^^ United states

Department of

Agriculture

Economic

Research

Service

Rural Development

Research Report

Number 76

c 3

Prospective Rural

Effects of Bank

Deregulation

Stephen W. Hiemstra

•^5i-

'^C -p»

rr • ' , -o

^VA - :d>

"Z.^- C^ --

CO •>. !,.'■■''

;c ■■-

'5-V-, .-3

O

73 r^
It's Easy To Order Another Copy!

Just dial 1-800-999-6779. Toll free (in the United States and Canada).

All other areas please dial 301-725-7937.

Ask for Prospective Rural Effects of Bank Deregulation (RDRR-76).

The cost is $11.00 per copy. For non-U.S. addresses, add 25 percent (includes

Canada). Charge your purchase to your VISA or MasterCard, or we can bill you. Or

send a check or purchase order (made payable to ERS-NASS) to:

ERS-NASS

P.O. Box 1608

Rockville, MD 20849-1608.

We'll fill your order via 1st class mail.
Prospective Rural Effects of Bank Deregulation. By Stephen W. Hiemstra.

Agriculture and Rural Economy Division, Economic Research Service, U.S.

Department of Agriculture. Rural Development Research Report No. 76.

Abstract

Congressional legislation in 1988, not passed but still under consideration,

would repeal provisions of the National Bank Act of 1933, known collectively

as the Glass-Steagall Act. The proposed legislation would expand the powers

of commercial banks to underwrite securities both in the bank and through a

bank holding company affiliate. These powers may generally encourage greater

bank operating efficiency and reduce portfolio risk through diversification.

Rural bank participation, however, is expected to be low because most rural

banks are small, and they have relatively little experience with securities

markets. Little net increase in rural growth is expected because efficiency

gains are likely to be small. Few benefits of new bank powers may accrue to

rural banks to offset insolvency risks and increased competition from

innovative urban banks.

Ke3rwords: Banks, deregulation, bank regulation, rural development, GlassSteagall Act, rural banks, agricultural finance, investment

banking, securities markets, commercial banking, credit markets,

agricultural credit markets, rural credit markets, and bank powers.

Acknowledgments

The author recognizes the helpful comments of many colleagues, including Gail

Bolear of the American Bankers Association, Greg Gajewski, Steven R. Koenig,

Jim Mikesell, Dan Milkove, Clifford Rossi, and Jerome Stam of the Economic

Research Service, Weldon Barton of the Independent Bankers Association of

America, David Freshwater of the Joint Economic Committee, U.S. Congress,

William J. Fitzpatrick and George R. Monahan of the Security Industry

Association, and William Herr of Southern Illinois University. Ron Durst and

Pat Sullivan, ERS, provided technical advice and administrative support for

this research. Paula Dyer furnished valuable support in preparation of this

report. Jim Carlin of the Economics Management Staff provided editorial

assistance.

Note

Use of trade names in this publication is for identification only and does not

imply endorsement by the U.S. Department of Agriculture.

1301 New York Avenue, NW.

Washington, DC 20005-4788 March 1990
Preface

The Financial Modernization Act of 1988 (Senate Bill 1886) and the Depository

Institutions Act of 1988 (House of Representatives Bill 5094) updated existing

conunercial bank regulations to conform to a changing marketplace. Both bills

were reported out of committee, but because of disagreements in the House a

conference committee never convened. Congress is likely to act on the issue

of bank product deregulation in the future because of Administration support,

regulatory innovation, and market incentives.

Recognizing the ongoing nature of the bank product deregulation discussion,

this study outlines some of the issues affecting rural institutions and rural

growth. By focusing on rural issues, the hope is that future legislation will

be better able to meet the challenges facing rural America.

Contents

Page

Summary ill

Abbreviations iv

Glossary v

Introduction ..... 1

The Financial Modernization Act of 1988 2

New Powers and Restrictions 2

Provisions of Special Interest to Rural Areas ...... 4

The Future of Congressional Action on Product Deregulation .... 5

The General Case For Bank Product Deregulation 5

Factors Motivating Reform of Banking Legislation ... . 6

Potential Efficiency Gains with Deregulation . 12

Safety and Soundness Considerations 20

Deregulation Issues Affecting Rural Areas . ... 23

Effects on Rural Banks ......... 23

Effects on Rural Issuers . 30

Effects on Rural Economic Growth 31

Safety and Soundness Considerations 36

References 37

Appendix: Detailed Legislative Review 48

11
Summary

Congressional legislation in 1988 tried to repeal provisions of the National

Bank Act of 1933, known collectively as the Glass-Steagall Act. The proposed

legislation would expand the powers of commercial banks to underwrite

securities both in the bank and through a bank holding company (BHC)

affiliate. These powers may generally encourage greater bank operating

efficiency and reduce portfolio risk through diversification. Rural bank

participation, however, is expected to be low because most rural banks are

small and have relatively little experience with securities markets. Little

net increase in rural growth is expected because efficiency gains are likely

to be small. Few benefits of new bank powers may accrue to rural banks to

offset insolvency risks and increased competition from innovative urban banks.

Current analyses provide few solid conclusions about how repealing the GlassSteagall Act will affect rural banks and issuers. The precise form of the

eventual legislation has yet to emerge, and rural linkages to national markets

are changing rapidly. General observations can, however, be made.

An important starting place in evaluating bank product deregulation is to

observe that the benefits of deregulation accrue from increases in firm and

market efficiencies. Efficiency increases may result, for example, from

shared technology and personnel that might be better utilized by a more

diversified banking firm. Efficiency gains are, however, likely to be small.

Commercial banks can already offer numerous financial services, including the

underwriting and trading of many security products, and most banks do not take

advantage of the security powers already permitted. This is particularly true

of small, rural banks.

Potential increases in efficiency can accrue to rural banks and rural issuers

only if they participate. But, participation appears more likely for large

firms than for small, rural firms, limiting extensive benefits to communities

not served by large banks. Participation by smaller firms is feasible in the

context of BHC's, loan participations, and securities syndications, but the

most lucrative profits are likely to accrue to larger firms with enough

capital to organize deals and benefit from scale economies. The ability to

share in joint securities offerings is unlikely to be as profitable for small

banks as for large banks because few advantages exist beyond those currently

available to rural banks through loan participations.

While rural communities are unlikely to be net gainers from product

deregulation, large, well-managed rural banks could very well benefit. A

rural BHC could, for example, form a securities affiliate for purposes of

starting a mutual fund and compete nationwide for investors' savings. Most of

the alternatives that provide adept bank managers opportunities for growth,

however, suggest greater linkage with national than local markets for credit.

Prospective examples of successful rural bank entry into securities markets,

particularly most new rural business generated by these new bank powers, may

come from the substitution of security for loan financing and of rural for

urban financing.

Bank product deregulation may entail additional risks for rural firms. Two

risks stand out. First, smaller firms are less likely than larger firms to

understand securities markets. Before the passage of Glass-Steagall, rural

banks were often sold securities at par value that could not be sold

111
elsewhere. So, new bank powers pose a greater challenge to managers of small

banks than to large banks because securities markets are more removed from the

basic business of rural banking and because more demands are already placed on

individual managers in a small bank than in a large bank. The same kinds of

problems can arise for small issuers. Second^ increased risk from any source

that results in insolvencies may affect rural banks more than urban banks

because of their smaller size and the general tendency of bank regulators to

treat smaller banks as more expendable. If regulators were to provide the

small banks the same treatment as large banks, this problem would, in part, be

alleviated. If small rural bank failures have a larger impact on rural

communities than small urban bank failures have on urban communities, then

equal bank treatment may not imply equal prospects for economic development.

Abbreviations

BHG Bank holding company

CAMEL Capital, assets, management, earnings, and liquidity

CD Certificates of deposit

CRA Community Reinvestment Act of 1977

BFHC Diversified Financial Holding Company

DIDMCA Depository Institutions Deregulation and Monetary

Control Act of 1980

EC European Community

FADA Federal Asset Disposition Association

FDIC Federal Deposit Insurance Corporation

Federal Reserve Board of Goverüors of the Federal Reserve System

FSLIC Federal Savings and Loan Insurance Corporation

GAO General Accounting Office

LBO Leveraged buyout

MBHC Multibank holding company

MMMF Money market mutual fund

Metro Metropolitan

SEC Securities and Exchange Commission

SIPC Securities Investor Protection Corporation

IV
Glossary

Agricultural bank. A bank that has at least 25 percent of its assets invested

in agricultural loans.

Agency issue. A security, tjrpically a bond or pass-through security, that is

issued by the Federal Government or a government-sponsored enterprise (public

corporation).

Basis points. One hundred basis points are defined to equal 1 percent.

Bank holding company. A company that owns one or more separately incorporated

banks.

Broker, An agent that arranges transactions between buyers and sellers

without taking title to the underlying commodity, such as common stock.

Commercial bank. A bank that takes deposits and makes loans as its primary

business.

Dealer. An agent that purchases a commodity, such as common stock, in large

quantities like a wholesaler with the objective of selling smaller lots to the

public like a retailer. The New York Stock Exchange employs dealers as market

makers who keep the market liquid by standing ready to buy and sell stock at

market prices. The difference between quoted purchase and sale price is the

dealer's margin.

Deregulation. Regulatory reform designed to increase reliance on market

incentives.

Economies of scope. Exist when the cost of providing joint products (or

services) declines as the production volume increases.

Investment bank. A bank that underwrites corporate stocks and bonds as its

primary business.

Leveraged buyout. The acquisition of a corporation financed by unsecured

debt. This debt will presumably be repaid with revenues generated by future

profits, the closing of unprofitable divisions, and asset sales.

Money center bank. A large bank located in a major financial center, such as

New York.

Rural bank. A bank that has its headquarters in a nonmetropolitan county.

Scale economies. Exist when the cost of providing a product (or service)

declines as the quantity produced increases.

Shelf-registration. A program introduced by the Securities and Exchange

Commission that allows issuers to complete the registration procedure in

advance so that once the decision to issue bonds is made, they can be issued

with minimal administrative delay.
Prospective Rural Effects of

Bank Deregulation

Stephen W. Hiemstra

Introduction

The Financial Modernization Act of 1988 (Senate bill 1886) was one of several

failed attempts in the 1980's to expand the types of financial services that

commercial banks can offer/ In particular, this legislative proposal would

have repealed provisions of the National Bank Act of 1933 (commonly known as

the Glass-Steagall Act) that limit commercial banks from underwriting various

classes of securities^ and separate commercial banking from investment

banking. Under this proposal, banks underwrite securities only after being

restructured as a bank holding company (BHC). Underwriting activities are

confined to a securities affiliate of the BHC. Other provisions of the

legislation expand the power of regulators to oversee these changes, mandate

disclosure of contract terms to depositors and borrowers, and clarify existing

regulations that allow banks to underwrite insurance. Parallel legislation in

the House of Representatives (H.R. 5094) provided more limited security

underwriting powers and expanded the list of consumer protection provisions

required as compensation for the advantages bestowed on commercial banks.

The Bank Holding Company Act of 1970 defined commercial banking as the

business of taking deposits and making loans (Huertas).^ Commercial banks can

be free-standing firms, a branch office, or a subsidiary of a holding company.

Commercial banks raise funds through many different channels, such as time and

demand deposits and the sale of certificates of deposit (CD's). Their

investments are largely short-term commercial and industrial loans. Treasury

securities, and obligations of State and local governments. Commercial banks

are regulated by the Board of Governors of the Federal Reserve System (Federal

Reserve), the Federal Deposit Insurance Corporation (FDTC), the Comptroller of

the Currency (an agency of the U.S. Department of the Treasury), and State

chartering agencies.

Investment banking is the business of assisting public agencies and private

corporations in raising capital through underwriting stocks, bonds, and assetbacked securities. Underwriting is the core function of investment banking

and consists of three components: origination, risk-bearing, and distribution

(Pugel and White; Giddy). Other functions performed by investment bankers

include brokering, dealing, risk arbitrage, and management counseling (Bloch).

The markets served by investment bankers are divided mainly into these

categories: corporate and government securities, negotiated versus

The author wrote this report while a financial economist with the Agriculture and Rural Economy Division,

Economic Research Service, U.S. Department of Agriculture. He is currently a financial economist with the

Farm Credit Administration.

^The Senate passed a similar bill (S. 2851) on September 13, 198A, which permitted bank holding companies

to underwrite municipal revenue bonds, mortgage-backed securities, and commercial paper. No action was

taken by the House of Representatives (Proxmire).

In this report, securities means common stock, bonds, government issues, mortgage-backed obligations, and

any other obligation issued by a corporation or government entity for purposes of raising investment capital

or transferring ownership.

Names in parentheses cite sources listed in the References section.
competitive bidding, publiely offered or privately placed, underwriting versus

brokerage/dealing, mergers and acquisitions, regional versus national, and

domestic versus foreign (Hayes, Spence, and Marks). The investment banking

business is regulated in public offerings by the Securities and Exchange

Commission (SEC).

This report focuses on rural implications of the expansion of commercial banks

into investment banking and ;addresses these spécifie questions:

o What provisions were iñ the proposed legislation?

o What will be the general effects of bank product deregulation?

o How might these proposals have affected rural issuers and banks, and

rural economic growth?

This report evaluates the proposed legislation against existing research and

frames questions for further discussion and inquiry.

The Financial Modernization Act of 1Ï88

The objective of^ deregulation is to reduce the regulatory barriers to entry

ixito commercial and investment banking, insurance underwriting, real es1:ate

investment, and xxther financial services. Reduced barriers to entry should

increase competition, lowering prices to consumers and enhancing the

competitiveness of U.S. firms. Bills introduced in 1988 proposed to lower

some barriers to entry and to compartmentalize financial activities to

simplify regulation. These bills require Federal banking regulators to

analyze ways of providing more consistent and equitable regulatrion.

New Powers and Restrictions

Bank deregulation legislation in 1988 focused on Senate bill 1886, known as

the Financial Modernization Act of 1988.^ Table 1 presents añ outline of the

titles of this and the parallel House bill, the Depository Institutions Act of

1988. Frovisions affecting^ leural areas are highlighted below. The appendix

provides a more detailed review of the provisions.

The House and Senate bills both balance the new bank powers wit:h new

regulations protecting consumers.

New Commercial Bank Powers

The Senate bill's first title repeals^ sections 20 and 32 of the Glass-Steagal^^^

Act which forbid commercial bank entry into securities underwriting. Parallel

provisions restricting investment banks^ entry into commercial lending were

not repealed. The House bill amends these sections, retaining the prohibition

on the underwriting of corporate equities. This prohibition is significant

because corporate equities are the most risky and the most profitable

securities to underwrite.'

^irth (1986) provides a legislative history covering product deregulation bills introdiiced in the

Congress during 1983-85.

The standard deviation of returns is a proxy ïor risk, and mean return is a proxy for profitability.

During 1947-84, corporate stock had a mean return of 12,48 percent/ with a standard deviation of 17.17

percent. All other individual investments, as a class, had lower mean returns and lower standard

deviations. A typical market portfolio for this period had a mean return of 7.92 percent and a standard

deviation of 4.64 percent (Irwin, Forester, and Sherrick).
Table 1--Titles contained in Senate bill 1886 and House of Representatives

bill 5094, 1988

Title Senate 1886 House of Representatives 5094

I Securities affiliates of BHC's

(pp. 4-49)

II Expedited procedures (pp. 50-61)

III Brokers and dealers (pp. 61-70)

IV Bank investment company

activities (pp. 70-79)

VI

Strengthened enforcement

authority (pp. 79-131)

Truth in savings and investment

(pp. 132-S3)

VII Home equity loans (pp. 154-69)

VIII Insurance activities

(pp. 169-79)

IX Miscellaneous (pp. 180-93)

S ecur i t i e s act iviti e s of

national banks and BHC

subsidiaries (pp. 3-57)

Bank and consumer safeguard

provisions (pp. 57-82)

Insurance activities (pp. 82-95)

Consumer protection provis ions :

Community benefits

Agency reforms

Access to financial services

Notice of branch closures

by bank and thr ift

institutions

Truth in savings

Home equity loan requirements

Expedited funds availability

amendments

Access to credit (pp. 96-237)

Real estate activities

(pp. 238-42)

Enhanced enforceinent power:

Insider abuse prevention and

enhanced enforGement powers

Report to Congress

(pp. 242-342)

Federal asset disposition

association (pp. 343-55)

Miscellaneous provisions and

technical and conforming

amenckients relating to

reorganization (pp. 356-76)

BHC - Bank holding company.
New Commercial Bank Restrictions

The House and Senate bills impose different restrictions for the privilege of

underwriting securities. The House bill places more emphasis on new banking

restrictions than the Senate bill.® The House bill's amendmeTits to the

Community Reinvestment Act (CRA) of 1977, for example, constitute a major

policy initiative directing bank resources toward urban and rural community

development projects. The Senate bill outlines broad policy parameters while

the House bill details specific regulatory guidelines.

The House and Senate bills agree on other new restrictions. The bills require

that banks adopt a BHC structure and provide securities services through an

affiliate,^ giving the Federal Reserve primary jurisdiction over the new

entities. The BHC structure retains an organizational separation of

commercial and investment banking activities, facilitates regulatory oversight

by function, and insulates the bank from affiliate losses. The bills forbid

commercial banks from underwriting insurance, except as permitted by State law

and except in small, rural communities.They also strengthen regulatory

oversight and consumer disclosure requirements and expedite bank conversion

into BHC's.

New Regulatory Focus

These proposals shift the focus of bank regulation and call for greater

coordination among Federal banking^ regulators to reduce financial incentives

to change bank structure or recharter (regulatory arbitrage). Both bills

propose a new balance between consumer and industry benefits, but bankers

prefer the Senate version.

Provisions of Special Interest to Rural Areas

Some provisions in both bills were written specifically to benefit

agricultural banks and small banks. Amendments to the Bank Holding Company

Act permit small banks to organize BHC's so that rural banks can participate

in securities markets.

Rural banks also benefit from exemptions to new restrictions imposed on

commercial banks. Banks with $500 million or less in assets are, for example,

exempted from prohibitions on individuals serving on the boards of directors

of several banks (interlocking directorates). Small banks ($25 million or

less in assets) and agricultural banks with no more than $50 million In assets

are also exempted from most CRA amenctoents. Some assets of special interest

to rural banks are exempted from SEC registration and may be originated by

banks directly, rather than through an affiliate. These assets include

municipal bonds. Farmer Mac® securities, and Investments in small business

investment companies.

Both the House and Senate bills exempt rural banks in communities with

populations below 5,000 from general prohibition on underwriting Insurance.

^The title strengthening enforeement powers, for example, takes up 52 pages in the Senate bill and 100

pages in the House bill.

"in a legal sense, an affiliate Of a corporation is a person that controls, is controlled by, or is under

common control with the corporation. A "person" in this context may be a natural person, corporation,

partnership, some kinds of trusts, or other organized groups of people (R. Clark).

^Farmer Mac is the trade name of the Federal Agricultural Mortgage Corporation organized under provisions

of the Agricultural Credit Act of 1987. Farmer Mac will guarantee pools of agricultural real estate loans

(Hiemstra, Koenig, and Freshwater).
This exemption provides no new authority, however, because Federal bank

regulators previously granted this exemption in agency regulations.®

The Future of Congressional Action on Product Deregulation

Two considerations affect the future of congressional attempts to repeal the

Glass-Steagall Act. First, Federal Reserve Chairman Alan Greenspan strongly

endorses bank deregulation and has used regulatory innovation (allowing

selected banks to underwrite securities) to prompt Congressional action. The

FDIC has likewise issued opinions that allow some commercial banks more

securities powers (Eisenbeis). Second, resolution of the thrift crisis took

precedence over deregulation in Congress in 1989. Soundness considerations

are now expected to receive a higher priority in future deregulation

proposals. ^°

The General Case For Bank Product Deregulation

The commercial and investment banking industries are highly regulated. Past

deregulation focused on relaxing deposit interest rate ceilings, expanding

permissible financial services, and easing geographic limits on branching and

acquisitions. The objectives of deregulation are to increase competitive

equity ("level the playing field"), customer convenience, and firm

profitability (Wirth). Bank product deregulation focuses on eliminating the

separation of commercial and investment banking mandated by the Glass-Steagall

Act of 1933.

