In this period of rapid change in the banking system,
it is important to maintain and strengthen communication between
bankers and the bank supervisory agencies. Today's program contributes
to that objective, and I thank you for inviting me to participate.
I will begin by commenting on several changes and trends in the
banking industry: consolidation, new products and tools, and new
delivery channels. Then, I will suggest some implications and questions
for public policy that I see following from those trends.
Consolidation of Banking
The most obvious trend in banking today is consolidation. In the
last two decades, nearly all the traditional barriers to geographic
expansion have come tumbling down. States took the lead with legislation
liberalizing intrastate branching and permitting interstate bank
holding companies. The federal government followed with the Riegle-Neal
Act in 1994, which allows interstate branch banking.
Banks are taking advantage of these new opportunities, and the
net result has been an unprecedented wave of geographic expansion.
Why are banks consolidating in number and expanding in size and
geography? There is no single factor explaining the current merger
wave, which actually dates back to 1981. Clearly, many banks are
recognizing natural markets that cross political boundaries. For
example, the Washington, D.C., area is one banking market that
had been artificially divided between the District of Columbia
and the states of Maryland and Virginia. Now, it is much easier
for financial institutions to establish offices throughout the
region in a format that fits their business plans. Clearly, there
is some convenience gain to consumers, especially those who work
and live in different political jurisdictions.
A second explanation is the market for corporate control. To
some extent, the market is sorting banks into those viewed as
survivors and those viewed as acquisition targets. In large measure,
this division is based on the market's assessment of management
and the past performance of the bank. Some managers can best maximize
shareholder value by finding a buyer that is willing to pay a
high multiple for future earnings. Other managers can do better
for their shareholders by expansion, including through the acquisition
of banks in new markets.
Third, technological change has always played a role in the
merger movement. Data warehouses, call centers, home banking services,
upgrades to legacy systems all require expensive information technology
investments that can be justified by a larger customer base. Now,
we hear anecdotal evidence that some banks are candidates for
acquisition because they have not been willing or able to update
their technology, or have not been able to adjust to the year
2000 computer problem.
Fourth, consolidation may yield scale economies in some specific
banking activities, and some mergers have led to more efficient
banks. However, the long-term survival and profitability of small
banks suggest there are few overall scale economies in banking.
An efficiently run small bank can provide standard banking services
and be as profitable as a large bank. The scale economies may
arise in services that are more commonly provided by large banks.
Whatever the motives, the transition to a nationwide banking
structure is resulting in many mergers and acquisitions. About
400 healthy-bank mergers now occur each year. The number of banking
organizations has decreased from approximately 12,300 in 1980
to approximately 7,100 now. At the national level, the percentage
of domestic deposits held by the 100 largest organizations increased
from 47 percent in 1980 to nearly 69 percent in 1997.
Turning from banking to the larger financial services industry,
some nonbank firms have expanded to become full service financial
institutions. While banks have had to fight for many years to
provide investment and insurance products, nonbank firms have
been able to enter multiple segments of the financial services
I am a strong supporter of the need to modernize our banking
laws and regulations and recognize that cross-industry consolidation
is inevitable. However, I do not believe that the financial conglomerate
will be the only, or even the dominant, means to distribute financial
services. In the end, for some the challenge of cross marketing
and cross selling financial products will prove to be quite difficult.
Just as I believe that there are customer segments for which small
banks will be the preferred choice, I also believe that there
will be product segments for which focused providers will be viable
New Products and Tools
The second trend of the past several years is the introduction
of many new banking products and tools, and a more intense use
of some products and tools that have existed for quite awhile.
