Banking Review 

2004 VOLUME 16, NOS. 1 AND 2 

This year's FDIC Banking Review features papers from the FDIC's Future of Banking project. Initiated by 

Chairman Donald Powell, the study projects likely trends in the structure and performance of the banking 

industry and anticipates the policy issues that will confront the industry and the regulatory community in 

the coming years. 

The Future of Banking in America 

Summary and Conclusions (page 1) 

by George Hanc 

This paper summarizes the 16 papers that constitute the future of banking study, and finds that the 

industry has favorable prospects for the years immediately ahead. The paper concludes with a 

discussion of possible events that might alter this outcome. 

The Evolving Role of Commercial Banks in U.S. Credit Markets (page 29) 

by Katherine Samolyk 

The author examines 50 years of Flow of Funds Accounts (FFA) quarterly data to assess the 

significance of commercial banks in the provision of credit in the United States. 

The Effect of U.S. Banking on Payment System Changes (page 67) 

by Neil B. Murphy 

The author discusses the major payments methods with emphasis on the major interbank networks 

and their implications for banks and the regulatory community. 

The views expressed are those of the authors and do not necessarily reflect official positions of the Federal Deposit Insurance 

Corporation. Articles may be reprinted or abstracted if the FDIC Banking Review and author(s) are credited. Please provide the 

FDIC’s Division of Insurance and Research with a copy of any publications containing reprinted material. 

Single-copy subscriptions are available to the public free of charge. Requests for subscriptions, back issues or address changes 

should be mailed to: FDIC Banking Review, Public Information Center, 801 17th Street, N.W., Washington, DC 20434. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

and Research 

Deputy Director Fred Carns 

Managing Editor Jack Reidhill 

Editorial Committee Christine E. Blair 

Valentine V. Craig 

Rose M. Kushmeider 

Publication Manager Geri Bonebrake 
The Future of Banking in America
 

Summary and Conclusions 

George Hanc* 

Purpose and Approach of the 

Future-of-Banking Study 

The purpose of the FDIC’s study of the future of 

U.S. banking is to project likely trends in the 

structure and performance of the banking industry 

over the next five to ten years and to anticipate 

the policy issues that will confront the industry 

and the regulatory community.1 

This study comes 17 years after the FDIC’s last 

comprehensive consideration of the future of 

banking.2 That earlier study, Mandate for Change, 

was undertaken against a background of increased 

competition for banks, weak profitability, and a 

reduced market share in commercial lending. The 

study recommended product and geographic 

deregulation, with appropriate safety-and-soundness safeguards, to ensure the viability of the 

banking industry. 

Since then, the environment for banking has 

changed radically. Legislation was enacted to permit both interstate branching and combinations 

of banks, securities firms, and insurance companies. A generally strong economy, as well as 

deregulation, led to marked improvements in 

bank profitability and capital positions. At the 

same time, however, the deregulation of products 

and markets intensified competition among banks 

and between banks and nonbank financial companies. In addition, together with improved information technology, deregulation accelerated the 

consolidation of the banking industry through 

mergers and acquisitions and set the stage for the 

establishment of huge banking organizations of 

unprecedented size and complexity. 

Although the condition of the industry has greatly improved over the past decade or so, banks and 

the regulatory community will face significant 

challenges in the years ahead. Competition will 

continue to be intense, and few banks, if any, will 

be insulated from its effects. In the view of some 

observers, rapid consolidation of the banking 

industry will continue and may adversely affect 

the availability of credit for small businesses and 

local economies. Large, complex banking organizations may pose difficult supervisory issues, while 

*Former Associate Director, Division of Insurance and Research, Federal 

Deposit Insurance Corporation.
 

1 Throughout the paper, “this study” refers to the FDIC’s collective project on
 

the future of banking (FOB), consisting of the 16 papers listed in the first
 

section of the references.
 

2 FDIC (1987).
 

FDIC BANKING REVIEW 1 2004, VOLUME 16, NO. 1 
The Future of Banking 

the burden of reporting and other regulatory 

requirements will fall heavily and disproportionately on small banks unless remedial action is 

taken. Further advances in information technology will permit the development of new products, 

services, and risk-management techniques but 

may also pose important competitive and supervisory issues. Nonbank entities will continue to 

offer bank-like products in competition with 

banks, raising anew the question of whether 

banks are still “special” and, more fundamentally, 

whether banks are sufficiently different from nonbank firms to justify the maintenance of a safety 

net for banks. 