At the time of its passage, the Glass-Steagall Act had three objectives: to

discourage speculation, to prevent conflicts of interest, and to promote bank

soundness (Hayes, Spence, and Marks). Recent congressional hearings cited

these objectives in regulating commercial banking:

o To ensure market access,

o To balance competition and soundness,

o To enhance market efficiency by preventing conflicts of interest,

o To ensure responsible financial management,

o To promote economic growth, and

o To protect consumers.

Structural separation of commercial and investment banking presumably fosters

these goals by: ensuring adequate financing for all sectors, widening

informed opinion on financial policy, preventing conflicts of interest and

concentration, minimizing the policing of transactions, and encouraging

competition (Wirth) .""^

The case for repealing the Glass-Steagall Act rests on presumed efficiency

benefits. The debate over these benefits has focused on scale economies in

banking and securities underwriting, competitive effects, and activity

^Efforts to deregulate financial services in the European Community (EC), while more advanced in the area

of allowing commercial banks to underwrite securities, have also not shown much success in liberalizing

insurance markets. A fair degree of reciprocity among member states is provided to commercial banking

services, some is allowed for securities services, but almost none is allowed in insurance services (Key).

Gilbert surveyed the wider array of proposals for reforming banking legislation.

^^Eisenbeis pointed to five considerations in evaluating the desirability of policy reform in banking:

(1) economic efficiency, (2) risk, (3) conflicts of interest, (4) concentration of power, and (5)

competitive equity.
diversification. Arguments against repeal focus on bank safety and

soundness. ^^

Factors Motivating Reform of Banking Législation

The factors motivating repeal of the Glass-Steagall Act may be classified as

pressures on commercial banks, pressures on investment banks, and

miscellaneous factors, such as changing political values, international

competition, and technological change.^V Because the Glass-Steagall Act

remains an unresolved issue, review of these motivating factors is

appropriate.

Pressures on Commercial Banks

The 1980's have been hard on conraiereial banks. Rising interest rates have

increased the cost of loanable funds and motivated investment in riskier

assets. New financial products and innovative nonbank firms led to increased

competition. Increased competition and more volatile Interest rates have

raised the risk of existing assets. Problem loans in energy, real estate,

agriculture, and developing countries have led to losses. Bankers have

reacted by calling for more equitable regulatory treatment and increased bank

powers.^^

Rising Interest Rates. Interest rate deregulation and rising interest rates

have provided incentives for change in the financial services industry in

recent years. Following the Penn Central bankruptcy in 1970, the Federal

Reserve permitted banks to issue large denomination CD's at market rates to

^restore liquidity in the commercial paper market (Brimmer). Securities

brokers responded by introducing money market mutual funds (MMMF's). In turn,

these MMMF's drew deposits away from banks and thrifts too small to issaae

large CD's whenever interest rates rose above interest rate ceilings on their

deposit accounts (Wirth). Interest in MMMF's was accordingly strongest when

interest rates rose above 5.25 percent. Figure 1 shows selected long-term

interest rates, 1970-86.

The Depository Institutions Deregulation and Monetary Control Act of 1980

(DIDMCA) and the Garn-St. Germain Depository Institutions Act of 1982 (GarnSt. Germain Act) phased out the Federal Reserve ceilings found in Regulation

Q. These acts permitted banks and savings and loan companies (thrifts) to

offer financial products, such as money market accounts arid adjustable-rate

mortgages, to enhance their competitive position (Federal Reserve Bank of

Chicago).

The Securities Industry Association published a white paper which outlines its perspective on conmercial

bank deregulation and seeks to rebut many of the arguiments supporting repeal of Glass-Steagall. Kaufman

(1988b) provides a recent review of hank securities activities. Cargill argues that the Glass-Steagall Act

is still needed.

^ In a similar review, Kaufman (1988b) cited five factors influencing banks to expand their securities

operations: (1) advances in information-processing and conmunications technology; (2) declining

profitability of permitted bank activities; (3) rapid growth and large profits In full-service securities

activities; (A) a more liberal interpretation of the Glass-Steagall Act by regulators and the courts; and

(5) growing internationalization of financial markets.

Coiwnerciai banks have also introduced financial products competing with the investment banks and

investment trusts. In the early 1970's, for example, a number of banks began offering "automatic investment

services," (AIS's) and related "closed-end investment funds," An AIS is an investment service in which bank

customers can elect to withdraw a fixed amount each month from their checking account for investment in any

of the top 25 corporations listed in the Standard & Poor's Industrial Index. A closed-end investment fund

is an investment fund that "does not continuously engage in issuing and redeeming shares fox customers'

accounts, nor will it issue new shares after an initial offering, except at infrequent intervals/ and will

not redeem issued shares" (Clark and Saunders).
Figure 1-Selected quarterly interest rates, 1970-86

Percent

20

16

12

Commercial bank

home mortgages

Federal land bank

farm mortgages

I i i_ _j I I I 1 i

Treasury bonds

J 1 1 L_

1970 1975 1980 1985

Competition from New Financial Products. Several financial innovations were

particularly damaging to commercial banks as interest rates rose in the

1970's. Corporate borrowers increased use of commercial paper and private

placement bonds and decreased use of commercial bank loans. Commercial paper,

bonds, and large denomination bank CD's compete in money markets. Bank

reserve requirements increased the cost of bank CD's. Higher interest rates

reduced bank access to deposit funds and increased reliance on CD's. The cost

of holding reserves, therefore, disadvantaged banks in competing for corporate

accounts (Zigas; Rowe; Ricks) J* MMMF's provided a similar alternative for

small investors (Federal Reserve Bank of Chicago; Rosenthai and Ocampo).

These innovations made it harder for banks to keep both corporate clients and

depositors when interest rates rose above Regulation Q ceilings. Bank

profitability suffered.

Geographic Restrictions on Branching and Firm Acquisition. Bank failures have

risen rapidly in the 1980's. The number of banks closed by the FDIC rose from

10 in 1980 to a record 184 in 1987 (fig. 2). These failures were concentrated

in energy- and agriculture-dependent regions and rose with reduced bank

profitability and portfolio assets (Savage; Kling; Simmons). Following the

1981-82 recession, for example, oil-dependent coimnunities in the Southwest

suffered from lower oil prices that reduced emplojnnent and growth in the local

economy. Agricultural communities likewise suffered losses during this period

as higher exchange rates reduced agricultural exports and farm incomes

(Gajewski and Burkhart). The close tie between commercial banks and their

ISTIn a review of the growth in the commercial paper market in the 1970/s, Rosenthal and Ocampo estimated

that AAA corporate borrowers saved 70 basis points (0.7 percent) in 1970 by switching from bank loan to

commercial paper financing.
communities led to pressure to remove geographic restrictions on branch

banking and BHC's (Korobow and Budzeika; Amel and Keane; Rhoades).

Developing-Country Debts. OPEC earnings deposited in U.S. banks after the

1973 oil embargo pressured the banks to extend profitable, large-dollar loans

to developing countries. Debt-repa5nnent difficulties followed the change in

U.S. monetary policy after the 1978 oil crisis and led to bank losses. The

failure of the Continental Illinois National Bank and Trust Company, a

commercial bank with assets of $41.4 billion was, for example, partly

attributed to developing-country debts.'® Developing-country debt repayment

problems continue to depress the earnings of the Nation's leading commercial

banks relative to foreign and regional competitors (Shane and Stallings;

Truell; Board of Governors, Federal Reserve System, 1988).''^

Pressures on Investment Banking

The pressures on investment banking for regulatory change arise, in part, from

poor public relations and a perception that the industry is tightly held.

Poor Public Relations. The effort to repeal Glass-Steagall garners support

from the public's general uneasiness with the securities market following the

crash of October 19, 1987, and recent insider trading scandals. More focused

concern centers on excessive use of low-grade corporate bonds (alternatively,

"high-yield" or "junk" bonds) to finance leveraged buyouts (LBO's) (Rudnitsky

and others).

An LBO is an acquisition of a corporation using future profits, the closing of

unprofitable divisions, and sales of assets to generate revenues needed to

retire the bonds issued (Vise and Coll). Because many of these unprofitable

divisions are older, labor-intensive production facilities, the rapid growth

of LBO's in the 1980's may have accelerated unemployment in some areas of the

country (Bluestone and Harrison). The increased debt burden may leave the

reorganized firm vulnerable to cyclical decline. Congress has been concerned

about tax revenues lost as companies switch from equity to debt financing.

Discontent with LBO financing has often been directed at the investment

banking industry even though commercial banks often play an important role

(Thompson; Linowes; Victor) .^®

LBO's played an important role in restructuring food system corporations in

the early 1980's. Companies in the meatpacking industry made extensive use of

LBO's in the early 1980's to introduce new technology, reduce labor costs, and

reduce losses on unprofitable plants (Business Week. 1982, 1983, and 1984;

Wiener; Kichen and Ozanian; Farhi; Coll, 1988b).

Need for Greater Domestic Competition. An important argument for repealing

the Glass-Steagall Act is that restrictions on commercial bank entry into

^^Continental Illinois failed in May 1985 and was balled out by the FDIC with the cooperation of other

Federal bank regulators. To put this failure into perspective, the total assets of the 79 conmercial banks

and thrifts that failed in 1984 amounted to $3.3 billion (Jackson).

^^Meltzer used market value to book value ratios to evaluate the strength of 40 publicly traded U.S. banks

and reported that the 10 lowest valued banks had ratios ranging from 55 to 75 percent. Included among these

poor performers were **several of the largest banks in the country." On average, these poor performers had

invested one-third of their portfolios in foreign loans. The poor valuation of these banks reflects the

fact that developing-country debt, such as loans to Mexico, currently trade on secondary markets at 30 to 40

cents on the dollar (Melloan).

A typical LBO financing consists of 50-60 percent secured bank loans, roughly 30 percent low-grade

bonds, and 10-20 percent equity financing. The Comptroller of the Currency estimated that of the $150-$18Ö

billion in LBO debt outstanding, $80 billion is held by commercial banks (Thompson).

8
Figure 2--Commercial bank failures reported by tlie FDiC

Number Qf. ^ .

commercial banks

200

150 —

100

50

1970 1975 1980 1985

investment banking raise underwriting costs. For markets in which commercial

banks underwrite securities--U.S. treasury obligations, general obligation

municipal bonds, bond issues for housing, and other securities--in competition

with other underwriters, most studies show that competition lowers the cost to

issuers. Silber (1980), for example, surveyed studies of commercial bank

underwriting of municipal revenue bonds and concluded that eligibility to

underwrite a particular class of municipal bond reduced the net interest cost

for issuers from 3.5 to 14 basis points.

Pugel and White studied competition in underwriting and concluded that spreads

in underwriting fees are smaller for debt than equity issues, well-known

companies making second issues, large issuing companies, large dollar amount

issues, and competitive rather than negotiated underwritings (by public

utilities). This pattern is consistent with cost factors. When combined with

other evidence (such as high employee salaries), it suggests that increasing

competition may lower issuing costs.^®

The securities industry is not always more profitable than commercial banking.

It is, however, generally more profitable than manufacturing or commercial

banking (Pugel and White). The investment banking profits during the last

bull market (August 1982 through August 1987) came at a time when commercial

'^This is clearly the position of commercial bankers. Advocates for investment bankers stress the

relationship between issue characteristics and cost factors. They also point out that competitive

conditions have changed dramatically in the 1980's with the introduction of shelf registration, new

technology, and because of the October 1987 market crash. A leading firm in the municipal bond market

(Salomon Brothers), for example, recently left the market entirely following losses suffered, in part,

because of changes in the tax law, technological and organizational change, and increased market competition

(Doran, Mysak, and McCorry; Bianco).
bank failures were high and rising (fig. 2), suggesting perhaps why money

center banks have taken an interest in new bank powers (Ford) .

Other Pressures for Change

Efforts to repeal the Glass-Steagall Act gather support from groups generally

opposed to regulation and from perceived weaknesses in the legislation. New

financial products, offshore banking, and competition from nonbank financial

firms weaken the separation of commercial and investment banking.

Pro-Competitive Political Values, Deregulation advocates prefer market

outcomes and focus on increasing economic efficiency. They typically discount

bank safety and soundness concerns because deposit insurance ensures that bank

insolvencies do not individually threaten financial system stability. On the

contrary, they welcome insolvencies as a market incentive encouraging improved

credit pricing and lower costs (Meltzer).

Efforts to repeal the Glass-Steagall Act continue. Implementation of a riskbased capital requirement will simplify repealing the act by discouraging

excessive risk-taking. Changes in Federal Reserve regulations have lowered

the threshold between commercial and investraent banking by allowing several

BHC subsidiaries to underwrite certain classes of securities. These BHC's may

underwrite commercial paper, municipal revenue bonds, and asset-backed

securities, provided such activities do not exceed 5 percent of gross earnings

(Taylor, 1988a and 1988b ; and Guenther, 1988a>.

International Competitive Pressures. The globalization of trading and dealing

in bond and equity markets may have reduced the effectiveness of the GlassSteagall Act. Several observations support this argument. First, problems

created during the October stock market crash in 1987 in one national market

spilled over into other markets (Anders and Forman). The separation of

commercial banking and investment banking in the United States provided no

bulwark against this instability because banks operating abroad, including

U.S. banks, underwrite securities. Second, large U.S. commercial banks have

recently suffered significant losses. Finally, the Glass-Steagall Act^ may

disadvantage U.S. banks relative to foreign banks. Large corporate clients

may find cheaper financing through offshore banking centers, such as the

Eurobond market^\ where foreign banks offer additional competition.^

The United States has promoted international financial services liberalization

through the General Agreement on Tariffs and Trade (GATT) and other forums.

At least some barriers between commercial and investment banking have been

reduced in Canada, the United States, Japan, and the United Kingdom (Ford;

^^Glass-SteagalL is not the only structural difference between U.S. and foreign banks. Japanese Mid West

German banks are» for example, much larger than U.S. banks, measured by the dollar value of their assets and

are permitted to take equity positions in foreign firms («ellons). In Germany, but not Japan, conmercial

banks are allowed to underwrite securities.

^^The Eurobond market has two key features. A Eurobond is underwritten by an international syndicate and

it is offered simultaneously in a number of countries. A foreign bond, by contrast, is a bond underwritten

for a foreign company by a domestic investment bank for sale in the domestic market, Eurobond underwritings

amounted to $50 billion in 1982. Private corporate issues in the united States were $53.4 billion in 1982

(Levich). ^ ^

^^Guenther (1988) cites an example in which Chase Manhattan Bank lost a corporate account to Deutsche Bank

AG because the German bank was able to underwrite corporate bonds in the United States while Chase could

not. Levich (1985) cites underwriting costs for domestic U.S. corporate bonds at 0.75-lyO percent while

Eurobonds cost 2.0-2.5 percent. Domestic underwritings are therefore likely to be preferred by issuers.

10
Kincaid). Progress has also been made in negotiating international capital

adequacy standards (Ingersoll),^

Trade liberalization focused briefly on bank deregulation in 1988. The

European Community (EC) initially requested repeal of the Glass-Steagall Act

as a compensation condition for "national treatment" of U.S. banks in the EC,

where universal banking, a combination of commercial and investment banking,

is the norm. National treatment was initially interpreted to mean application

of home country regulations. Later, an alternative to repealing GlassSteagall--"better than national treatment"--was suggested so that EC banks

might enjoy the same freedom in the United States as U.S. banks enjoy in the

EC. More recently, the EC has dropped the insistence on reciprocity and has

interpreted "national treatment" to mean accepting host country banking

regulations (Key),

Changing Technology. The 1980's have been a period of rapid technological

change for commercial and investment banks (Hunter and Timme, 1986).

Innovations that were novelties in the 1970's, such as credit cards, automated

teller machines, automated clearinghouse facilities, microcomputers, and

photocopy machines, are now in widespread use (Frisbee; Hannan; McDowell).

Innovations in investment banking include around-the-clock trading, new

products such as financial options and futures, and program trading (Kincaid;

Linowes).

Technological change challenges the distinction between commercial and

investment banking. Asset-backed securities, for example, have permitted

commercial banks to tap the liquidity of securities markets and avoid reserve

requirements (Rosenthal and Ocampo; Johnson and Murphy; GAG, 1988b). Such new

'risks have raised questions about the adequacy of the current regulations to

promote soundness of the banking system (GAD, 1988a; Coll, 1988a; Meltzer,

1986).

Competition from Nonbank Banks. The Bank Holding Company Act of 1970 defined

a bank as a financial corporation which takes demand deposits and makes

commercial loans (Huertas). When interest rates rose and banks experienced

declining liquidity, finance companies evolved that either took deposits or

made loans but not both. Such institutions were called nonbank banks.^^

These nonbank banks avoided Regulation Q, restrictions on bank acquisitions,

and geographical regulation because they were not considered banks by

regulators. They were also subject to less stringent reserve requirements

than banks. Asymmetries in regulation have accordingly made nonbank banks

highly controversial.^^

23The agreement was worked out by the Basie Committee on Banking Regulations and Supervisory Practices

composed of the Group of Ten countries plus Luxembourg. The objectives of the Basle Conmittee are: (1) to

strengthen the stability of the international financial system; (2) to provide a fairer and more consistent

basis for evaluating bank capital positions; (3) to take asset risk into account in determining capital

adequacy; and (A) to avoid discouraging banks from holding liquid, low-risk assets (Board of Governors,

Federal Reserve System, 1988).

nonbank banks need to be distinguished from other financial services firms competing with commercial

banks. Nonbank financial services firms can be classified as retailers (such as Sears), industrial-based

companies (such as General Motors Acceptance Corporation—GMAC), diversified financial firms (such as

Merrill-Lynch), and insurance-based firms (such as Prudential). Nonbank banks are not all ec[ually

profitable, and they do not all compete effectively with banks (Parvel and Rosenblum).

**A life insurance company subsidiary can, for example, operate a mutual fund while a bank subsidiary may

not. Life insurance companies have likewise operated "disguised" investment companies through cleverly

designed life insurance products. Similar bank innovations have been forbidden by the courts (Clark, R.).

These and other developments may have contributed to the consolidation of financial eonglomerates (Wirth).

11
The Competitive Equity Banking Act of 1987 amended the Bank Holding Company

Act by defining a bank as any institution offering FDIC-insured deposits and

restricting nonbank bank activities. The nonbank bank issue was not settled,

however, because the 1987 Act contained many exemptions, and some restrictions

expired on March 1, 1988.

Potential Efficiency Gains with Deregulation

The efficiency arguments favoring repeal of the Glass-Steagall Act are

difficult to evaluate, and the net benefits of repeal are expected to be

small. Large banks will likely benefit more than small banks. Some

securities markets may become more competitive. An effective manager may

reduce portfolio risk through diversification into securities underwriting.

These conclusions depend on management objectives and quality, the generation

of new underwriting business, and improved use of bank resources.

Scale Economies

Providing new bank powers may lower unit costs because scale economies exist

in bank operations or securities underwriting. Scale economies exist when the

per-unit cost of producing a given product or service declines as the volume

of production increases. Economies can exist because overhead costs, such as

machinery or advertising, are better utilized by larger firms or because the

product itself is not easily divided up for use by smaller firms. The

existence of scale economies is widely recognized in securities underwriting

(Hayes, Spence, and Marks), while the issue of scale economies in coBomercial

banking has not been resolved.^

Securities Underwriting. In the 1988 proposals, commercial banks were

exempted from restrictions in the Bank Holding Company Act on forming BHG's,

apparently to permit small banks the opportunity to participate in securities

underwriting. Congress appears to believe that scale economies exist in

securities underwriting.

