest Rates Affect Bank
Profits?" Business Review, Federal Reserve Bank of Philadelphia,
(September/October, 1980).

18

Paul R. Watro, "Financial Services and Small Businesses," Economic
Commentary, Federal Reserve Bank of Cleveland, January 11, 1982.
19

Peter C. Eisemann, "Empirical Evidence on Sources of Business Finance,"
in The Future of the Financial Services Industry, Conference Proceedings,
Federal Reserve Bank of Atlanta, June 1981, pp. 77-84.




3

20

Frederick C. Klein, "Some Firms Fight Ills of Bigness by Keeping
Employee Units Small," Wall Street Journal, February 5, 1982, p. 1.
21

William F. Ford, "Banking’s New Competition: Myths and Realities,"
Economic Review, Federal Reserve Bank of Atlanta (January 1982), p. 11.
22

Ibid, Chart 1 and Chart 2, p. 5.

23

Statement on "Financial Institutions in a Revolutionary Era" to The
Committee on Banking, Finance and Urban Affairs, U.S. House of
Representatives, December 10, 1981, p. 2.
24

See Bernard Shull, "Multiple-Office Banking and the Structure of
Banking Markets: The New York and Virginia Experience," in Proceedings of a
Conference on Bank Structure and Competition, Federal Reserve Bank of Chicago,
1972, pp. 30-40.
25

Lorman L. Lundsten and Lewis Mandell, "Consumer Selection of Banking
Office— Effects of Distance, Services and Interest Rate Differentials," in
Proceedings of a Conference on Bank Structure and Competition, Federal Reserve
Bank of Chicago, 1977, pp. 260-86.
2 6

Such shopping around may involve little cost. Just as billboard CRT
displays of U.S. Government securities prices have revolutionized the
government bond market by reducing transaction and information costs, it can
be expected that similar technology will be extended to less homogeneous
borrowers in the future.
27

Stephen A. Rhoades, "Limitations of Antitrust Law for the Analysis of
Market Extension Mergers," unpublished paper, 1981.
28
Mercantile Texas Corporation v. Board of Governors of the Federal
Reserve System.
29

See Chayim Herzig-Marx, "Comparing Market and Regulatory Assessments of
Bank Condition," in Proceedings of a Conference on Bank Structure and
Competition, Federal Reserve Bank of Chicago, 1977, pp. 89-112. This paper
suggests that the market evaluates the same information as do bank
supervisors; and further, the market prices the cost of bank funds in relation
to risk. See also George G. Kaufman, The U.S. Financial System: Money
Markets, and Institutions (Englewood Cliffs, N.J.: Prentice Hall, 1980),
Ch. 16.