I can only touch on a selected few. First, there have been products
and tools that have changed the nature of lending. Interest rate
swaps, credit scoring systems and the securitization of loans
have all changed some dimension of lending and allowed banks to
more nearly obtain their desired degree of interest rate and credit
New methodologies for the control of risk are another important
advance in banking. Risk that was measured mainly by the judgment
of a loan officer can, to an increasing degree, now be quantified
and risk criteria standardized across loan officers. While most
traditional risk analysis was framed in terms of credit risk,
it is becoming possible to evaluate the whole asset portfolio
in terms of credit risk, interest rate risk, foreign exchange
risk or liquidity risk. With the tools now available, the individual
bank can, to a degree almost unimaginable only a few years ago,
decide on the amounts of the various types of risk that it is
willing to assume and build a portfolio that provides its desired
New retail payment products round out the list. However, they
have not yet overcome the public's attachment to the familiar
payment tools. Debit cards are gaining popularity, but most people
still prefer to have the canceled check as a receipt for the transaction
and gain the float. Stored value cards seem to have great potential
as a means of payment, but most of the experiments conducted thus
far appear to have had limited success.
Channels for the Provision of Banking Services
Finally, the ongoing experimentation with new channels for the
delivery of banking services is very exciting. But, at this point,
the eventual outcome of the experimentation is highly uncertain.
Supermarket branches are receiving much attention these days.
Clearly, there are savings in terms of bricks and mortar, and
many customers like the expanded hours. While this new approach
to the provision of banking services seems to hold great promise,
there have been anecdotal reports that the profitability of supermarket
branches has generally been disappointingly low.
Distribution channels based on computer and communications technology
have also received a great deal of industry attention. ATMs are
the most well-established of those technically driven distribution
channels. Many banks also have their own home page on the World
Wide Web; a few banks offer proprietary home banking services
via telephone or personal computers; and a few offer services
through companies that own the basic personal computer financial
management systems. For some customers comfortable with the technology,
these computer-based systems will likely become the preferred
mode of banking.
Directions for Public Policy
Let me now turn to some of the longer-term public policy implications
of these experiments and changes in structure, products and channels.
I would like to discuss three elements of public policy that
might be influenced by these forces at work in the banking industry.
These areas are: competition policy, using the market to control
risk taking and appropriate policies to foster new products and
Let me start with a few words on banking competition. As I mentioned,
consolidation is a trend in banking. The Bank Merger Act and the
Bank Holding Company Act require that the Board approve only those
mergers that are not expected to adversely affect competition.
In assessing the competitive impact of a proposed merger, the
Board examines many factors. Particularly important are the change
in concentration and the post-acquisition level of concentration
in each local market in which the banks operate. Through its published
orders on applications, the Board has, for many years, attempted
to provide the industry with a reasonably clear indication of
its competitive standards for approval. In particular, when the
basic screening guidelines of the Department of Justice are exceeded,
mitigating factors must be present; the more a proposal exceeds
the screening guidelines, the greater the need that the mitigating
factors be significant.
Policy-makers recognize that measures of concentration are proxies
for the likely impact on pricing and service quality that will
result from a merger. These impacts currently are difficult to
observe directly. Nonetheless, we should remain alert to any evidence
that new technologies and delivery channels are making the current
approach to market definition obsolete. Based on survey evidence,
that time is not yet at hand, but we should recognize that it
may come at some point.
Market Control of Risk Taking
Turning from competition to safety and soundness, the ongoing
changes in the banking industry raise numerous issues. Key safety
and soundness concerns include the accuracy of the Basle Accord's
risk-based capital standards as a measure of risk and, more broadly,
the appropriate role for market discipline on insured depository
institutions. While I obviously cannot discuss these in adequate
detail, I would like to give you a feel for the nature of my concerns.
A core function of central banks is to protect the stability
of the banking and financial systems. But the days when bank examiners
could exercise that function by focusing almost solely on a bank's
books and use simple formulaic rules are long past, if they ever
existed. As I mentioned, we are in an era when financial transactions
are increasingly complex and risk management systems of banks
Given this complexity, how should capital standards vary across
While the Basle Accord was originally intended to apply only
to large, internationally active banks, the accord's designers
worked hard to craft it so that it could be applied in much the
same manner to virtually all banks. But events have called into
question the wisdom of this approach. Supervisors are increasingly
looking for opportunities to use banks' internal measures of risk
for ensuring adequate control. Thus, for example, U. S. bank supervisors
have recently moved to require only large, internationally active,
American banks to meet the accord's capital requirements for market
risk using their own "internal models" with appropriate monitoring
and safeguards imposed by the supervisors. Moreover, efforts are
under way to see if we can advance further in this direction with
respect to credit risk in the banking book.