The ideal size of a Federal agency is«ue provides a benchmark for analyzing

the number of banks that could maintain a securities affiliate. Silber (1974)

reported that the average cost of issuing agency securities declined until

size of the issue reached a value of approximately $300 million. The Senate

bill requires that banks hold no more than 15 percent of total assets in

securities. A bank accordingly needs a minimum of $2 billion in assets to

underwrite a $300-million issue. Figure 3 shows that 340 commercial banks (of

14,200, or 2.4 percent) in the United States had more than $1 billion in

assets in 1986 (FDIC, 1986). Clearly, most commercial banks need either to

join a BHC or to participate in a syndication to service an optimal-sized

agency issue.

While agency issues are not the only alternative for an underwriter, they are

important in establishing the firm as a leader in the industry and in

developing expertise in pricing bond issues. Bond issues are typically priced

relative to U.S. Treasury bonds. The difference in price between private and

Tl. Clark raised the possibility that the holding company form of corporate ownership may itself benefit

from scale economies. These economies might exist because of scale economies in raising capital, because

excess capacity could exist in some firm operations that might be sold, because of reduced transactions

costs from sharing information within the firm, and because of superior management controls over poor

performance. He cites claims by independent data-processing firms that BHCs underprlce information

services within the firm.

12
Figure 3--FDIC-insured banks in the United States, 1986

(total banks-14,300)

Number

6,000

5,000

4,000

3,000

2,000

1,000

0

- ¥W/'

^^

-

^^^

-

iií^^ \////y///\

0-25 25-99 100-1,000 1,000 «dm<,r.

Million dollars in banl< assets

public agency issues arises from factors such as the reduced liquidity and

increased risk of private issues relative to public issues (Bloch). If an

underwriter is too small to underwrite Treasury bond issues, the firm may

incur a higher operating cost.^^

The recent controversy over LBO financings provides insight into the structure

of the evolving market. Participating banks typically earn fees of 129 basis

points (compared with 62 basis points for working capital loans) and may price

debt 200 to 250 basis points above the London Interbank Offer Rate (LIBOR).

These loans are profitable but risky. Money center banks have kept 10-20

percent of these loans in portfolio and sold the remainder to large regional

banks to spread their risk (Wiener; Guenther, 1988c). Were they able to

underwrite low-grade corporate bonds as well as loans, commercial banks could

attract a wider group of investors and potentially earn larger fees.

The pyramidal structure of investment banking dates back more than a

century.^® An underwriting syndicate may have four or more tiers of

participants. The managing firm is responsible for organizing the deal,

soliciting participants, stabilizing market prices during distribution,

keeping records, and enforcing contracts. Participating firms are ranked

according to the capital provided in purchasing blocks of stock and their role

in distribution. The prestige enjoyed by the managing firms in the pyramid

^^Not only are there likely to be scale economies in underwriting, there may also be scale economies in

securities brokering and dealing, and in exchange operations as a whole. The New York Stock Exchange, for

example, has had a market share in excess of 50 percent for decades (West and Tinic).

"^^The term pyramidal structure is attributed to Judge Medina who presided over an antitrust suit brought

under the Sherman Act against the major investment banking firms in 19A7 by the Department of Justice.

Medina dismissed the case in 1953 on the grounds of insufficient evidence (Bloch). According to Hayes,

Spence, and Mark, the real point is not whether a pyramidal structure exists in the investment banking

industry, but whether it is being misused.

13
stems from their ability to manage and fund the largest deals; provide expert

advice, meet deadlines, and operate^ with discretion (Hayes, Spence, and

Marks).

The introduction of Rule 415, which provides for shelf-regist:râtion, may have

altered the terms of trade between imderwriters and Issuers. Shelfregistration permits the issuer to reduce the time required ^o register an

issue with the SEC, waiting risk, from weeks to just days or >hoursv Because

issuers may now react more quickly to market developments, the bond market has

become more volatile. In the case of firm-commitment deals, greater market

volatility raises underwriting costs. Because waiting risk lias declined and

underwriting risk has increased, a iMore competitive market has evolved since

19B2 when this rule was introduced (BOloch; Rosenthal and Ocampo) .^

For bond and other small under^ritings characterized by low volatilityv,s^

registration has led to a collapsing of the T^yramidal structure^ The

pyramidal structure of syndications remains important for equity issues

generally and for all issues during volatile periods, \rtienthe^n

diversify underwriting risks and to place securities quickly becomes m^

critical.

Shelf-registration may also reduce the^^d

private placements, and public issues. These distinctions have always b^

subject to interpretation and may läepetnd mostly on marketing consi derat ions.-

If a loan financing has a largeniunber of purchasers, smiall dollar-amount

participations, an active secondary market, and a large number of nonbank

participants, then it could be classified as an underwriting under th

Steagall Act. If it has a small number of bank purchasers who hold large

dollar-amount participations, then Glass-Steagall may not apply. In this

sense, a loan participation should bear a closer resemblance to a privateplacement bond than a public-issue bond. A loan participation agreement must

also carry language protecting the purchaser against default of t^

originating bank, and the loan sale must be without recourse to the

originating bank under regulatory accounting principles and standards provided

by generally accepted accountiñg^rtnciples (Rosenthal and Ocaui^

Underwriting fees in syndications stilly however, reflect the old pyramidal

structure. The lead underwriting firm earns a management fee equal to 20

percent of the top gross spreadv This fee represents compensation for

negotiating the deal, preparing^ the issue, and organizing the syndication.

Participants in the syndication earn their fees by purchasing securities a

discounts to the par value given in the prospectus. The lead \mderwriter

earns the largest fee, in part> because of larger security purchases an^

because of a deeper discount frotir par than other participants. Other

participants in the syndication are permitted to purchase securities at a

les ser discount which is determined by their willingness and ability to share

in the underwriting risk and merchandising the issue CBloch).

^^Some critics have argued that shelf-registratipn has reduced competition because the short turnarpund

time in underwriting has increased the competitive position of larger underwriters located near stock

exchanges. Smaller, regional underwriters that used to join syndicates in marketing issues have, as a

consequence, either liai to develop a presence nearer to the exchanges and become lead underwriters or give

up participating in und erwr i tings CBloch );. i -ü v

-Securities industry representatives have argued that the ^lass^Steagall Act forbids conmercial i>anks

from engaging in loan participations and private placeroehts in general and from providing adyiGe to

accompany such transactions in particular. The xatlonale for these objectaions stems from the close

substitutability of these transactions for securities transactions in spite of explicit languag^^ act

allowing at least some such activities (Clark and Saunders).

14
The existence of scale economies depends on production cost savings as the

size of issue increases. Issuing costs appear to decline with issue size

because of reduced pricing, underwriting, and liquidity risks. Distribution

costs may also decline with issue size, although they are not typically

counted in discussions of scale economies. The fee structure in syndications

does not appear conducive to passing these cost savings back to issuers,

however, because management fees are levied on a percentage basis.

Commercial Banking. Researchers are divided as to the existence and

significance of scale economies in banking. Fraser and Kolari conclude, after

a review of the literature, that scale economies are exhausted when banks

reach $25 million in portfolio assets. Litan conducts a similar review of

both scale economies and scope economies. While acknowledging that past

studies have reported few economies and that large firms are typically

excluded from the data sets employed, Litan argues that studies of bank

performance have little relevance in analyzing recent changes because of the

introduction of new products and banking services. The addition of new

services to existing customer networks, computer systems, and marketing

channels should result in efficiency gains. Other authors have pointed to

technological changes as the source of new efficiency gains likely to increase

optimal bank size (Hunter and Timmer, 1986 and 1987). Bryan and Allen cite

five classes of banks--small and large community, small and large regional,

and top 20 in the United States--and discuss how specific innovations will

increase the efficiency of each class. Kaufman, Mote, and Rosenblum suggest

that marketing efficiencies may likewise reinforce production efficiencies to

increase optimal bank size.

The option to underwrite securities, both within th^ bank and through an

affiliate, will result in scale or scope economies to the extent that

complementarities (shared inputs that are underemployed) exist between these

products and existing products in production or marketing. In agricultural

lending, which has a strong seasonal component, such complementarities could

exist if securities underwriting enables banks to utilize employees and other

resources more fully in slack periods. Complementarities are more likely when

securities are underwritten within the bank because more overhead costs can be

shared. If economies exist, optimal bank size could increase.

Diseconomies may also exist. The existence of economies presumes that fixed

resources are either underutilized or that they have public good

characteristics, as in the case of a shared logo or shared advertising. When

fixed resources are fully employed, the addition of new opportunities either

means that resources must be diverted from existing activities or that

resources are spread more thinly. In a small bank, the scarcest resource is

likely to be management expertise, and new securities powers are likely to be

difficult to employ effectively, particularly for small banks without a trust

department or comparable securities activity. Managers are likely to enter

these markets gradually and to specialize in securities closest to the markets

they already understand (Kaufman, 1988b).

Diversification into Securities Underwriting

Portfolio diversification may provide an important econoinic justification for

allowing commercial banks to underwrite securities. Diversification decreases

profit variability when losses in one activity are offset by gains in another

(FDIG, 1987). The diversification benefits accruing to rural banks from

15
seeurities underwriting will depend critically on the quality of bank

management and are likely to be small in the absence of special management

expertise.

Table 2 displays the activities permitted under the Senate and House bills and

previous legislation.^' Several observations can be made. First, many

securities activities are permitted within bank departments and need not be

confined to the BHC affiliate. Second, many activities approved for banks

were previously permitted by Federal bank regulators. The Federal Reserve

already allows several banks to earn up to 5 percent of total revenue in new

securities activities. Kaufman (1986 and 1988b) provides a summary of

currently allowed bank securities activities. Third, securities activities

may not have the desired diversification effect. The industry and region that

are financed and the point in the business cycle may be as important as the

credit instrument used to determine the benefits of new bank powers.

Several authors have examined diversification effects resulting from

differences in the timing of activity profitability. In a survey of such

activities, Saunders reported banks may increase profits by adding

underwriting or brokerage activities. He reported that the partial

correlation between the underwritings of commercial and industrial loans and

underwritings of nonconvertible debt (mostly corporate debt) over the period

from 1973-83 was -0.5, This implies that a 10-percent increase in the

profitability of loan originations is associated with a 5-percent decline in

the profitability of nonconvertible debt underwritings. In other words, a

bank diversifying into securities activities could on average expect to reduce

its profit variability.

Litan reported low correlations between the after-tax earnings in banking

activities and a wide range of possible alternative financial activities.

^Comparing his own estimates with those of other authors, he shows that the

correlation between securities activities and banking activities varied over

different time periods. The correlation between after-tax earnings in banking

activities and "securities brokers, dealers, and flotation companies" was

reported as 0.06 for 1973-82 and -0.11 for 1962-82. Litan concluded that "the

opportunities for reducing risk through pair-wise combinations of bank and

nonbank activities appear impressive" because low correlation means that

firms can lower the variance of their profits by entering into new activities.

Repealing the Glass-Steagall Act may therefore permit commercial banks to

reduce portfolio risk through diversification. Whether banks choose to use

these new powers to reduce risk depends on management objectives.

Competitive Effects

The entry of commercial banks into securities underwriting will affect

competition in both commercial banking and investment banking. The

competitive effects within these two markets are unlikely to be significant.

Gross-market effects may, by contrast, be very significant.

In 1985, the nonpermissible securities activities for Federal Reserve banks were: (1) underwriting,

trading, and distributing corporate bonds, corporate equities, commercial paper, and some municipal revenue

bonds; (2) mutual funds underwriting and distributing; and (3) full-service brokerage and investment

advising (Kaufman, 1986).

16
Table 2--Underwriting and investment activities permitted by Senate bill 1886

and House of Representatives bill 5094

Approved for banks 1/ Restricted to BHC affiliates

Unsolicited brokerage services (S)

Trust or fiduciary activities

U.S. Government securities

Commercial bills and paper

Bankers acceptances

Municipal securities 3/

Asset-backed securities

Private placement activities

1,000 transactions not otherwise

exempted

Securities brokerage (H)

Mutual fund sales (H)

Buying and selling on own account (H)

Information processing activities (H)

Small business investment company

activities (H)

Activities incidental to foreign

business operations (H)

Insurance underwriting in small,

rural communities

Corporate equities (S)

Corporate bonds

Convertible bonds (H) 2/

Securities not exempted (S)

Commission and solicited sales (S)

Not allowed for banks or BHC

affiliates

General insurance underwriting

Real estate activities (H)

BHC - Bank holding company.

S - Senate bill only; H = House bill only.

\J Most of these activities are currently permitted under Federal bank

regulator agency regulations.

2/ Convertible bonds may be underwritten if the conversion price is set

at least 15 percent above the equity price at the time the bond is

issued.

3/ If the bank has a securities affiliate, then these activities must be

transferred from the bank to the affiliate.

Commercial Banking. The impact of increased securities underwriting on

competition in commercial banking depends, in part, on the extent to which

banks compete on a geographic, customer service, or product basis (Bryan and

Allen). Allowing banks to underwrite securities will place banks in

competition not only with other financial services firms, but also with other

banks.^ A bank underwriting a mutual fund, for example, can be expected to

compete nationally with other mutual funds. Some large banks currently

compete nationally for credit card accounts and home mortgage loans (Guenther,

1988b and 1988d; Rosenblum, Clemente, and O'Brien).

The expectation under product deregulation is that banks will compete on a de novo basis with

established securities firms. In the past, however, "structural and regulatory efforts to promote

competition within the financial services industry have stressed the heed to prévent impediments to

competition that result from conflicts of interest, tie-ins, and the concentration of financial resources"

(Wirth).

17
The size of commercial banking markets relates to the size of corporate

borrx>wers. For borrowers with less than $1 million in assets, the workable

market is the local metropolitan (metro) ^rea/ Larger borrowers are ab

search more widely (Edwards) . Becaiise only the largest firms can issue

securities,^ commercial banks offering underwriting services apd commercial

loans may draw profitable customers from small banks not offering this

service. This service could be attractive to potential issuers if securities

financing is preferred to loan financing or if customers prefer otie-stop

financing. If the underwriting bank drew customers from across State lines,

product deregulation could undermine State bank regulation and bring about a

form of de facto geographic deregulation in States where it does not currently

exist.

Investment Banking. Entry of commercial banks into more securities markets is

promoted as a mechanism for increasing the competitiveness of ir^

banking. A high degree of market concentration in underwriting suggests the

need for greater competition. Four-firm concentration ratios <that is^ the

market share of the top four firms) in riegotiated underwriting averaged 41.4

percent in 1988. In competitive bid iftarkets, the four-firm ratio was 32.2

percent.^ By contrast, fpur-firm concentration ratios in commercial banking

are much lower <table 3) (Savage).'^

The high level of concentration in investment banking supports two

interpretations of market behavior. Industry critics argue that the high

shares of leading firms result from a lack of competition,^ which leads to

higher prices, Industry deferiders ar^ue that investment banking is a highly

competitive industry with price differences that result from différences in

underlying costs. The industry view is credible if scale economies in

securities underwriting and a small market size preclude the profitable entry

of additional firms.

Empirical studies of the competitive effects of commercial bank entry into

investment banking have focused on the influence of commercial banks on the

underwriting of municipal bonds, The observation that general obligation

municipal bonds are better collateralized than revenue bonds may explain why

commercial banks are permitted to underwrite general obligation bonds but not

revenue bonds. Silber ( 19^80) reported that virtually all studies looking at

the distinction between general obligation and revenue bonds agreed that

commercial bank eligibility reduced the cost to issuers of issuing bonds. For

this reason, most public issuers explicitly encourage commercial bank

eligibility. Studies comparing the effect of competitive bidding with

negotiated underwritings reinforce this point of view (Ederington). The

larger the number of bids on an issue, the lower the cost to issuers.

Bierwag, Kaufman, and Leonard (referred to here as the BKL study) question

these results. They argue that earlier studies of the municipal bond market

misspecified the equations in their statistical analysis by not including bond

purpose as an explanatory variable. Commercial banks may underwrite some

bonds, but not others, which makes it likely that bond value will

purpose. By testing this hypothesis, the authors found that commercial bank

eligibility was no longer a significa.nt explanatory variable once a variable

^A firm contemplating going publit; should have a minimum of $1 million in net annual income and $15-20

million in annual sales with good growth prospects (Sloch).

^'*Thôse figures were provided by Lhe Securities Industry Association. Pugel and White cited con^arable

figures for 1972-77.

^Pugel and White, and Litan sumnarize the issues raised by commercial bank entry into investment banking.

18
Table 3--Concentration levels in selected financial service industries, 1984

Industry

Top 10 firms

All firms Total asset Share of

value total assets

Number Million dollars Percent

7,802 11,206 46.6

11,451 723,940 25.6

3.159 152,324 15.6

2,134 352,689 48.7

1,773 71,350 27.0

300 569,880 24.0

Securities

Conmercial banks

Thrifts

Life insurance

Other insurance 1/

Institutional investors

1/ Property and casualty insurance.

Source: (Wirth).

for bond purpose was added. From their perspective, this result is

intuitively correct because entry into investment banking is restricted only

for commercial banks. Other adequately capitalized firms can freely enter and

compete in the bond market because a charter is not required to enter

investment banking.

Several observations are pertinent in reconciling the BKL study with previous

studies. First, the BKL study results are inconsistent with the structureconduct -performance perspective. We normally expect competition to lower

issuer costs. Second, the correlation between bond purpose and bank

eligibility suggests that multicollinearity may make it impossible to

distinguish independent effects. The BKL results depend on the credibility of

the Theil test which separates these effects. Finally, the conclusion that

bank eligibility did not previously affect issuer costs does not imply that

increasing bank underwriting powers will not decrease issuer costs now. If

banks could not take advantage of scale economies in the past because of

insufficient underwriting powers, new bank underwriting powers may encourage

more commercial banks to enter investment banking, which could lower issuer

costs.

Several reasons can be cited for why industry market shares may understate the

competition in investment banking. First, the market for investment banking

services is segmented, with little competition between segments and intense

competition within segments. Market share data accordingly focus on the wrong

level of aggregation (Hayes, Spence, and Marks). Second, although corporate

clients relied traditionally on their investment banker for most of their

financial advice, large corporations have increasingly upgraded the quality of

their finance staff. Corporate managers are accordingly much more capable of

evaluating the quality of the advice they receive from investment bankers and

the competitiveness of the spreads they are offered on their issues (Levich).

Third, the Eurobond market is generally perceived to be more competitive than

the U.S. bond market, giving large corporations an alternative to domestic

financing that serves to limit oligopolistic pricing (Levich). These reasons

suggest that at least the market for large corporate issues is fairly

19
competitive. Small firms competing in less profitable market segments, having

no endogenous financial staff and without the reputation needed to enter the

Eurobond market, are less likely to receive competitively priced service in

the securities market.

Cross-Market Effects. Cross-market effects could become more important with

repeal of the Glass-Steagall Act. Direct market linkages include vertical

integration and illegal activities, such as tied sales. Indirect market

linkages include shared costs, cross-subsidy effects, and development of

financial conglomerates. The independent effects of new bank powers may not

be important, however, in view of market innovations, such as securing bank

assets (that is, the sale of securities backed by bank assets).

The effect of product deregulation in a competitive sense may be close to that

of forward integration. Where secondary markets exist, the bank could serve

as originator, pooler, and distributor. A bank's competitive position in all

three activities might improve because it possesses better market information

than firms that specialize in any one function or because the bank can crosssubsidize the more competitive activities.^ The bank could also switch

between loan and securities financing as market conditions vary, thereby

gaining a straightforward marketing advantage.

Large, multimarket financial conglomerates could develop around BHCs that

have new powers. Because insurance company holding companies have already

expanded into underwriting, however, BHC conglomerates do not provide a unique

threat (Clark, 1979).^^ In fact, limits on interstate branching may make it

difficult for BHCs to gain the advantages of vertical integration already

available to other firms.

Safety and Soundness Considerations

The thrift crisis has forged a link between the issues of financial safety and

soundness and bank product deregulation that had been missing. Deregulation

advocates previously dismissed bank failures as individual events not

threatening the viability of the whole banking system or as a regional problem

associated with recession. Now that the errors made in the name of thrift

deregulation have been exposed, bank risk exposure under deregulation is being

seriously discussed.

Lessons from the Thrift Crisis

The savings and loan association crisis of the 1980's is important in

approaching the repeal of the Glass-Steagall Act for several reasons.

Legislative action to deregulate bank products has been held up in Congress

because of the urgency posed by the thrift crisis. Congressional action on

the thrift crisis will shift the focus of the deregulation debate to place

greater stress on bank safety and soundness than might otherwise have evolved*

"^A recent example has been provided by Citicorp's development of a nationwide mortgage underwriting

business, wedding this activity to an inhouse mortgage-backed securities iinderwriting business (Harney; and

Guenther, 1989). While Citicorp has used mortgage-backed securities to market its mortgages in the past, it

has only recently acquired the right to underwrite them inhouse (Rosenthal and Ocampo). This is, by ño

means, a recent phenomenon. Cross (1923) reported that a Chicago area bank was doing this at the turn of

the century.

^''pears of financial conglomeration are often raised by citing the Japanese example of the Zaibatsu

corporation. A Zaibatsu conglomerate owns both banks and inanufacturing concerns. Firms in the Zaibatsu

cooperate not only in financing but also in pricing practices and management (Clark, 1979).

20
Some feel that fundamental reform of financial services regulation is

necessary.

These elements contributed to the thrift crisis:

o Portfolio restrictions encouraged thrifts to extend 30-year, fixedrate mortgages in spite of rising interest rates,

o A flat fee for deposit insurance encouraged thrifts to make riskier

loans than is normally prudent (Kane).

o Deposit insurance was underpriced, increasing unfunded Treasury

contingent liabilities (Kane).

o Delay in closing insolvent thrifts led them to borrow high-cost funds

which increased risk exposure.

o Changes in State laws encouraged real estate developers to acquire and

manage thrifts in a manner considered a conflict of interest by bank

regulators.

o Congressional intervention slowed regulators in closing insolvent

thrifts, which raised Treasury losses.

o Staffing cuts reduced the niomber and extent of thrift examinations

facilitating fraud and abuse,

o Private auditors valued bank assets at book rather than market values

and provided a clean bill of health to some thrifts only weeks before

Federal regulators closed their doors.^

Each element contributed to the crisis and if any subset of these elements

were absent, the crisis or associated costs might have been avoided.

Estimates of the cost of closing insolvent thrifts or finding buyers for

productive assets range from just under $50 billion to over $150 billion,

depending on assumptions with respect to the number of thrifts affected,

prevailing interest rates, and the state of the economy. Cost estimates rise

as time passes.

The chief lesson learned from this crisis is that regulatory laxity yields

costs too large to be dealt with administratively or legislatively without

testing the political consensus. The deposit insurance system was successful

in averting thrift runs and a collapse of the financial markets, but only at

enormous taxpayer expense. Although banking regulation has clearly been more

stringent than thrift regulation, common problem areas, such as the deposit

insurance system, are obvious.^ It seems likely that further product

deregulation efforts will receive more scrutiny than might have been true in

the past and will need to be compatible with a safe and sound banking system.

Sources of Bank Risk

Benston, and Kaufman (1986) outline nine sources of bank risk: fraud, credit

risk, interest rate risk, securities speculation, foreign-exchange risk, risktaking by related organizations, regulatory risk, operations risk, and

liquidity risk.

Reporting bank assets at book value follows "generally accepted accounting principles" or GAAP. When

market values for an entire region deviate substantially from book values, as recently happened in energy

and agricultural regions, traditional GAAP procedures can obscure insolvencies (Kane).

^^Cargill argues that we need to develop a policy for dealing with failed institutions and to redefine the

Federal guarantee provided through deposit insurance before considering repeal of the Glass-Steagall Act.

Litan has suggested elimination of deposit insurance in favor of portfolio limitations on deposit

institutions to require that funds obtained from depositors be invested only in federally guaranteed

securities that carry no default risk.

21
Benston, and Kaufman (1986) reviewed the literature on bank failures and

reported that the risk of fraud was a factor in more than half of all bank

failures. This observation was borne out in the thrift crisis. Simple

looting of bank vaults was less prevalent than making questionable loans to

friends and insiders who invested in risky ventures or spent the money

outright. Minimizing the risk of fraud clearly remains an important objective

of bank regulation.'**'

Credit (or default) risk was an important problem in recent rural bank

failures. Rural banks often serve a narrow set of industries, such as energy

and agriculture, which makes them profitable in good times and leaves them

poorly diversified in bad times. Product deregulation may reduce credit risk,

if new customers in new regions and industries are served. Loan sales, for

example, could provide this advantage. Geographic deregulation is normally

felt to be more important than product deregulation in reducing credit risk

although product and geographic deregulation may have similar effects.

Interest rate risk, the risk of unexpected change in interest rates, is less

of a problem for banks than for thrifts. Banks generally specialize in

offering short-term production and consumer credit which more closely match

the maturities of their short-term time and demand deposits and reduce

interest rate exposure. Thrifts, by contrast, have in the past been

encouraged by regulators to specialize in offering home mortgage loans at

fixed interest rates. The thrift crisis evolved, in part, because thrifts

were exposed to losses when interest rates on deposit accounts rose above

those received from old mortgages in the late 1970's and early 1980's,

Minimizing the losses associated with securities speculation was a major

objective of the Glass-Steagall Act. As outlined earlier, banks may

underwrite and trade numerous classes of corporate and public bonds,

particularly when managing trust accounts. Commercial bank trading and

holding of LBO loans and low-quality bonds has recently been a concern,

although bank insolvencies have not been associated with such activities since

the Great Depression.

Foreign exchange risk has not been an important concern for rural banks.

Trading in foreign exchange markets was, however, a major source of revenue

earnings for money center banks following the October 1987 crash of the stock

market.

Risk-taking by related institutions has likewise not recently been an

important problem for rural banks. Rural banks suffered numerous insolvencies

before Glass-Steagall, however, as a result of loan participations and

security syndications that left them exposed to risks they could not

themselves evaluate. In the 1920's, money center banks sold securities at par

to rural institutions that could not be sold at par through the exchanges.

Money center banks often subjected their own trust departments to this same

sort of treatment.^^

^aiik examiners are sensitive to cases involving fraud. An FDIC study of resolution costs for bank

failures in 1985 and 1986 showed that fraud was a factor in 25 percent of the cases studied. The cost of

resolving these cases was^ however» lower than the average cost. The authors hypothesized that examiners

were cjuicker to close banks in the case oí fraud, accomiting for the lower cost (Bovenzi and Murtón).

This practice is currently illegal in the United States. The practice of stuffing investment or trust

accounts with securities priced above market rates remains, however, a problem in some European banks

participating in the Eurobond market <Levich).

22
Regulatory risk is the risk that regulators will misuse the authority granted

them and cause banks to suffer losses. Two kinds of regulatory risk currently

concern rural banks. First, regulators may view rural banks as more

expendable than larger, urban institutions and provide them less assistance

than larger banks in stressful times. Second, asymmetric regulation can

motivate product and institutional innovations that raise costs or result in

unwarranted risk-taking. Thrift regulation in the early 1980's, for example,

may have allowed thrifts greater freedom than banks to take risks and resulted

in an unnecessary increase in insolvencies. The risks for rural banks of

policy failure may, in general, be greater than those of urban banks if they

are not as well represented as urban banks in the political process.

Management risk, the risk that management will lack for expertise or attention

to detail, is probably greater for small banks than large banks. Rural banks

probably suffer no more operation risks than any other small bank or small

business.

Liquidity risk, the risk of running out of cash to meet current obligations,

is often associated with other forms of risk as a bank nears insolvency.

Because the Federal Reserve normally stands ready to lend money to solvent

institutions experiencing temporary cash shortages, liquidity risk is not

currently an issue (Meltzer).

Deregulation Issues Affecting Rural Areas

Rural banks and issuers are not the major beneficiaries of new bank powers,

and rural economic growth is not expected to be significantly affected.

Repealing the Glass-Steagall Act may simply allow competitive rural banks a

chance to participate in changes already taking place and allow rural issuers

slightly more options in financing. Additional insolvency risks may also

accrue.

Effects on Rural Banks

The effects on rural banks of increased bank powers can be divided into these

categories: locational effects, scale effects, diversification effects, and

competitive effects.

Locational Effects

Milkove analyzed the difference between metro and nonmetro banks and reported

that nonmetro banks tend to be small, and their problems stem more from bank

size than location. He concluded that nonmetro and metro banks of equal size

are likely to do equally well in adjusting to the increased market competition

created by bank price deregulation. If Milkove's conclusions are accepted,

then the locational benefits accruing to rural banks with product deregulation

are also likely to be small.

Milkove's conclusions are worth examining more closely. Location may affect

bank performance for several reasons. First, bank location determines, in

part, whom it will serve. Second, bank location influences accessibility to

major financial markets. Third, bank location determines the State laws that

regulate chartering, organization, and branching opportunities.

23
Location determines in large measure what corporations the bank will serve. A

large rural corporation is likely not to patronize a small rural bank, even if

the bank could offer both commercial loans and underwriting services, because

it has capital and management requirements too large for a small bank to

serve. A large rural bank may, however, find that being able to offer

underwriting services significantly enhances its ability to attract and hold

large corporate accounts within its usual marketing area and beyond.

Accessibility to major markets may be a problem. Several observations about

locational effects can be drawn from table 4. First, the largest number of

banks are located in the North-Central region. These banks are the smallest

of any region in average value of assets, loans outstanding, and deposits.

The North-Central region has a large proportion of agricultural banks and

several States with unit banking laws that restrict or forbid branching.

Second, the smallest number of banks and the largest in size are found in the

Northeast region, which includes New York. Third, totally rural banks (that

is, those headquartered in counties with no town larger than 2,500 inhabitants

and not adjacent to a metro area) make up 1,107 of 7,742 nonmetro banks, or

about 14 percent. These baTiks are, on average, smaller than metro or other

nonmetro banks, in the value of assets, loans outstanding, and deposits.

Nonmetro banks in general were larger than totally rural banks, although

nonmetro banks were themselves smaller than metro banks in 1985,

Given the relationship between location and structure, several provisions in

the House and Senate bills potentially affect banks in some locations more

than others. Most obvious of these effects is size: the large banks of the

Northeast are more likely than the smaller banks of other regions to be able

to underwrite optimal size security issues because of the capital requirements

of large issues. A large bank in another region would not, however, be

disadvantaged in issuing minimum cost security issues.

Location still affects the State laws that apply, but the growth of interstate

branching in the 1980's has reduced the differences among State statutes.

Only three States still have unit banking, for example, and only one State

prohibits multibank holding companies (MBHC's) that could substitute directly

for branches. Repealing the Glass-Steagall Act is therefore unlikely to

stimulate changes in bank behavior designed solely to circumvent State

restrictions on branching.

Scale Economies in Securities Underwriting

The chief impediment to rural bank participation in securities markets is

size: rural and agricultural banks are typically smaller than metro banks.

The average nonmetro bank in 1985 had $42.8 million in assets and the average

agricultural bank (that is, banks with 25 percent or more of their loans in

agricultural loans) had $27.6 million in assets compared with an average of

$360.9 million in assets for metro banks. The six largest nonmetro banks had

average assets of $1.5 billion in 1985 (Mikesell). Some nonmetro banks might

be able to own a securities affiliate able to take advantage of scale

economies in the securities market. The majority would need either to join a

BHC or to participate in a syndication.

This basic conclusion will apply to even the smallest of issues, such as

issues of rural municipal bonds, which are not particularly large--roughly, at

least $1 million in face value. A small municipal issue Is likely to be a

negotiated, rather than a competitive, underwriting. For some classes of

24
Table 4--Selected mean characteristics of noninetropolitan banks, 1985

Net

Classification Banks Assets Loans Deposits income

Number

14,357

_ _ T^ r^ f\^ 1 e? Q m /H dollars

All U.S. banks 189,349 146,817

-inousana

114,407 1 ,264

All metro banks 6,615 360,917 221,962 274,351 2 ,359

All nonmetro banks 7,742 42,756 22,508 37,849 328

Branching law:

Unit 3,089 32,492 16,004 28,902 193

Limited 3,830 44,295 23,179 39,300 349

Statewide 823 74,121 43,797 64,672 744

County type :

Totally rural 1,107 23,936 11,688 21,272 171

Agricultural 2,255 26,853 12,817 23,839 149

Mining and oil 571 46,878 23,533 41,221 407

Bank size:

Very small 3,475 14,323 7,107 12,733 69

Small 3,672 48,032 24,483 42,822 368

Medium 589 162,937 91,970 142,389 1 ,480

Large 6 1,483,681 914,472 1,277,963 13 ,459

Region:

West 646 39,841 22,290 35,432 151

North-Central 4,019 34,710 17,345 30,877 206

South 2,822 49,681 26,549 43,809 474

Northeast 255 100,324 59,707 87,891 1 ,100

Source : (Mikesell)

municipal bonds, the primary underwriter is usually the local bank because few

other underwriters can effectively evaluate credit risk (Sullivan, 1983b).

The issue will likely be placed with a small number of investors (or held by

the bank itself), and the issue will likely not be actively traded. The lack

of an active market raises interest rate risk, which in itself justifies a

larger underwriting spread (Sullivan, 1983a)^ and suggests that bank loans

are a close substitute.

Consider the case of an average-sized agricultural bank with $27.6 million in

assets. If the bank regulator constrains the maximum financing to 3.5 percent

^^The lack of competition may explain why negotiated municipal bond sales tend to carry higher interest

costs than competitive bid sales. High transaction costs are another explanation (Silber; West; Ederington;

Hendershott and Kidwell).

25
of bank assets,"*^ for example, this bank could underwrite an issue no larger

than $970,000. Portfolio diversification requirements accordingly make the

average agricultural bank too small for even a small municipal bond issue.

A special problem may exist in the case of small, rural firms not quite at the

point of going public. Unless the firm is a high-technology firm with good

prospects for growth and able to attract outside funding, the firm will likely

depend on local banks for funding xmtil it reaches a size of $1 million in

annual net income and annual sales of $15-$20 million <Bloch). If the common

stock issue has a price-to-earnings ratio of 12, then the initial public issue

for this small firm would be $12 millioTi. A sum this large poses much too Mg

an underwriting risk for the average rural or agricultural bank. Beyond the

problem of the issue, however, the majority of nonmetro banks do not

themselves earn so much income and might have difficulty providing loans large

enough to support a firm just under this size (table 4) (Rogers, Shaffer, and

Pulver). If this is the case, the chief credit problem for rural firms might

arise in obtaining the "bridge loans" necessary to grow to the point of goihg

public because firms large enough to go public will likely search outside the

local area for assistance in underwriting.

A commercial bank entering the underwriting business may specialize in such

small issues. Alternatively, it might begin by cooperating in a joint

offering. If smaller issues are expensive because of a lack of competition

(negotiated underwritings), then repealing the Glass-Steagall Act might

conceivably encourage more banks to enter this market and reduce costs to

issuers. If smaller issues are more expensive because of added risk and scale

economies, then repealing Glass-Steagall may have littlii or no impact on the

market for smaller bond issues. Research reviewed in previous sections

suggests that new competition may indeed lower issuing costs (Silber, 1980),

but there is no guarantee that repealing the Glass-Steagall Act will initiate

new competition because of the existence of scale economies in underwriting

(Hayes, Spence, and Marks).

Providing banks with new securities powers seems unlikely to benefit rural

banks because of scale economies in underwriting. The advantages of

securities market participation seem to benefit large banks and large issuers.

Even if small banks and small issuers can participate, the benefits are modest

relative to those of large banks and large issuers.

Diversification into Securities Underwriting

The association of rural bank failures in the 1980's with stress in the

agricultural and energy sectors of the Southwestern States suggests that the

diversification effects of product deregulation may be important. Available

research suggests that geographic deregulation offers more diversification

potential than product deregulation. These results may, however, be sensitive

to cyclical change and the securities activities taken up.

This is the constraint imposed in the Agricultural Credit Act of 1987 on the largest loan in a Farmer

Mac pool (Hiemstra, Koenig, and Freshwater). A similar constraint may also be imposed on the total

percentage of that class of assets. Ko standard has as yet been proposed. The Federal Reserve recently

permitted several money center banks to earn up to 5 percent of their revenues through securities

underwriting and trading. This is a stringent standard and it may soon be relaxed to 10 percent. By

contrast, the National Bank Act allows an unsecured loan to be as large as 15 percent of unimpaired capital

and a secured loan to be as much as 25 percent.

26
Product deregulation does not offer significant potential for diversifying

rural bank portfolios according to existing studies. A study of changes

occurring with the Bank Holding Company Act of 1970 concluded that because

geographic deregulation requires no departure from retail banking, it has a

higher probability of success than product deregulation that involves managing

new products and accepting new risks (Eisenbeis, Harris, and Lakonlshok).

Research on product expansion through nonbank acquisition of banks likewise

reported no significant stockholder benefits (Born, Eisenbeis, and Harris).

These results are sensitive to the financial condition of individual banks.

Several studies have reported that shareholder benefits of superregional banks

of interstate expansion were likely to be positive while those of moneycenter banks strapped by developing-country debts would likely be negative

(Black and others; Meltzer). While these studies do not address the rural

bank diversification problem specifically, their conclusions seem consistent

with rural bank experience.

The time period chosen for study may also affect these results. Securities

underwriting is a highly cyclical business. Hayes, Spence, and Marks

reported:

Smaller and usually more marginal issuers tend to drop out of the public

offering markets during slack periods identified with economic slumps and

with more quality-conscious investor sentiments. These second-tierquality issuers are principally associated with the smaller investment

banks. The large, more powerful investment banks tend to be associated

with the larger first-tier-quality corporate issuers, who usually have

continued access to public markets, even during recessions.

If smaller investment banks are disadvantaged more than larger investment

banks by cyclical downturns, and the diversification benefits of securities

underwriting are generally small, rural banks are unlikely to benefit

significantly from underwriting activities.

The potential for rural bank diversification may also depend on the class of

securities underwritten and traded. If rural banks are more likely to

participate in regional or national securities markets, diversification into

securities markets will probably lower risk, all other things being the same.

If rural banks begin to offer securities as a service to their existing

customer base, little or no net reduction in risk may occur because losses on

local loans and local issues are likely correlated.

Competitive Effects in Commercial Banking

Efforts to increase competition among commercial banks through interest rate

and geographic deregulation in the 1980's appear to have benefited rural

borrowers. The small decrease in the number of independent rural banks

because of insolvencies has been more than offset by the entry of new banks

and branching of urban banks into rural communities. The number of bank

offices in nonmetro counties rose 11 percent from 1980 to 1986^ and a growing

number of nonmetro countries are now served by a lender experienced in

commercial and industrial lending (Milkove and Sullivan).

The repeal of the Glass-Steagall Act could have two important competitive

effects on rural banks and borrowers. First, money center banks may gain a

competitive edge over rural banks in some product markets by vertically

integrating in secondary market transactions. Second, increased competition

27
in some loan and security product markets may motivate banks to redistribute

the allocation of overhead costs away from the more competitive product

markets. Greater competition could, for example, raise the cost of

"character" or "good neighbor" lending practices and thus reduce its incidence

in rural banking.^ By making cross-product subsidies more obvious, this

could decrease the subsidization of low-quality loans by high-quality loans.