On a closely related front, the Federal Reserve has been exploring
incentive-compatible capital standards for market risk in the
trading account. One approach, the "pre-commitment" approach,
requires an institution to formally identify and disclose a level
of potential loss beyond which it would be subject to severe supervisory
penalties. This approach recognizes differences among institutions
in the nature of their trading activities while providing strong
incentives to ensure prudent risk management, more efficient allocation
of capital and the maintenance of minimum prudential standards.
There are both benefits and problems with such approaches. However,
with refinement, some form of individually designed capital requirements
may well be a reasonable evolution from the internal models approach
for establishing capital adequacy of a trading business. Therefore,
the time is here for regulators, domestic and international, to
seriously review the viability of these intriguing alternatives.
More generally, when designing supervisory policy, I believe
that we should always remember that markets can, and normally
do, provide powerful incentives to control risk. Perhaps there
is more that we can do to allow market incentives to be an ally
in public policy. I wonder whether, eventually, we might wish
to shrink the coverage of the deposit insurance safety net further.
It might be reasonable to ask if some of today's range of banking
products and services should be removed from the list of financial
activities meriting such support.
Perhaps a touchstone of future regulatory reform might be either
a narrowing of the banks covered by full deposit insurance or
a reduction of insurance coverage. The clear goal should be to
reduce the moral hazard in--and hence the regulation imposed upon--our
Another approach that I believe deserves some future debate
is requiring banks to issue a minimum amount of subordinated debt
to unrelated parties. An active market in such debt would give
banks and their investors an incentive to bring more transparency
to the banking endeavor and could be quite useful for more market-based
These are only ideas now, ideas that seem to many to be impractical.
The doubters may be right, but we should not stop debating how
to use market incentives, rather than supervision, to control
Policies Toward New Products and Services
Finally, we need to speed the development of modern, efficient
and safe retail payment products and services. Although the Federal
Reserve has a role as provider of interbank clearing and settlement
services to banks and thrifts, and will continue to play that
role, the market will ultimately decide which electronic payment
products and services will best meet the needs of households and
small businesses. However, I believe that the Federal Reserve
should look for ways to encourage the private sector in fostering
experimentation with, and expanding usage of, newer retail payment
Our role might include identifying and reducing regulatory burdens
that unreasonably inhibit experimentation. Regulation may reduce
uncertainty and product development costs for some, but it may
also discourage investment in new products or technologies by
others. This is particularly true if the product is relatively
new, and demand for it is relatively uncertain, as is currently
the case with stored-value cards. Thus, in my view, the government
should avoid regulatory actions that may inhibit the evolution
of emerging payment products and services or prevent the effective
operation of competitive market forces. It is much too early to
regulate these new products.
Well, I hope that I have provided a few ideas for you to think
about. Let me conclude with a short recap of my major points.
The financial system is rapidly consolidating, and new products,
services and channels are being developed.
The vast changes occurring in our financial system also raise
new questions for our public policy debates. Do we measure the
competitive impact of mergers correctly? What is the best way
to set capital standards? How can we use market forces to control
risk taking? How do we foster new financial products and services?
I do not have answers to each of these questions. However, I do
know that, to be successful, supervisors will surely need to adapt
in new and innovative ways. The task before us is not easy. Balancing
sometimes conflicting goals remains a challenging task for both
banks and their supervisors, but I believe we have no choice but
to adapt to our rapidly evolving financial landscape.
Governor Ferguson made these remarks
[via Board of Governors] to the Ohio Bankers Day conference in Columbus earlier this year.