Rural banks could be disadvantaged in this new, more competitive environment

relative to urban banks. Being smaller than other banks, they may simply lack

the assets, the employees, and the expertise to enter securities underwriting

directly, and lack the merger appeal of larger institutions to enter the

business indirectly. A study of the effects of eliminating restrictions on

interstate banking, for example, suggests that small rural banks are likely to

be spectators rather than players in a merger movement (Philis and Pavel)."^

Securities products closer to the basic business of retail banking--those that

can be underwritten within the bank--may pose a greater problem for rural

banks than those confined to a securities affiliate because more

diversification and efficiency benefits potentially accrue.

The opportunity to join a BHC may also be unattractive, because the securities

business is too distant from familiar markets and customers. This may explain

why a recent survey of bank managers showed that while managers of large banks

generally favored product deregulation, managers of small- to medium-size

banks ($10-$250 miHion in assets) generally opposed deregulation (Horowitz).

The advantage of large size in securities underwriting should not, however, be

overstated because large banks may have already achieved this advantage by

virtue of size alone (Hanweck and Rhoades).

Although deregulation legislation has been promoted primarily by large money

center banks, several analysts have suggested that large regional banks may

also benefit for several reasons. First, the securities that banks were

ariowôd to underwrite in the past, particularly general obligation municipal

bonds,^ did not provide enough business to keep a bank underwriting business

afloat. By increasing the number of products banks can offer, the legislation

may allow regional banks enough business to benefit more from scale economies.

Second, most underwriters are located in major metro areas. Regional banks

entering the underwriting business may accordingly serve investors and issuers

who might not otherwise be adequately served by large, money center

underwriters. These bank underwriters might expand the securities market and

have a comparative advantage in local markets (Kaufman, 1988b; Hayes). Third,

the superregional banks are better capitalized than the money center banks

(Meltzer; Black and others), Although the superregional banks may benefit

from new powers, this development may be accompanied by geographic

consolidation and a reduction in bank numbers (Kaufman, Mote, and Rosenblum).

If so, then the basic analysis holds--big banks benefit most--with the

recognition that some large regional banks may also benefit from new powers.

^ural banks may also be significant recipients of goo*fliil business. I found that regional chain stores

felt a strong obligation to support local suppliers by channeling some fixed portion of theii businesis to

them, in spite of cost and quality considerations. Even though these local suppliers provided only an

insignificant portion of total inputs to the chain, this business represented a significant share of the

business available to these local supplljers<Hi«mstra). While such practices are often viewed as motivated

strictly by philanthropic motives, the chains could be using these alternative suppliers as a means of

keeping track of competitive conditions in their input markets and reducing their dependence on national

suppliers (Porter).

^%ilkove and Sullivan argue that rural banks may see less change than urban banks with reduced regulation

because they are less specialized. The argument here does not dispute this observation but rather

interprets it to mean that rural banks may be less con^jatitiva on account of their lack of specialization,

28
Competitive Effects in Investment Banking

If repeal of the Glass-Steagall Act leads to additional bids from commercial

bank underwriters, then rural issuers may see the cost of underwriting

services decline. This result depends on the significance of scale economies

in underwriting, competition from loan financings, and the entrance of new

investors along with commercial banks into the market for rural issues.

The larger, better capitalized corporate issuer can hire a competent finance

staff, is likely to attract multiple bids on issues, and may be big enough to

view the Eurobond market as an alternative, as argued before. For the typical

rural issuer, the Eurobond market is not an option and competition from loan

financing and loan participations is likely to be important.

The difference between a loan participation and a securities financing lies

primarily in the number and nature of investors included in marketing. If the

target market is a small number of commercial banks or institutional

investors, then a loan participation makes sense and the cost of public

registration is eliminated. If the target market is the public, then a

securities underwriting is warranted. The competitiveness of loan

participations relative to securities underwrltings, therefore, depends on

local market conditions, the point in the credit cycle, and other factors,

such as the number of firms willing and able to compete in these markets.

Freedom of entry into Investment banking and the offset of cyclical profits by

cyclical losses in underwriting may also affect competition in the rural

credit market. The effect of coramercial bank entry into the undervriting

business over the course of the business cycle may depend on what the new

investors commercial banks bring into the market and the Importance of scale

economies in securities underwriting. If coimnerclal banks bring new investors

in the market, more firms will be viable in the market in view of scale

economies. This new competition could then reduce the underwriters' spread on

new issues.^ Because underwriters are often dealers in the secondary market,

greater competition would also likely reduce price variability and the cost of

trading outstanding Issues in the secondary market (West and Tlnic). If

repeal brings little or no new Investment to the market, then the number of

firms In the Industry is unlikely to change as new entrants are offset by the

exit of less competitive firms.

Cross-Market Effects

Secondary market activities may Increase vertical integration opportunities

and significantly affect competition in rural credit markets. A money center

bank could, for example, follow the example of the home mortgage market and

Integrate back Into the market for farm mortgages by (Guenther, 1989; and

Harney):

o Purchasing agricultural or rural housing mortgages through rural agents

who receive a commission for brokering borrowers with good collateral

and cash-flow characteristics;

o Assembling a pool of agricultural or rural housing mortgages;

^The need for new competition is underscored by the periodic appearance of a "hot issues" market when^

fringe underwriters take advantage of small, startup companies in selected industries by offering their

stock at a larger discount than normally prevails (Ritter).

29
o Issuing Farmer Mac guaranteed securities collateralized by that pool;

and

o Distributing those securities to institutional investors (Hiemstra,

Koenig, and Freshwater).

Competition between rural and money center banks might improve the service and

pricing of high-quality agricultural and rural housing mortgages.

Increased market competition could improve pricing as increased market

arbitrage links thinly traded product markets and regional interest rate

differences. This competition may reduce the costs to high-quality credit

applicants and raise the cost to other applicants as overhead costs are

shifted toward less competitive products.^^ A rural borrower that qualifies

for security financing, for example, will be in a better position to negotiate

loan financing than a rural borrower unable to employ the securities market.'^

CRA amendments proposed in the 1988 House Act to provide low-cost check

cashing and transactions accounts could likewise become expensive and

disadvantage small banks depending more heavily on deposit funds.^

Effects on Rural Issuers

New bank powers could benefit rural issuers by increasing competition and

lowering underwriting spreads. Low rural bank participation in the securities

market and limited substitutability between loan and securities financing may,

however, limit the competitive effect. If the average rural bank is not large

enough to provide the loans needed by public corporations, then it is unlikely

that the introduction of securities financing will increase competition for

their established customer base.

Increased competition in the investment banking industry could improve rural

service, but only if current service is poor. The cost of securities

financing may be higher in rural than urban areas because of cost factors, but

there is little evidence that suggests rural issuers cannot obtain

underwriting services.

Pugel and White hypothesized that increasing the distance from a major

financial center reduces the number of bids on an issue and raises the size of

the underwriter's spread in initial public offerings. They reported that a

10-percent increase in distance is associated with a 0.01-percent increase in

the underwriter's spread. This variable was not statistically significant.

Pugel and White used market data for 1981.

This result is expected: While a small company or municipality far from a

major financial center might have trouble attracting bids from major

underwriters, large companies probably would not. Large rural businesses are

"^^The existence of cross-subsidies to less desirable borrowers seems likely if rural credit markets are

not highly competitive. Following Leibenstein's theory of X-inefflciency, firms do not use their market

power so much to achieve higher economic profits as to make their life easier. In a rural context, this

might be exemplified by "good neighbor" or "character" lending policies that give borderline borrowers the

benefit of the doubt under normal circumstances.

"^^This is an application of the theory of price discrimination (Henderson and Quandt). The demand by a

rural borrower able to obtain security financing will be more elastic than the demand by a rural borrower

unable to obtain such financing. Consec[uently, theory predicts that the borrower with the more elastic

demand will receive credit on more favorable terms.

"^^A recent study found scale economies in complying with Federal Reserve regulations B (Equal Credit

Opportunity) and Z (Truth in Lending). These economies were quickly exhausted as bank size increased and

diseconomies were reported for the larger banks. The proposed CRA amendments, which are more substantive

than regulations B and D having an elaborate compliance mechanism yet similar in intent, seem likely to

share in these scale economies (Elliehausen and Kurtz).

30
often subsidiaries of even larger, urban-based conglomerate firms that have no

problem attracting major underwriters and, in any case, arrange for financing

through their corporate headquarters. Improvements in communication

technologies in recent years have, in any case, probably reduced the

significance of location in participating in financial markets.

Repealing the Glass-Steagall Act may not change this result for several

reasons. First, most nonmetro banks are too small to underwrite an issue or

own a securities affiliate. Second, securities activities allowed within the

banks provide the most important benefits. Most of these activities are

already permitted and few changes are expected. Third, BHC's organized by

nonmetro banks might expand competition. BHG underwriting would still be

small compared with large underwriters and rural companies. Scale economies

will raise their costs and limit the competitive benefit. Fourth, the

securities affiliate of a BHG may specialize in a narrow set of securities

activities, such as managing a mutual fund, that provides no special advantage

to rural customers. Fifth, if the affiliate specializes in offering rural

services, participating banks may receive only minimal diversification

benefits because the health of the local economy affects loan and security

financings equally.

If repealing the Glass-Steagall Act inGreases competition, then issuers will

benefit most. Because issuers generally have better credit ratings than

nonissuers, new competition is more likely to lower financing cost than to

increase its availability. Security issues may compete effectively with bank

loans, but only loans too big to be obtained from an average rural bank.

Security issuers may therefore experience lower financing costs, but: only at

financing costs competitive with other large bank customers.^ Rural banks

will be affected only to the extent that they lend to corporations and

municipalities large enough to issue securities.

Even if rural banks entered securities underwriting, their competitive effect

could be small. In a study of competition in investment banking, Hayes,

Spence, and Marks reported that customer loyalty (low client turnover) tended

to be more important for the leading investment banking firms than for other

firms in the industry. Because rural BHC's are unlikely to become leading

investment banking firms, they may enter market segments only where

competition is not a problem. The advantage to rural issuers may, therefore,

not be significant.

Effects on Rural Economic Growth

Repealing the Glass-Steagall Act may increase competition in underwriting and

improve the availability or the pricing of rural financing. Theory and

empirical studies show little increase in economic growth with institutional

changes in the financial sector under normal circumstances. By contrast,

distributional effects are expected. If repeal increases the likelihood of

bank failure and if regulators let more rural than urban banks fail, rural

banking services could be lost and economic growth could be slowed.

^The National Federation of Independent Business reported a study showing that "thrse-fourths of all bank

loans to small business were made by small- and medium-sized banks, and that loans to small firms make up 95

percent of the commercial loan portfolio of small banks and 77 percent at medium-sized banks, compared to

just 13 percent at large banks." (Wirth).

31
Theoretical Linkages between Financial Structure and Growth

The role of financial intermediaries is to facilitate linkages between savers

and investors and to reduce transactions costs. Once a market is established,

the primary effect of changes in the structure of financial institutions is to

redistribute funds. Some reduction in transaction costs is possible with

Increases in competition, but cost savings are expected to be small in the

absence of significant barriers to entry. The effect on economic growth of

structural change is likewise expectejd to be small because redistributing

funds among competing Investors normally yields comparable contributions to

growth.^^

This result is possible in the case of rural financial markets in the long run

so long as the rural economy is essentially open and prices are allowed to

vary with market conditions. If there were no access to underwriting services

ill the rural areas, for example, then the reduced investment would lower^áges

and raise interest rates stimulating an outflow of labor and an inflow of

capital. The inflow of capital could take place through bank loans,

government transfer payments, or direct investment by large commercial firrais

hoping to take advantage of lower wages. To argue that rural financial

markets constrain economic growth, therefore, one needs to demonstrate that

prices are inflexible, that barriers to trade exist, or that markets are

monopolized.

Because these conditions are not fully met in rural America, we expect that

rural credit markets will not pose large constraints on economic growth. The

speed of adjustment to changing economic conditions may be slow. Transactions

costs may be higher than in urban areas. We expect, however, that the

differences between urban and rural areas in economic growth in the aggregate

over the long run are roughly comparable.

Effec ts of Changing Financ ial S tructure on Economic Growth

Regional economic growth is defined as an Increase in aggregate demand and is

measured by increases in the gross domestic product. Measurable economic

growth accordingly occurs whenever a firm increases its demand for inputs, or

whenever consumers make additional purchases. Economic growth will normally

be accompanied by employment growth.^

At least three possible links between product deregulation and rural economic

growth can be cited. First, rural bank profitability could increase, spurring

local growth as profits are distributed to shareholders and bank employment

increases. Second, the securities market could expand, alleviating local

financing constraints to increase rural investment. Third, market competition

could increase, lowering rural financing costs and increasing rural

investment.

Rural Bank Profitab11itv Effects on Growth. Repealing the Glass-Steagall Act

presumably could stimulate economic growth by reducing bank portfolio risk or

^^0. Williamson's work on transactions costs suggests that market allocations^^^^

firms; particularly large congloraeJ^ate firms, are roughly substitütable. In the event of market failure or

high transactions costs within the market, we therefore expect to see greater use of intra-firm allocations.

In other words, institutional structure only matters when transactions costs aré high. In the literature on

institutional economics, this is known as the "Coase hypothesis." See, for example: (Goase).

^^The normal case holds, provided that labor-saving technological change is not an important source of the

economic growth.

32
increasing bank profitability. Scale economies in securities underwriting,

however, suggest that significant rural bank participation in securities

underwriting is feasible only through joining a BHC. Because the primary

benefit of BHC participation is bank portfolio diversification and

participation is likely to be low, rural bank profitability is not expected to

increase significantly. The contribution to economic growth is consequently

expected to be small.

Effects of Reduced Financing Constraints on Growth. Repealing the GlassSteagall Act could presumably alleviate local constraints on financing and

spur economic growth as rural issuers increase investment. These constraints

could take the form of credit rationing or overpricing.

Credit rationing--inadequate access to credit--is sometimes alleged to

constrain rural growth. The significance of this effect depends on the number

of rural firms that have sought financing unsuccessfully and the number that

will now find financing because of increased underwriting. Rogers, Shaffer,

and Pulver explored the question of rural capital market adequacy in a study

of Wisconsin rural nonfarm businesses. After adjusting for risk, they

concluded that firms with assets under $100,000, which were small relative to

the largest local lender, and had a lender very familiar with their industry

were more likely to be denied credit. Firms with assets over $500,000 and

with a relatively large number of medium- and long-term loans were more likely

to experience an underfunding of a loan request. Lenders were reported to

discriminate against firms with declining sales, high debt-sales ratios, and

limited management experience, and firms in the startup or expansion stage of

growth in extending loans. If these denials ultimately lead borrowers to give

up seeking the credit desired, the authors' conclusions suggest that untapped

growth potential may exist in rural Wisconsin and, by analogy, in rural areas

more generally. Alternatively, lending requests denied by one lender may be

funded by another.

Another constraint could arise because of overpriced credit. Overpricing

could occur either because the local market has excess demand for credit or

because the local supply of credit is constrained either through a low savings

rate or monopoly pricing.

Some evidence of rural-urban pricing discrepancies can be cited. Freshwater,

for example, cited a survey that reported small rural businesses paid 2.2

percent above the prime lending rate for credit that cost firms in large metro

areas 1.7 percent above prime. Hiemstra and Lee reported statistically

significant differences in agricultural mortgage interest rates among lenders,

regions, ownership classes, and classes of land for fixed-rate mortgages.

While such discrepancies are often cited as evidence of insufficient rural

credit (or a rural credit "gap") or rural market inefficiencies, they may not

be statistically significant after adjusting for differences in borrower risk

characteristics. The causes of the discrepancies are generally not analyzed.

Concerns about credit rationing and overpricing most likely arise not from a

general problem with availability or with pricing, but because credit

availability and pricing change over the course of credit cycles. If rural

credit markets have been isolated from the national capital market in the

past, then deregulation could increase credit market integration and improve

both credit availability and pricing through regional inflows and outflows.

Rural areas, therefore, experience the same advantages and disadvantages of

the national credit market as urban areas.

33
Rural market integration into the national credit market has clearly increased

in the 1980's (Mikeseil and Davidson). Rural banks can already import capital

through the market for Federal funds, relationships with the Federal Reserve,

loan participations j and coi^resppndent relationships with larger urban banks.

Rural banks may, however, be reluctant to use these linkages in extending

credit for fear of unforeseen risk or out of inexperience. Repealing the

Glass-Steagall Act will likely increase the integration of rural credit

markets in the national market, but increased integration seems unlikely to

stimulate rural growth significantly in view of existing market linkages.

Competitive Effects on Growth. Repealing the Glass-Steagall Act could

presumably stimulate economic growth by lowering rural financing costs and

increasing rural investment.

To argue that new competition in financial markets will increase economic

growth, one must demonstrate first that the new competition will significantly

benefit either rural banks or rural issuers. 1 have argued that these effects

are likely to be small and that the primary market affected would be the

market for bank loans to public corporations. Because this market is always

expected to be more competitive than the market for bank loans to smaller

firms, the independent effect of Glass-Steagall is not expected to be large.

We might expect to see a small increase in the rate of growth of large public

corporations in the rural areas relative to smaller firms. We would not

expect to be able to measure an increase in the aggregate rate of rural

economic growth.

This result is consistent with past studies that have analyzed the effect of

banking structure on economic growth. Lombard! and Zink reporteti in a study

of eight Southwestern States that the four with statewide branching grew

faster than the four without during the I960's. Loan-to-deposit ratios were

higher in the States with statewide branching laws. Shane reached compatible

conclusions in a Minnesota study, observing that the average Minnesota bank in

1974^ when unit banking laws applied, could not provide the average financing

requirements of the average commercial farm borrower in the State. The

implication is that constraints on loanable funds made it difficult for banks

to meet the reasonable credit demands of local business.

These studies have their critics. A higher loan-to-deposit ratio, for

example, does not imply that loans are made locally or that a demand exists

for additional funding. Darnell observes that unit banking States have lower

loan-to-deposit ratios. He argues, however, that higher rates of growth

should be associated with the longer term debt required to finance plant and

equipment, not the short- and intermediate-term usually obtained from banks.

He also observes that bank size is the factor that best explains high loanto-deposit ratios because of the greater opportunity a large bank has to

diversify its portfolio. In a county-level study of banks and regional growth

in Appalachian States in 1974, Dreese is skeptical that banks and bank

structure contribute significantly to regional growth. Dreese reported that

employment growth was a better explainer of commercial and industrial loan

growth than vice versa. Loan growth follows deposit growth. Dreese concludes

that the availability of loanable funds is probably a necessary but not a

sufficient condition for regionar growth. Milkove and Weisblat reported that

banks in competitive markets had higher loan-to-deposit ratios. They were

unable, however, to demonstrate that a competitive market stimulated economic

growth.

34
Empirical studies of previous changes in the structure of rural financial

institutions clearly show mixed results. This supports the contention that

the link between institutional changes in rural financial markets and economic

growth rates is weak.

Growth Effects of Bank Failures

Product deregulation is promoted as a means of allowing commercial banks to

diversify portfolio risk. Because investment banking is a highly cyclical

business, risk reduction may be a long-term result but not a short-term

result. Product deregulation may increase profits during cyclical upswings

and decrease profits during cyclical downswings, actually increasing risk

rather than decreasing it in the short to intermediate term. Increased risks

might also arise out of problems with commercial bank management of securities

activities due to inexperience, insufficient scale, or problems in the

relationship between the BHC and the securities affiliate. Whatever reasons

are cited, product deregulation could raise, rather than lower, the

probability of bank insolvencies.

The risk of increased rural bank failures with product deregulation may be

more important than upside gains, even if rural banks do not fail any more

often than urban banks of a similar size. Two reasons can be cited. First,

if rural areas have an industrial base more specialized than urban areas

(Killian and Hady), rural bank failures could have a larger impact than urban

bank failures on local growth. Second, if bank regulators are less likely to

intervene to prevent a rural bank failure than an urban bank failure, then

rural policymakers should accept fewer risks than urban policymakers, all

other things being the same, because they face larger downside risks.^

In a 1988 study of bank failures in three Great Plains States, Gilbert and

Köchin reported that, on average, Oklahoma communities experiencing a bank

failure had a 20-percent decline in local employment within 10 months after

the bank closed. Estimates for Kansas show a 2-percent decline in employment

6 months after the bank closed. Estimates for Nebraska showed no employment

effect. Employment effects arise, presumably, because shareholders and

uninsured depositors lost money, and because borrowers lost established

relationships with their lender. Alternative lenders presumably discounted

the ability of these borrowers to repay loans (that is, "rationed" them) and

provided them less credit or credit on less favorable terms.^ These costs

reduced rural employment by depressing the local economy.

Given the wide variation in employment effects, what role do banks play in the

local economy? Minisky (1965a) cites seven possibilities: allocating capital

funds, providing legitimate credit needs, servicing the flow of savings,

facilitating capital inflows, transmitting Federal Reserve policy, managing

the economy's payment system, and providing financial services.

Banks can absorb or amplify shocks to the local economy. The banking system

amplifies a shock when losses are passed through the financial system to

^It should be recognized that bank failures are often caused (or at least associated) with problems in

the local economy. High levels of unemployment and firm failures may, therefore, cause a bank to fail

rather than the other way around.

^A study of the closing of a bank branch office in Philadelphia in 1980 reported neighborhood lending

declined 62 percent, while areawide lending increased AO percent. Small businesses in the area not only

received fewer loans, but they experienced a loss of business (Community Resource Center).

35
liability holders, when by protecting itself from losses the bank generates

greater losses and defaults than might otherwise occur, and when financing

conditions tighten whenever income has fallen. Gilbert and Köchin observed

little or no additional unemployment when failed banks were kept open through

takeovers arranged by bank regulators. Minisky (1965b) observed that banks

absorb shocks to the local economy up to a point and amplify shocks after that

point. The net worth of the bank, the character of its liabilities, and the

actions of regulators determine the ability of banks to absorb financial

shocks. These conclusions are consistent with recent work in macroeconomics

(Gertler; Williamson; and Bernank),

Highly specialized rural areas may face higher opportunity costs when banks

fail than more diversified areas because fewer financing alternatives exist in

rural than urban areas. Hard evidence to support this contention is not

available.

The second hypothesis, that the attitude of banking regulators could

disadvantage rural areas, appears almost self-evident. In a recent study of

bank failures, Gajewski concludes:

Banks specializing in farm finance or headquartered in gas-[energy]

dependent counties are found to face higher closure probabilities; Large

banks and banks affiliated with MBHC's that have many other subsidiaries

are found to have lower closure probabilities.

'Because bank regulators focus primarily on the cost of bank failures in

determining how to resolve them, this result might follow because failed rural

banks are simply cheaper to close than to sell.^ Because small banks are no

more expensive to close than large banks (Bovenzi and Murtón), however, it

seems more likely that regulators treat small rural banks as expendable while

larger urban banks are considered too large to fail (Kaufman, 1988a).^ If

this is true, then rural development suffers disproportionally more than urban

development from bank failures under similar circvimstances. Some of these

bank closings may, of course, be offset by the entry of new rural financial

firms (Milkove and Sullivan). If product deregulation raises the risk of

rural bank failure, however, then rural growth prospects may bear more of the

cost than urban growth.

Safety and Soundness Considerations

If we accept the premise that rural banks are disproportionally affected by

bank failures, then the focus of product deregulation efforts needs to shift

from what new bank powers are most efficient to what new bank powers are most

consistent with a sound banking system (Cargill). The thrust of the 1988

proposals, as they pertain to safety and soundness considerations, is to limit

self-dealing, conflicts of interest, and bank insolvencies by confining

securities operations to securities affiliates. This approach limits the

efficiency gains likely to arise from diversification and better use of

^^Bovenzi and Murtón list five options open to bank regulators: deposit payoff, purchase and assumption

transactions, insured-deposit transfers, open-bank assistance, and bridge banks. While most options result

in a change in management and losses to stockholders, only the deposit payoff results in the inmediate

cluing of the bank.

usually this argument is stated the other way around. In examining the bailout of Continental Illinois

Bank, Jackson, for example, asks whether money center bank depositors enjoy a full Government guarantee at

the expense of smaller bank depositors whose partial guarantee comes at greater relative expense. If the

cost of the guarantee to money center depositors is lower than that paid by other depositors, then an

incentive to consolidate banks exists and a disincentive exists to bank with a smaller institution.

36
overhead costs, but facilitates regulation by making commercial relationships

more transparent, allowing regulators to maintain the current division of

labor.

Another approach is to ask whether repealing the Glass-Steagall Act is the

most effective way to deregulate financial product markets in view of the

structure of rural financial markets. The small size of rural banks and the

existence of scale economies in securities underwriting make it clear that

rural banks will not be the biggest beneficiaries of this form of

deregulation. The small size of rural banks might not preclude them, however,

from taking a larger role in insurance and real estate markets, which require

less overhead capital and local, rather than national, market expertise.^^

There may also be ways that regulators can help reduce the transaction costs

required in the market for loan participations by providing underwriting

standards and encouraging the development of secondary markets in rural loans.

References

Amel, Dean F., and Daniel G. Keane. 1987. "State Laws Affecting Commercial

Bank Branching, Multibank Holding Company Expansion, and Interstate Banking."

Unpublished manuscript. Board of Governors of the Federal Reserve. January.

Anders, George, and Craig Forman. 1988. "London has Growing Role as a

Conduit for the Program Trading of U.S. Stocks," Wall Street Journal.

September 21.

Baughn, William H., Thomas I. Storrs, and Charles E. Walker. 1988. The

Bankers' Handbook. Third edition. Homewood, XL: Dow Jones-Irwin,

Benston, George J. 1986. "Federal Regulation of Banking," Deregulating

Financial Services: Public Policy in Flux. George G. Kaufman and Roger C,

Kormendi (editors). Cambridge, MA: Ballenger Publishing Company, pp. 1-47.

Bernanke, Ben S. 1983. "Nonmonetary Effects of the Financial Crisis in the

Propagation of the Great Depression," American Economic Review. June, pp.

257-76.

Bianco, Anthony. 1987. "Can Salomon Grow by Shrinking?" Business Week.

October 26, pp. 30-31.

Bierwag, G.O., George G. Kaufman, and Paul H. Leonard. 1984. "Interest Rate

Effects of Commercial Bank Underwriting of Municipal Revenue Bonds," Journal

of Finance, pp. 35-50.

Black, Harold A,, M. Andrew Fields, Robert Schweitzer, and others. 1988.

"Changes in Interstate Banking Laws: The Impact on Shareholder Wealth."

Working Paper No. 88-16, Federal Reserve Bank of Philadelphia. November,

Bloch, Ernest. 1989. Inside Investment Banking. (second edition).

Homewood, IL: Dow Jones-Irwin.

^Rural banks evidently are anxious to underwrite revenue bonds, to be able to organize mutual funds, to

broker insurance, and to broker and invest in real estate. Even though banks are forbidden in general to

offer these services, rural banks are often a family affair and these services may be provided legally

through a separate business run by a spouse of the bank president. This arrangement may add cost to the

basic service, however, without adding value.

37
Bluestone, Barry, and Bennett Harrison. 1982. The Deindustriallzation of

America. New York: Basic Books, Inc.

Board of Governors, Federal Reserve System. 1980. "The Depository

Institutions Deregulation and Monetary Control Act of 1980." Federal Reserve

Bulletin. June, pp. 444-53.

. 1988. 74th Annual Report: 1987.

Born, Jeffrey A., Robert A. Eisenbeis, and Robert S. Harris, 1988. "The

Benefits of Geographical and Product Expansion in the Financial Services

Industry," Journal of Financial Services Research, pp. 161-82.

Bovenzi, John F., and Arthur J. Murtón, 1988. "Resolution Costs of Bank

Failures," FDIC Banking Review, pp. 1-13,

Brimmer, Andrew F. 1989. "Distinguished Lecture on Economics in Government:

Central Banking and Systemic Risks in Capital Markets." Journal of Economic

Perspectives. Spring, pp. 3-16.

Bryan, Lowell, and Paul Allen. 1988. "Geographic Strategies for the 1990's :

Preparing for a Smart Endgame," The Bankers' Handbook. (third edition).

Edited by William H. Baughn, Thomas I. Storrs, and Charles E, Walker.

Homewood, IL: Dow Jones-Irwin, pp. 26-45.

Business Week. 1982. "Swift: Cutting Costs and Adding Products to Beat a

Profit Deadline." June 21, pp. 65-66.

. 1983. "ConAgra: The Payoff Could Be High from Its Risky Bet on

Armour." December 19, pp. 85 and 90.

. 1984. "The New Food Giant: Merger Mania is Shaking the Once

Cautious Industry." September 24, pp. 132-38.

Cargill, Thomas F. 1988. "Glass-Steagall is Still Needed," Challenge.

November/December, pp. 26-30.

Clark, Jeffrey A. 1988. "Economies of Scale and Scope at Depository

Financial Institutions: A Review of the Literature." Economic Review.

Federal Reserve Bank of Kansas City. October, pp. 16-33.

Clark, Robert Charles. 1979. "The Regulation of Financial Holding

Companies," Harvard Law Review, pp. 787-863.

Clark, Matthew, and Anthony Saunders. 1980. "Glass-Steagall Revised: The

Impact on Banks, Capital Markets, and The Small Investor," Banking Law

Journal. October, pp. 811-40.

Coase, R.H. 1960. "The Problem of Social Cost," Journal of Law and

Economics. October, pp. 1-44.

Coll, Steve. 1988a. "New York Stock Exchange; Program Trading is

Continuing--Firms Executing Deals for Customers," Washington Post. September

23.

38
1988b. "Food Industry Takeover Wars Part Economics, Part Fashion,"

Washington Post. October 25.

Community Resource Center. 1984. Banking Report—A Record of Community

Disinvestment. Philadelphia.

Gross, William T. 1923. The Making of a Trust Company: Twenty-one Years'

Experience of Chicago Trust Company. Chicago: Chicago Trust Company,

Darnell, Jerome. 1972. "Does Banking Structure Spur Economic Growth?"

Business Review. Federal Reserve Bank of Philadelphia. November, pp. 14-23.

Doran, John J., Joe Mysak, and John McCorry. 1987. "Dealers React to Salomon

Bombshell," Credit Markets. October 19, pp. 4-5.

Dreese, G. Richard. 1974. "Banks and Regional Economic Development,"

Southern Economic Journal. April, pp. 647-56.

Ederington, Louis H, 1976. "Negotiated Versus Competitive Underwriting of

Corporate Bonds," Journal of Finance. March, pp. 17-28.

Edwards, Franklin R. 1964. "Concentration in Banking and Its Effects on

Business Loan Rates," Review of Economics and Statistics, pp. 294-300.

Eisenbeis, Robert A, 1986. "Risk as a Criterion for Expanding Banking

Activities," Deregulating Financial Services: Public Policy in Flux, pp. 169-

89.

Eisenbeis, Robert A., Robert S. Harris, and Josef Lakonishok. 1984.

"Benefits of Bank Diversification: The Evidence from Shareholder Returns,"

Journal of Finance, pp. 881-92.

Elliehausen, Gregory E., and Robert D. Kurtz. 1988. "Scale Economies in

Compliance Costs for Federal Consximer Credit Regulation," Journal of Financial

Services Research, pp. 147-59.

Farhi, Paul. 1988. "Pizza Rising Fast in Fast Food Market," Washington Post.

September 20.

Federal Deposit Insurance Corporation (FDIC). 1986. Statistics on Banking:

1986.

. 1987. Mandate for Change: Restructuring the Banking Industry.

October.

. 1988. 1987 Annual Report. June.

Federal Reserve Bank of Chicago. 1984. "Leveling the Playing Field: A

Review of the DIDMCA of 1980 and the Garn-St. Germain Act of 1982," Readings

in Economics and Finance. November.

Ford, Theresa. 1987. "Global Banking, Financial Integration Major Conference

Topics," Economic Perspectives. Federal Reserve Bank of Chicago.

July/August, pp. 23-27.

39
Fraser, Donald R., and James W. Kolari. 1985. The Future of Small Banks in a

Deregulated Environment. Cambridge, MA: Ballenger Publishing Company.

Freshwater, David. 1989. "Redefining the Federal Role in Providing Credit to

Rural America." Unpublished manuscript. Joint Economic Committee, U.S.

Congress.

Frisbee, Pamela S. 1986. "The Automated Clearing House: An Elusive Dream,"

Economic Review. Federal Reserve Bank of Atlanta. March, pp. 4-8.

Gajewskl, Gregory R. 1988. "Modelling Bank Closures in the 1980's : The

Roles of Regulator Behavior, Farm Lending, and the Local Economy."

Unpublished manuscript. U.S. Department of Agriculture, Economic Research

Service.

Gajewski, Gregory R., and M. Ellen Burkhart. "Farm Banks in the Energy Belt:

A Double Whammy?" Forthcoming. U.S. Department of Agriculture, Economic

Research Service.

Gertler, Mark. 1988. "Financial Structure and Aggregate Economic Activity:

An Overview," Journal of Money. Credit, and Banking. August, pp. 559-88.

Giddy, Ian H. 1985. "Is Equity Underwriting Risky for Commercial Bank

Affiliates?" Deregulating Wall Street: Commercial Bank Penetration of the

Corporate Securities Market. Ingo Walter (editor). New York: John Wiley and

Sons, pp. 145-69.

Gilbert, R. Alton. 1988. "A Comparison of Proposals to Restructure the U.S.

Financial System," Economic Report. Federal Reserve Bank of St. Louis.

July/August, pp. 58-73.

Gilbert, R. Alton, and Levis A. Köchin. 1988. "Credit Rationing and Economic

Activity: Evidence from Bank Failures in the Rural Midwest." Unpublished

manuscript. Federal Reserve Bank of St. Louis.

Guenther, Robert. 1988a. "Chase to Ask Fed for Securities Powers If Current

Congress Doesn't Change Law," Wall Street Journal. October 12.

. 1988b. "Citicorp Shakes up the Mortgage Market: Rivals

Contend Its Brokerage Fee Hurts Borrowers." Wall Street Journal. November 3,

. 1988c. "Banks Offer Glimpse at LBO Portfolios, Showing that

Many Loans are Re-Sold," Wall Street Journal. December 13,

. 1988d. "HUD Expected to Issue Rules Opposing Mortgage

Procedure Backed by Citicorp." Wall Street Journal. December 30.

. 1989. "Citicorp Has Delaware Unit Issue Securities," Wall

Street Journal. March 14.

Hannan, Timothy H., and John M. McDowell. 1984. "The Determinants of

Technology Adoption: The Case of the Banking Firm," Rand Journal of

Economics. Autumn, pp. 328-35.

40
Hanweck, Gerald A., and Stephen A. Rhoades. 1984. "Dominant Firms, 'Deep

Pockets,' and Local Market Competition in Banking," Journal of Economics and

Business. pp. 391-402.

Harney, Kenneth R. 1989. "*Instant Commitment' Loans Revolutionizing the

Industry," Washington Post. February 4.

Hayes III, Samuel L. 1979. "The Transformation of Investment Banking,"

Harvard Business Review. January-February, pp. 153-70.

Hayes III, Samuel L., A. Michael Spence, and David van Praag Marks. 1983.

Competition in the Investment Banking Industry. Cambridge, MA: Harvard

University Press.

Hendershott, Patrie, and David S. Kidwell. 1978. "The Impact of Relative

Security Supplies," Journal of Money. Credit, and Banking. August, pp. 337-

47.

Henderson, James M., and Richard E. Quandt. 1971. Microeconomic Theory: A

Mathematical Approach (second edition). New York: McGraw-Hill Book Company.

Hiemstra, Stephen W. 1985. "Labor Relations, Technological and Structural

Change in U.S. Beef Packing and Retailing." Ph.D. dissertation, Michigan

State University, East Lansing.

Hiemstra, Stephen W., Steven R. Koenig, and David Freshwater. 1988.

Prospects for a Secondary Market in Farm Mortgages. AER-603. U.S. Department

of Agriculture, Economic Research Service. November.

Hiemstra, Stephen W., and Hyunok Lee. 1989. "Implications of the Land

Transfer Survey's Financial Data for the Farmer Mac Secondary Market,"

contributed paper, American Agricultural Economics Association conference,

Louisiana State University, Baton Rouge. August.

Horowitz, Jed. 1988. "Executives Split on Question of Bank Underwriting,"

Banking Week. September 12.

Huertas, Thomas F. 1988. "Can Banking and Commerce Mix?" Cato Journal.

Winter, pp. 743-62.

Hunter, William C, and Stephen G. Timmer. 1986. "Technological Change,

Organizational Form, and the Structure of Bank Production," Journal of Money.

Credit, and Banking. May. pp. 152-66.

. 1987. "Concentration and Innovation: Striking a Balance in

Deregulation," Economic Review. Federal Reserve Bank of Atlanta.

January/February.

Ingersoll, Bruce. 1988. "Fed Clears Minimum Capital Standards Forcing Some

Banks to Raise $15 Billion," Wall Street Journal. August 4.

Irwin, Scott H., D. Lynn Forster, and Bruce J. Sherrick. 1988. "Returns to

Farm Real Estate Revisited," American Journal of Agricultural Economics.

August, pp. 580-87.

41
Jackson, William. 1985. Public Rescue of Private Liabilities: The

Continental Illinois Case. Report No. 85-172 E. Congressional Research

Service, Library of Congress. November 20.

Johnson, Sylvester, and Amelia A. Murphy. 1987. ^'Golng Off the Balance

Sheet," Economic Review. Federal Reserve Bank of Atlanta. September/October,

pp. 23-35.

Kane, Edward J. 1986. "Confronting Incentive Problems in U.S. Deposit

Insurance: The Range of Alternative Solutions." Deregulating Financial

Services: Public Policy in Flux. Cambridge, MA: Ballenger Publishing

Company, pp. 97-120,

Kaufman, George C. 1986. The U.S. Financial System: Money. Markets. and

Institutions (third edition), Englewood Cllffs, NJ: Prentice-Hall.

. 198&a. "Bank Runs: Causes, Benefits, and Costs." Cato

Journal. Winter, pp. 559-87.

1988b. "Securities Activities of Commercial Banks: Recent

Changes in the Economic and Legal Environments." Journal of Financial Services

Research, pp. 183-99.

Kaufman, George C, Larry R. Mote, and Harvey Roseblum. 1984. "Consequences

of Deregulation for Commercial Banking." Journal of Finance. July, pp. 789-

803.

Key^ Sydney J. 1989. Financial Integration in the European Community.

International Finance Discussion Papers, No. 349. Board of Governors of the

Federal Reserve System. April.

Kichen, Steve, and Michael Ozanian. 1986. "The Shadow Economy." Forbes.

November 17, pp. 190-93, 196-208, and 212-22.

Killian, Molly Sizer, and Thomas F.Hady. 1987. "The Economic Performance of

Rural Labor Markets," Rural Economic Development in the 1980's : Preparing for

the Future. Staff Report Ño, AGES870724. U.S.Department of Agriculture,

Economic Research Service. July, pp. 8-1 to 8-23.

Kincaid, G. Russell. 1988. "Policy Implications of Structural Changes in

Financial Markets." Finance and Development. March, pp. 2-5.

Kling, Arnold. 1988. "A Rise in Bank Failures from a Macroeconomic

Perspective," Journal of Financial Services Research, pp. 353-64.

Korobow, Leon, and George Budzeika. 1985. "Financial Limits on Interstate

Bank Expansion," Quarterly Review. Federal Reserve Bank of New York. Summer,

pp. 13-27.

Leibenstein, Harvey. 1978. General X-Inefficiency Theory and Economic

Development. New York: Oxford University Press.

Levich, Richard M. 1985. ''A View from the International Capital Markets,"

Deregulating Wall Street: Commercial Bank Penetration of the Corporate

Securities Market. Edited by I. Walter. New York: John Wiley and Sons. pp.

255-302.

42
Linowes, David F. 1987. "Is Merger Mania Good for the Nation?" Illinois

Business Review. June, pp. 10-13.

Litan, Robert E. 1987. What Should Banks Do? Washington, DC: The Brookings

Institution.

Lombardi, Walter G., and Lee B. Zink, 1971. Economic Growth and the Banking

System. (revised edition). New Mexico Studies in Business, No. 26. Bureau

of Business Research, Institute for Social Research and Development,

University of New Mexico, Albuquerque. December.

Maloney, Michael T., and Robert E. McCormick, 1988. "Excess Capacity,

Cyclical Production, and Merger Motives: Some Evidence from the Capital

Markets," Journal of Law and Economics. October, pp. 321-50.

Melloan, George. 1989. "*Forgiveness' Talk Enlivens the Bad-debt Market,"

Wall Street Journal. March 14.

Meltzer, Allan H. 1986, "Financial Failures and Financial Policies,"

Deregulating Financial Services: Public Policy in Flux. Cambridge, MA:

Ballenger Publishing Company, pp. 79-96.

Mikesell, James J. 1988. Nonmetro. Metro, and U.S. Bank Operating

Statistics. 1985. Staff Report No. AGES880715. U.S. Department of

Agriculture, Economic Research Service. September.

Mikesell, James J., and Steve Davidson. 1982. "Financing Rural America: A

Public Policy and Research Perspective," Rural Financial Markets: Research

Issues for the 1980's. (Proceedings). Federal Reserve Bank of Chicago,

pp. 159-97.

Milkove, Daniel L. 1985. Do Bank Size and Metro-Nonmetro Location Affect

Bank Behavior? RDRR-47. U.S. Department of Agriculture, Economic Research

Service. April.

Milkove, Daniel L., and Patrick J. Sullivan. 1989. "Should Rural Communities

Fear Bank Deregulation?" Rural Development Perspectives. February, pp. 2-8.

Milkove, Daniel L., and David B. Weisblat. 1982. The Effects of the

Competitive Structure on Rural Bank Performance and Economic Growth. Staff

Report No. AGES820226. U.S. Department of Agriculture, Economic Research

Service. August.

Minisky, Hyraan P. 1965a. "Overview," California Banking in a Growing

Economy: 1946-75. Edited by Hyman P. Minisky. Institute of Business and

Economic Research, University of California, Berkeley, pp. 1-23.

1965b. "Commercial Banking and Rapid Economic Growth in

California," California Banking in a Growing Economy: 1946-75. Edited by

Hyman P. Minisky. Institute of Business and Economic Research, university of

California, Berkeley, pp. 79-134.

Morrell, Stephen 0., and Richard P. Saba. 1983. "The Effects of Federal Home

Loan Mortgage Corporation Secondary Market on Regional Mortgage Yield

43
Differentials," Quarterly Review of Economics and Business. Spring, pp. 85-

98.

Murray, Allan. 1989. "Bush's New Solution for I'roblems of S & L's Could Kill

Them Off," Washington Post. February 7.

Pavel, Christine, and Harvey Rosenblüm. 19^5. "Banks and Nonbanfcs: The

Horse Race Continues, " Economic Persi^ectives. Federal Reserve Bank of

Chicago. May/June.

Philis, Dave, and Christine Pavel. 1985. "Interstate Banking Game Plans:

Implications for the Midwest. '^Economic Perspectives. Federal Reserve Bank of

Chicago. March/April.

Porter, Michael. 1980. Competitive Strategy. New York: Macmillan

Publishing Company, Inc.

Proxmire, William. 1 988 . Financial Moxiernization Act of 1988 .

Report 100-305. Committee on Banking, Housing, and Urban Affairs, U.S.

Senate. March 22.

Pugel, Thomas A. , and Lawrence J. White. 1985. "Analysis of the Competitive

Effects of Allowing Commercial Bank Affiliates to Underwrite Corporate

Securities," Deregulating^all Streets: Commercial Bank Penetration of the

Gor^orsLte Securities Market; Edited by : I .Walter. New York: John Wiley and

Sons, pp. 93-139.

Rauch, Jonathan. 1989. "Treating S 6c L's with Farm Credit Tonic," National

Journal. March 4, pp. 529-30.

Rhoades, Stephen A. 1985. "Iiiterst:âte Banking and Product Line Expansion;

Implications from Available Evidence, » Lovola of Los Angeles Law Review. pp.

1,115-45.

Ricks, Thomas. 1988. "SEC Proposes Wider Market for Securities, " Wall Streeit

Journal. October 26.

Ritter, Jay R. 1984. "The ^Hot Issues' Market of 1^m, " Journal of Business.

pp. 215-40.

Rogers, Glenn, Ron Shaffer, and Glen Pulver. 1988. "Rural Capital Market

Adequacy : Wisconsin Rural Notifarm Businesses. " Unpublished manuscript. U. S.

Department of Agriculture, Economic Research Service.

Rosenblum, Harvey, John Di Clemente, and Kit O'Brien. 1985. "The Product

Market in Commereial Banking: Cluster's Last Stand?" Economic Perspectives.

Fexieral Reserve Bank of Chicago. January/February.

Rosenthal, James A. , and Juan M. Ocampo. 1988 . Securitiza11 on of Credit :

Inside the New Technology of Finance. New York: John Wiley and Sons, Inc.

Roth, Howard L. 1988. "Volatile Mortgage Rates—A New Fact of Life?"

Economic Review. Federal Reserve Bank of Kansas City. March, pp. 16-28.

Rowe, Timothy D. 1986. "nnmmprnT^T PapPtr, " Instruments of the Money Market

(sixth edition). Federal Reserve Bank of Richmond, pp. 111-25.

44
Rudnitsky, Howard, Allen Sloan, Richard L. Stern, and Matthew Heller. 1986.

"A One-Man Revolution," Forbes. August 25, pp. 34-36, 40, 44, and 48-49.

Saunders, Anthony. 1985. "Bank Safety and Soundness and the Risks of

Corporate Securities Activities," Deregulating Wall Street: Commercial Bank

Penetration of the Corporate Securities Market. Edited by I. Walter. New

York: John Wiley & Sons, pp. 171-206.

Savage, Donald T. 1987. "Interstate Banking Developments," Federal Reserve

Bulletin. February, pp. 79-92.

St. Germain, Fernand J, 1988. Depository Institutions Act of 1988. Report

100-822, part 1. U.S. House of Representatives, Committee on Banking Finance

and Urban Affairs. August 4.

Securities Industry Association. 1977. "Bank Securities Activities:

Memorandum for Study and Discussion," San Diego Law Review, pp. 751-822.

Shane, Mathew. 1976. Minnesota Banking, the Flow of Funds, and Rural Credit.

Staff Paper P76-2. Institute of Agriculture. University of Minnesota, St.

Paul. February.

Shane, Mathew, and David Stallings. 1987. The World Debt Crisis and Its

Resolution. FAER-231. U.S. Department of Agriculture, Economic Research

Service. August.

Short, Genie D., and Jeffery W. Günther. 1988. The Texas Thrift Situation:

Implications for the Texas Financial Industry. Financial Industry Studies

Department, Federal Reserve Bank of Dallas. September.

Silber, William L. 1974. "The Market for Federal Agency Securities: Is

There an Optimal Size of Issue?" Review of Economics and Statistics.

February, pp. 14-22.

. 1980. Municipal Revenue Bond Costs and Bank Underwriting: A

Survey of the Evidence. Monograph 1979-3. New York University.

Simmons, Craig A. 1988. "Commercial Banking: Trends in Performance from

December 1976 through June 1987," Briefing Report to Congressional Requesters.

U.S. General Accounting Office. GAO/GGD-88-106BR. July.

Sullivan, Patrick J. 1983a. Examining the Rural Municipal Bond Market.

RDRR-34. U.S. Department of Agriculture, Economic Research Service. January.

. 1983b. The Cost of Metro and Nonmetro Government Borrowing. RDRR35. U.S. Department of Agriculture, Economic Research Service. January.

Taylor, Robert E. 1988a. "Fed Official Backs Limited Bank Role in

Underwriting," Wall Street Journal. September 9.

. 1988b. "Legislation to Broaden Underwriting by Banks Seems Doomed

in Congress," Wall Street Journal. October 13.

45
Thompson, James B. 1989. "Bank Lending to 130/s: Risks and Supervl^

Response," Economic Commentary. Federal Reserve Bank of Cleveland. February

15. ^ - - "

TrxieU, Peter. 1988. "Latin American Debt Prosapts Actloni Banks and Nations

Move to Reduce Burden," Wall Street Journalv September 22.

U.S. Congress, House Coimnittee on Banking, Finance, and Urban Äffairs (HOUSB^

Coimittee), Congress of the ttñitedSta1-es: 1987. Secondary Market for

Agricultural Loans. Hearings. Serial No. lOQ-35. September 30,

U.S. General Accounting Office (GAO), 1988^. "Financial liarket: Preliminary

Observations on the October 1987 Crash," Renort to Congressional Requesters.

GAO/GGD-88-3&. January.

. 1988b. "Banking: Off-Balance-Sheet Activities," Briefing Report

to the Chairman. Committee on Financial Institutions .Supervision; Regulation,

and Insurance. Gommittee on Banking. Finance. and Urban Affairs; House of

Representatives. GAO/GGD-8&-35BR. March.

Vice,; David A. , and Steve Coll. 1988. ^'SEC Charges Raise Fears over Future

ne JiiTiV Ronds '^ Wall Street Journal> September 8/

Victor, Kirk. 1989. "What About the Workers?" National Journal. February

18, pp! 395-96,

Wellons, Philip A. 1985. "Competitiveness in the World Economy: The Hole of

the XJ. S ' Financial System, " U.S . Competitiveness in the World Economy; Bruce

R. Scott and George C. Lodge (editors); Boston: Harvard Business School

Press, pp. 357-94.

West, Richard R. 1966. "More on the Effects of Municipal Bond Monopsony, "

Journal of Business. April, pp. 304-8.

West, Richard R. , and Seha M. Tinic. 1971. The Economics of the Stock

Market. New York: Praeger Publishers*

Whiteman, David. 1985; Property-Casualty Insurance Market Operation. Réport

No;85-629 E. Congressional Research Service, Library of Congress. March 20.

Wiener, Daniel P. 1987. "Deals of the Year "Fortune. February 2, pp. 68-

74.

Williamson, Oliver.1981. "The Modern Corporation: Origins^ Evolution,

A^^r^hut:f>g/' Journal of Economic Literature. December, pp. 1,531-68.

Williamson, Stephen D. 198^. «Financial Intermediation, Business Failures,

and Real Ri»c^r,a^<, CycA PS . " Journal of Political Economy, pp. 1,196-1,21$.

Winch, Kevin F. 1984. Discount Brokerage of Securities : A Status Report >

Report No. 84-32 E. Congressional Research Service, Library of Congress.

March 12.

Wirth, Timothy. 1986. Restructuring Einancial Markets: The Major Policy

Issues . Report 99 -DD. V. S. House of Représentâtives, Committee on Enex^ and

46
Commerce, Subcommittee on Telecommunications, Consumer Protection, and

Finance. July.

Zigas, David. 1988. "The Bonds Most Investors Never Hear About," Business

Week. September 19, pp. 152-53. ~~

47
Appendix: Detailed Legislative Review

The review that follows examines the titles found in Senate bill 1886 and

House of Representatives bill 5094, both passed in 1988. The House version of

this bill, the Depository Institutions Act of 1988, is lengthier with more

detailed consumer protection and regulatory oversight provisions. This

summary follows the format of the Senate bill and compares it with

corresponding provisions in the House bill/^ Table 1 shows titles of both

bills.

Securities Affiliates of Bank Holding Companies

This title repeals the Glass-Steagall Act, the primary focus of product

deregulation legislation.

Senate Bill

Title I of the Senate bill repeals sections 20 and 32 of the Glass-Steagall

Act that prohibit commercial banks from having securities affiliates. Upon

enactment, commercial banks organized as BHC's will be permitted to own a

securities affiliate. Within 6 months, the affiliate will be able to

underwrite mutual funds and corporate bonds. If approved by Congress, they

will be allowed to underwrite corporate equities in 1991.

This title permits securities affiliates to serve both as underwriters and

dealers of securities, subject to SEC regulation. No prior approval of the

Federal Reserve is required to acquire a securities affiliate, but the Federal

Reserve must be satisfied that the affiliate can be managed safely and

soundly, and large BHC's ($30 billion in assets or more) are prohibited from

acquiring large investment banking firms ($15 billion in assets or more). The

assets and liabilities of the securities affiliate cannot be consolidated with

the BHC, and the BHC's capital and total assets must be reduced by an amount

equal to its equity investments in the affiliate. The BHC may not extend

credit (or guarantees of any kind) to its affiliate (or a customer of the

affiliate) and may not purchase the affiliate's financial assets (or vice

versa). Officials and directors of the BHC may not also serve in the

affiliate, although a special exemption is provided to BHC's with less than

$500 million in assets, adjusted for inflation. The affiliate must disclose

in writing to its customers that the affiliate is not a bank or federally

insured institution and that the securities handled are not insured deposits.

The BHC may not recommend securities underwritten or traded by the affiliate

and may not disclose confidential information provided by its customers t^o the

securities affiliate. The affiliate may not commence operations unless the

BHC has complied with the risk-based capital standards of its Federal

regulator.^

This title also contains many technical amendments to existing legislation.

States may not prohibit BHC's from acquiring a securities affiliate. A BHC

may not be an affiliate of a securities firm, except as allowed under the Bank

Holding Company Act or the International Banking Act of 1978, or when acquired

before March 5, 1987. Limits placed on securities activities in this act do

not apply to activities that commercial banks were already allowed to do prior

^This section is based on the Senate and House bills and related conmittee reports (Proxmire).

^'Cotïmercial bank conflicts of interest were an important point raised by security industry lobbyists

(Securities Industry Association).

48
to the act. Large foreign conmiercial and investment banks are prohibited from

circumventing restrictions imposed on large domestic commercial and investment

banks in acquisitions approved under this act.

The title defines a "diversified financial holding company" (DFHC) as a

company that controls a bank, engages only in financial activities allowed for

BHC's in the Bank Holding Company Act, has less than 20 percent of its assets

in FDIC or FSLIC institutions, has no more than 40 percent of its assets in

depository institutions, including those abroad, and does not cross-market

banking products with products prohibited for BHC's. A DFHC may continue to

engage in activities begun before March 1, 1988, provided that they represent

less than 20 percent of total assets. A DFHC is also exempt from certain

examination and reporting requirements normally required of BHC's (Proxmire).

Financial activities of a DFHC are defined to include insurance underwriting

and agency activities, real estate brokerage, investment and development

activities, travel agency activities, and other activities as determined by

the Federal Reserve. If a DFHC fails to maintain the capital standards of its

banking subsidiaries required by any Federal banking regulator, the Federal

Reserve may require divestment of that bank.

The title requires the Federal Reserve, SEC, FDIC, Comptroller of the

Currency, and Commodity Futures Trading Commission to review and coordinate

their rules governing capital adequacy, reporting requirements, and

transactions between parent firms and affiliates on an ongoing basis to

establish greater compatibility and consistency. Regulators are further

required to prepare a report for Congress on: the effect and advisability of

applying consolidated prudent standards and financial reporting on all

financial firms; appropriate techniques for regulating relationships among

banks, securities firms, and their affiliates; ways to achieve international

harmonization of capital adequacy standards and reporting requirements for all

financial firms; the effect of global integration of securities markets; the

advisability of establishing a permanent, international framework for

coordinating financial market regulation; techniques of financial supervision;

and the impact of competition from firms that are neither banks nor securities

firms. The title also mandates the Federal Reserve, in consultation with

users, other regulators, and equipment providers, to prepare a study of the

U.S. large-payments system that outlines the steps necessary to ensure its

integrity and reliability as technology changes.

House Bill

The House and Senate bills disagree on the treatment of corporate equities

(common stocks). The Senate version permits securities affiliates to

underwrite mutual funds and corporate bonds within 6 months and corporate

equities in 1991, The House version prohibits affiliates from underwriting

corporate equities, although it permits corporate bonds and, subject to

limitations, convertible bonds (bonds that can be converted into stocks under

specified circumstances). The House bill also requires that BHC's meet the

risk-based capital standards established by the Basle Committee and required

by the Bank for International Standards before acquiring a securities

affiliate.

49
Expedited Procedures

The provisions in this title are intended to speed up procedures that might

impede commercial banks from immediately taking advantage of title I benefits.

In particular, this title encourages the formation of BHC's.

Senate Bill

Several provisions encourage formation of BHC's. First, commercial banks are

permitted to give 30-days' notice, in place of the current application

procedure, to convert to a BHC structure when ownership of the bank and the

BHC are roughly the same, capital adequacy standards are met, and the BHG does

not engage in any nonbank activities requiring special scrutiny. Second, the

procedure for authorizing approved BHC nonbank activities is changed from an

application process to a notification procedure. Third, the Bank Holding

Company Act of 1956 is amended to permit small banks to form bankers' BHC's

for purposes of collectively owning a securities affiliate. Fourth, the

waiting period in approving BHC mergers and acquisitions not affecting marketcompetitive relationships is shortenexi.

The title also amends the Depository Institution Management Interlocks Act of

1978. The threshold for exempting affiliated institutions from the provisions

of the act is lowered. Ownership is interlocked if 25 percent or more of the

voting stock (down from 50 percent) of two banks is owned by the same person

or persons. Small banks ($100 million in assets or less) and failed or

failing institutions are exempted from the provisions of the act. A limited

exemption for diversified savings and loan holding companies is also provided.

House Bill

Provisions of the Senate title are dispersed throughout the House bill,

although the language is substantially the same. Some confusion may result,

however, because title IV of the House bill contains provisions--expedited

funds availability amendraents--with a similar name that amends the Expedited

Funds Availability Act.

Brokers and Dealers

As previously interpreted, the Glass-Steagall Act permits banks to buy and

sell securities on behalf of customers provided that no investment advice is

offered. The Securities and Exchange Act of 1934 furthermore excluded

commercial banks from its definitions of "brokers" and "dealers." Bank

brokerage and dealing activities are organized as a "discount brokerage"

operation and were, by omission, exempted from SEC regulation,**

Consequently, the Federal bank regulators, particularly the Comptroller of the

Currency, took over regulation.

The Comptroller of the Currency cautiously interpreted Section 16 of the

Glass-Steagall Act that covers the activities of discount brokers between 1936

and 1982. Limits were placed on the profits a bank could make through

brokerage activities, on the solicitation of customers, and on credit extended

discount brokers function primarily as order takers and nomally do not offer investment advice.

Because discount brokers have increasingly offered services comparable to full-service brokers, they are

distinguished primarily by their pricing policies. Fee discounting has been allowed since fixed brokerage

fees were eliminated in 1975, and depository institutions have been allowed to offer discount brokerage

services since 1982 CWinch).

50
to finance securities activities. Since 1982, the Comptroller of the

Currency's and the Federal Reserve's more liberal interpretation of Section 16

has encouraged banks to expand more aggressively into discount brokerage

activities through securities affiliates. As a consequence, the SEC adopted a

rule on July 1, 1985, requiring bank brokers and dealers to seek SEC

registration. This rule requires banks to meet SEC capital adequacy

requirements and to be subject to SEC oversight and allows investors to

qualify for Securities Investor Protection Corporation (SIPC) coverage.

SIPC, established by the Securities Investor Protection Act of 1970, insures

investors against broker and dealer bankruptcy much the same way FDIC

insurance protects bank depositors against bank failure. SIPCs authority is,

however, more limited than FDICs. SIPC cannot assist in mergers or make

loans to troubled broker-dealers and returns to investors only the cash and

securities that can be retrieved from the insolvent firms--no insurance

against losses per se is provided (Wirth).

This title attempts to divide traditional bank brokerage and dealing

activities, primarily trust department activities, from activities competing

with securities brokers and dealers, and requires the latter to be organized

into a securities affiliate subject to SEC regulation.

Senate Bill

The title amends the Securities and Exchange Act to include banks that

publicly solicit securities brokerage business or that pay incentive

commissions. A broker carries out securities transactions for customers

without taking title to the securities. Activities exempted from SEC

regulation are: dealing in connection with trust or fiduciary activities;

dealing in U.S. Government securities, commercial paper, bankers' acceptances,

and commercial bills; dealing in municipal securities in the absence of a

securities affiliate; and dealing in certain securities secured by obligations

originated or purchased by the bank, its affiliate, or its subsidiary

(Proxmire). Private placement activities are exempted. A bank is also

allowed to make up to a 1,000 securities transactions per year in addition to

those allowed under other exemptions. The definition of a dealer is likewise

amended to include a bank buying and selling securities on its own account and

to require SEC regulation unless specifically exempted, as cited above.

Exempted brokerage and dealing transactions are regulated by Federal bank

regulators. Transactions not exempted must be organized into a securities

affiliate regulated by the SEC.

House Bill

The House provision (title I) takes a different approach to securities

activities. All securities activities, except those explicitly exempted, are

required to be transferred to the securities affiliate. The exemptions are

similar but not precisely the same. Exempted securities activities include:

engaging in securities brokerage and mutual fund sales; underwriting and

dealing in U.S. Treasury securities; buying and selling securities in the

bank's capacity as trustee, administrator, custodian, and managing agent;

engaging in private placement or investment advisory activities; buying and

selling investment securities for the bank's own account; engaging in certain

information activities; engaging in activities that are incidental to the

51
international or foreign business of the bank or its subsidiary; and engaging

in activities through small business investment companies (St. Germain).

Bank Investment Company Activities

Senate Bill

Much as title I permits BHC's to issue certain securities through a securities

affiliate, title IV amends the Investment Company Act of 1940 to allow BHC's

to underwrite and distribute investment company securities through a

securities affiliate. An investment company in this case can be a mutual

fund, a closed-end investment company, or a unit investment trust. Amendments

in this title regulate the relationship between the BHC and its securities

affiliate. These provisions: prohibit affiliate borrowing from the BHC,

except as allowed by the SEC; limit BHC officers from serving as directors of

the affiliate; require disclosure that securities sold by the affiliate are

not federally insured; prohibit the affiliate from purchasing securities used

to repay a BHC loan; and provide the SEC with rules-making authority under

certain circumstances not covered by the title.

The title also amends the Investment Advisors Act of 1940, much as title III

does for brokers and dealers, to require commercial banks' investment advisory

activities to be organized in a separate department registered with the SEC.

The intent here is to clarify regulatory responsibilities between the Federal

bank regulators and the SEC and to place responsibility for all advisory

activities with the SEC.

House Bill

The House bill gives no special treatment to investment company securities,

although it permits BHC's to sell mutual funds and, in general, to broker

securities.

Strengthened Enforcement Authority

Introduced earlier as a separate bill, this title may be cited as the

Enforcement Powers Improvement Act of 1988. It was requested by the Federal

bank and thrift regulators and is designed to provide uniform penalties across

regulators for similar violations. The title is directed at banks rather than

their securities affiliates.

Senate Bill

The last significant revision of enforcement powers was contained in the

Financial Institutions Regulatory and Interest Rate Control Act of 1978.

Those powers were initially considered adequate, but a need to strengthen or

clarify previous legislation arose out of subsequent court decisions. This

title provides the authority to order affirmative actions, including

reimbursements, indemnifications, or restitutions whether or not the offending

party was personally enriched by these actions. In other provisions,

administrative regulations already utilized were added to existing law

(Froxmire). The bill further provides for civil penalties of up to $10,000

per day for violations and forbids anyone convicted of such violations from

working in related financial services industries in the absence of prior

written approval from the Federal Reserve.

52
House Bill

The parallel title in the House bill contains substantially the same language

as the Senate title, although the civil penalty is reduced to $2,500 per

day.«^

Following this title in the House bill is an unrelated title without parallel

in the Senate bill that requires the FSLIC to dissolve the Federal Asset

Disposition Association (FADA). FADA was created in November 1985 to assist

FSLIC in managing and disposing of assets acquired from troubled and failing

thrifts. The committee report on this title maintains that FADA has not

fulfilled its announced purpose and should be abolished (St. Germain).

Truth in Savings and Investment

This title was introduced earlier as a separate bill and may be cited as the

Truth in Savings and Investment Act of 1988. The need for this title arose

primarily because the proliferation of new financial products in the 1980's

following interest rate deregulation has made it more difficult for consiomers

to compare products and to understand the terms of accounts. The title

requires uniform disclosure of terms and conditions on which interest and

earnings are paid and fees are assessed for savings and investment

instruments.

Senate Bill

This title requires disclosure of: the annual percentage yield, the yield

period, all minimum balance and time requirements to earn the advertised

yield, the minimum initial deposit required to earn the yield advertised, a

description of fees or other conditions reducing the yield, and a description

of penalties for early withdrawal. Additional disclosure requirements apply

for variable interest or multiple rate accounts. The title also authorizes

regulators to penalize noncompliance.

House Bill

Consumer protection provisions distinguish the House and Senate bills and

opposition to the House version stems from these provisions. Title IV,

subtitle E of the House bill addresses the Senate bill provisions in much the

same language. Other subtitles in title IV, however, amend the CRA, require

each banking regulator to establish a separate consumer division, require

banks and thrifts to offer a basic transactions account and check-cashing

services to low-income customers, require the last bank or thrift in a service

area to provide advance notice of branch closings, and require other reforms

designed to assist consumers. The CRA amendments, in particular, require

banks requesting any change in regulatory status or notification to meet all

requirements of the new provisions at the time of application.

These amendments are designed to toughen up enforcement of the CRA provisions.

They establish Community Review Boards for each Federal Reserve District to

The House committee report states its support for this title somewhat more emphatically than the Senate

report. It reports, for example, that "during the past three and a half years the Federal Home Loan Bank

Board found serious abuse, fraud, or criminal misconduct in 106 out of 210 savings and loan association

failures. For the same period of time, the cost to the FDIC, FSLIC, and the NCUA [National Credit Union

Administration] from failed banks, thrifts, and credit unions associated with such fraudulent misconduct

totaled at least $4.5 billion, and in all likelihood is substantially more." (St, Germain).

53
review performance of consumer laws, make recommendations on enforcement, and

prepare an annual report on financial consumer problems and issues. The

amendments revise the CRA ratings system^ and require that each bank in a BHC

be evaluated separately with the lowest rating of any bank dictating the

rating for the BHC. These banks would be exempted in evaluating BHC's: newly

established banks, independent banks with under $25 million in assets and

agricultural banks with assets under $50 million, and institutions acquired

under emergency regulatory provisions and banks acquired with a CAMEL rating

(capital, assets, management, earnings, and liquidity) of 4 or 5,^ Banks

with less than $25 million in assets and agricultural banks with less than $50

million in assets are generally exempted from these new CRA provisions,

although they are still bound by the 1977 Act. These amendments require

increased public disclosure of CRA ratings and a new evaluation every 18

months (St. Germain).^

Home Equity Loans

This title was introduced in 1987 in the House as a separate bill and may be

cited as the Home Equity Loan Consumer Protection Act of 1988. The need arose

because the Tax Reform Act of 1986 phased out the deductibility of most

consumer credit while allowing continued deductibility of home mortgage

interest. Consequently, demand for home equity loans has exploded in spite of

the liabilities normally associated with second mortgages.

Senate Bill

This title has two main parts. The first details disclosure requirements that

must be met 3 days before the consumer pays a nonrefundable fee. In

particular, the consumer must be told that the loan is secured with the home

and that the home could be lost in the event of default. The second contains

four restrictions on contract terms. The creditor: may not unilaterally

change terms of a loan once consummated; must use an index not under his

control to determine the interest rate; may not unilaterally terminate a loan,

except in the case of fraud, misrepresentation, failure to make payments, or

actions on the part of the consumer that reduce the value of the security;

must return all fees if the terms covered by the disclosure are changed and

the consumer elects not to take the loan (Proxmire).

House Bill

The House bill contains substantially similar language covering home equity

loan concerns in its consumer protection title.

The evaluation of depository institutions under CRA is based on their performance in providing credit

for housing, small businesses, small farms, and related n«eds to their service area. Performance is

measured on a 5-point scale: excellent, good, average, limited effort, and poor or substantial

noncompliance. Ratings are a comparison among banks with similar resources (St. Germain).

Banking regulators evaluate the cjuality of a bank based on its CAiffiL <Baughn, Storrs, and Walker). The

CAMEL system rates banks from 1 to 5 with distressed banks receiving a 4 or 5.

^Benston <1986), in a review of the CRA of 1977, argued that if lenders would meSne such loans in the

absence of these regulations, unnecessary complieince costs are imposed. If the loans would not be made in

the absence of these regulations, then he argues that the law encourages existing financial institutions to

leave the area affected and discourages other institutions from entering the area. From this perspective,

the law will benefit consumers only if bankers have been discrimiinating against borrowers for noneconomic

reasons.

54
Insurance Activity

This title was introduced earlier as a separate bill and may be cited as the

Bank Holding Company and National Bank Improvements Act of 1988. The title

attempts to clarify another area of product deregulation^ insurance, not

covered by repeal of the Glass-Steagall Act, but of obvious concern to

proponents of a more liberalized financial services sector. In contrast with

Glass-Steagall, however, insurance regulation has, since passage of the

McCarran-Ferguson Act of 1945,®^ been primarily handled by the States with

little or no interference from Federal authorities. This title reflects this

tradition by providing only limited authority for BHC's and national banks to

underwrite or distribute insurance products.

The insurance business has typically been divided into two separate

industries. One is composed of life, health, disability, and annuity

insurance ("life and health"). The other consists of auto, homeowners,

workers' compensation, marine, and fidelity and surety insurance ("property

and casualty"). Property and casualty insurance is normally considered more

risky and the industry is subject to significant business cycles (Whiteman),

Provision of insurance has been a grey area for commercial banks because,

before 1982, the Federal Reserve permitted BHC's to underwrite and sell

credit-related insurance, such as credit-related property and casualty

insurance, and to broker insurance in places with 5,000 or fewer residents,

provided that the bank was located there. The Garn-St. Germain Depository

Institutions Act of 1982 permitted BHC's to underwrite and sell credit life,

credit disability, and credit unemployment insurance; certain credit-related

insurance sold by BHC subsidiaries; general insurance in places with 5,000 or

fewer residents; and general insurance, if the BHC was small ($5 million or

less in assets). National banks, not part of BHC's, also were permitted

limited insurance activities under the National Bank Act and a provision

allowing exercise of "all such incidental powers as shall be necessary to

carry on the business of banking," The courts have typically limited these

powers to underwriting and selling credit-related life, health, and accident

insurance, and general insurance sales for banks headquartered in places with

5,000 or fewer residents (Proxmire).

The continuing restrictions on commercial bank entry into the insurance

industry in these proposals are significant because insurance holding

companies have recently been permitted by some States to diversify into many

of the activities forbidden to banks. Affiliates of these holding companies

have acquired controlling interests in other forms of insurance, mutual funds,

thrifts, personal finance companies, computer services, computer leasing, and

real estate development (Whiteman) .®®

Senate Bill

This title defines insurance as traditional insurance products and services,

variable annuity contracts, and variable life insurance contracts. Insurance

activities mean providing insurance as principal, agent, or broker.

The McCarran-Ferguson Act provided States the right to supervise and regulate insurance companies and

codified their exemption sections of antitrust law that forbid price-fixing (Wirth; Whiteman).

Clark (1979) provides an extensive discussion of insurance holding companies and lays out the arguments

for why securities activities may be considered close to the basic business of providing insurance.

55
The title establishes the general principle that a BHC, or its subsidiary, may

engage in insurance activities only to the degree permitted in State law and

only in the State where its largest assets were located in its "home State" as

of May 9, 1956, or the date when the company became a BHC. A BHC may not

change its home State, and it may provide insurance only in that State. The

title further limits national banks from providing credit-related insurance.

BHCs and national banks may both provide insurance products in places with

5,000 or fewer residents, provided insurance activities are confined to that

place and sold only to State residents (Proxmire).

House Bill

The House bill insurance title is almost identical to the Senate bill. Much

like the insurance title clarifies the involvement in the insurance industry,

the House bill contains a title that restricts bank or BHC affiliate

investment in real estate ventures (as opposed to investment in real estate

mortgages) for 2 years. Thrift real estate investment activities, by

contrast, are exempted. The committee report expresses concern over the

absence of legislative or regulatory guidance in the area of bank real estate

activities, notes that some 20 States have begun to allow it, and relates its

concerns to the FSLIC crisis. The title requires the Federal Reserve to

prepare a study with recommendations o^ how to protect the safety and

soundness of banks engaging in real estate activities and the FDIC insurance

fund, to maintain bank competitiveness, and to ensure consumer protection.

Miscellaneous

Both bills contain a title with an assortment of unrelated provisions.

Senate Bill

This title requires the Federal Reserve, in consultation with the Attorney

General, the Comptroller General, and the FDIC, to study the effects of

hostile acquisitions in the banking industry on the safety and soundness of

banking. The Federal Reserve is also instructed to study the need to continue

the separation of full-service banking and commerce. Other provisions

restrict the powers of nonbank banks and exempt industrial banks from the

definition of a bank under the Bank Holding Company Act of 1956.

House Bill

In addition to provisions mentioned elsewhere in the Senate bill, this title

contains provisions encouraging the expansion of minority and women's banks,

prohibiting discrimination in provision of credit based on a student's course

of study, limiting the grandfathering of trust companies to become nonbank

banks, and requiring a study of foreign bank acquisitions of U.S. banlcs.

56
Put Rural Development Research To Work For You

Rural Development Perspectives brings you information tliat will help you make your rural community or small town a better place to live, get more out of your budget, give you new ideas about

developing your area's economy, and help you understand the forces influencing rural development

in America in the 1990's.

In each issue:

Feature articles (8-10 of them) give you information you can put to use, not just put on a shelf;

Book Reviews tell you alx)ut good new t)ooks on rural and smalltown topics;

Short Subjects give you a digest of readings that will broaden your awareness of what matters to rural areas

and small towns;

Rural Indicators give you a graphic snapshot of trends affecting you and your community.

Subscription includes three issues. Save money by subscribing for more than 1 year!

Rural Development Perspectives

Subscription

1 Year 2 Years

Domestic $9.00 $17.00

Foreign $11.25 $21.25

3 Years

_ $24.00

^$30.00

For fastest service, call

tollfree,1-800-999-6779

(8:30-5:00 ET in U.S. and Canada)

I I Bill me. Q Enclosed is $

Credit Card Orders:

I I MasterCard ¡^ VISA Total charges $_

Use purchase orders, checks drawn on U.S. banks,

cashier's checks, or international money orders.

ñfáke payable to ERS-NASS,

Credit card number: Expiration date:

Month/Year

Name

Address

City, State, Zip.

Daytime phone (_

Mail to:

ERS-NASS

P.O. Box 1608

Rockville, MD

20849-1608
Keep Up-To-Date on Agricutturat Financial Developments.

Subscribe to the Agricultural Income and Finance Situation and Outlook report and receive timely

analysis and forecasts directly from the Economic Research Service. Issues contain analysis of general

economic conditions, the farm sector, agriculturallenders, and Federal income taxation for farmers plus

selected special articles on a variety of finance topics/ Subscription includes iour issues. Save nnoney

by subscribing for more than 1 year.

Agricultural Income and Finance Situation and Outlook

Subscription

Domestic

Foreign

1 Year

_ $12.00

.$15.00

2 Years

_$23.00

_$28.75

3 Years

_$33:00

.$41.25

For festesíservice^ call

toll free,1.800-999-6779

(8:30-5:00 ET in U.S. and Canada;

otiier areas please call 301-725-7937)

[ I Bill me. Q Enclosed is $

Credit Card Orders:

I I MasterCard | | VISA Total charges $_

Use purchase orders, checks drawn on UvS. banks,

cashier's checks, or international nrwney orders.

Make payable to ERS'NASS:

Credit card number: Expiration date:

Month/Yaar

Name

Address

City. State, Zip.

Daytime phone (_

Mall to:

ERS-NASS

P.O. Box 1608

RockviMe, MD

20849-1B08

njfliiMiMPEii msssm mm
Farm Policy—In Plain English

Basic Mechanisms of US. Farm Policy, by USDA's Economic Research Service, demystifies and clarifies

farm legislation and the programs spawned by it. It describes in plain English the key concepts of how U.S.

farm policy works and takes you step-by-step through the major programs.

The report guides you from the ARP through

the 0-92 program and all the major programs

in between. Need to know how to calculate

a deficiency payment? Look on page 11.

How about turning a commodity certificate

into cash money? It's here, too, page 56.

Farmer considerations in deciding whether to

redeem their grain from the FOR? Right on

page 68.

For Novices and Experts Both, A Quick

Way To Understand Farm Policy

Anybody with a need for a quick way to

understand farm policy will benefit by this

report. Farmers, food processors, exporters,

importers. Congress and congressional staffs,

lobbyists, trade association employees, and

students from high school to graduate school

are just some of the groups who can benefit.

Even farm policy experts will want to order

multiple copies of this informative report to help

show their clients what it's all about.

Basic Mechanisms of U.S, Farm Policy uses

easy-to-understand language and diagrams to

describe farm policy mechanisms. Be sure to

order enough for both your staff and your clients!

The complete array of farm policy mechanisms can appear

overwhelming to anyone unfamiliar with the history of U.S.

agricultural legislation. But each mechanism originated in

Congress, refíecting public concerns about food, agriculture,

and the needs of farmers.

SOh/IE BASIC MECHANISMS OF U.S. FARM POLICY

Target Price

Loan (Nonrecourse loan) Rate

Deficiency Payment

Original Deficiency

Reduced (Findley) Loan Rate

Emergency Compensation

Acreage Reduction Program (ARP)

Paid Diversion

Base Acres

Program Yield

Program Production

Basic Commodities

Acreage Conservation Reserve

Conservation Use

Payment Limitation

Projected Deficiency

Advance Deficiency

Base Acres & Program Yield

0-92 & 50-92

Commodity Certificate

Posted County Price (PCP)

PIK and Roll

Export Enhancement

Farmer-Owned Reserve (FOR)

Corn (& Wheat) Catalog

Reserve Rollover

Conservation Reserve Program

Disaster Payment

Marketing Loan

Part one of this report concentrates on the left side of this list,

and Part two covers the seven

mechanisms at the top right.

Part three covers the remaining seven mechanisms

on this list.

A sampling of what's in "Basic Mechanisms of U.S. Farm Policy.

Basic Mechanisms of U.S. Farm Policy (MP-1479)

Ü Yes! Send me copies of Basic Mechanisms of

U.S. Farm Policy for $_

Order up to 50 copies and pay $6.50 per copy.

Save 25%! Order 50 or more and pay just $4.90 per copy.

Payment method

Bill me Enclosed is $ .

Visa MasterCard Total charges $ .

For /asfesf service, order toll free,

1-800-999-6779

(8:30-5:00 ET, in the United States and Canada;

other areas, please call 301-725-7937)

Use purchase orders, checks drawn on U.S. banks, cashier's

checks or international money orders.

Make payable to ERS-NASS.

Add 25% for postage to foreign addresses (includes Canada).

Credit card number: QDoaaaaaaaQaaaaQ Expiration date:

Month

ÜÜ

Year

Name

Address

City, State, Zip _

Mail to: ERS-NASS

P.O. Box 1608

Rockville, MD

20849-1608

Daytime phone (_