It is useful, therefore, to try to chart the course of 

the banking industry in the next five to ten years 

and to consider what policy issues the industry 

and regulators will face. The authors of this study 

do not pretend to be clairvoyant. They are mindful of the many financial predictions that were 

once offered with confidence but turned out to be 

wrong or premature. This study is perhaps best 

described as an exercise in strategic thinking. Its 

approach is to analyze what has happened in the 

recent past, consider in detail reasons for expecting recent trends to continue or to change, and 

draw the consequences for bank and regulatory 

policies. As always, uncertainties abound, and 

events that may now appear fairly improbable 

may in fact shape the future. This paper closes 

with a discussion of a number of such possible 

events. 

The future-of-banking study addresses three broad 

questions: 

1. What changes in the environment facing 

banking can be expected in the next five to ten 

years? 

2. What are the prospects for different sectors of 

the banking industry in this anticipated environment? Because the banking industry is not monolithic and different segments of the industry have, 

to some degree, different opportunities and vulnerabilities, the study considers separately the 

prospects for large, complex banking organizations; regional and other midsize banks; community banks; and limited-purpose banks. 

3. What policy issues are the industry and regulators likely to face in the years ahead? Separate 

consideration is given to 

� Consolidation of the banking industry: What 

are the prospects for, and implications of, 

further consolidation of the banking 

industry, particularly relating to safety and 

soundness, market concentration, and 

small business credit? 

� Combinations of banking and commerce: 

What are the pros and cons of permitting 

common ownership or control of banks 

and commercial enterprises? What are the 

options for regulating such combinations 

so as to protect the bank safety net and 

avoid conflicts of interest? 

� Large-bank supervisory issues: What are 

the implications for bank supervision of 

the growing complexity of large banking 

organizations? 

� Governance issues: Recent corporate scandals have led to efforts to hold corporate 

directors and managements to a higher 

standard. What are the likely effects on 

banking and what should banks do to 

avoid governance problems? 

� Financial services regulatory issues: What 

should be done, either under existing law 

or through new legislation, to enhance 

the effectiveness of the federal financial 

regulatory system? 

� Bank liability structure: What are the 

implications for supervision and deposit 

insurance of changes in the structure of 

bank liabilities? 

� Economic role of banks: How does the 

increased role of nonbank financial institutions and markets affect the rationale 

for a safety net for banks? 

2004, VOLUME 16, NO. 1 2 FDIC BANKING REVIEW 
Summary and Conclusions 

The Environment for Banking 

The future of banking will be shaped, in large 

part, by the environment—economic, demographic, regulatory, technological, paymentsystem, and competitive—in which it operates. 

Economic Environment 

In the decade ahead, a climate of moderate economic growth without severe or long-lasting 

recessions would be conducive to the strong 

growth and profitability of the banking industry. 

In such a climate, bank failures would be few in 

number and idiosyncratic in nature—typically 

caused by managerial and internal control weaknesses, excessive risk taking, or fraud, rather than 

by broader economic forces. Such, at least, has 

been the pattern of bank failures in most of the 

years since the inception of the FDIC, with the 

principal and very large exception of the 1980s 

and early 1990s. However, the economy is not 

immune to speculative bubbles like those occurring in the energy, commercial real estate, and 

agriculture sectors in the 1980s, which were 

among the important causes of the wave of bank 

failures during that period, or the more recent 

bubble in communications technology in the 

1990s. Boom-and-bust conditions in markets in 

which banks participate could once again produce 

a significant number of failures caused by economic conditions, although the banking industry 

is stronger than it was on the eve of the 1980s, 

geographic diversification has reduced the vulnerability of many banks to local economic disturbances, and bank supervision has been 

strengthened. 

Demographic Environment 

Among the main demographic trends likely to 

affect banking in the years ahead are the aging of 

the population and the continued entry of immigrants.3 In the next decade or more, the baby 

boomers (people born during the post–World War 

II bulge in the birth rate) will retire or approach 

retirement. There are more than 80 million baby 

boomers, and they account for 30 percent of the 

total U.S. population. Life-cycle theory and the 

available data suggest that they will be engaged in 

liquidating assets to a greater degree—and will 

make less use of credit—than younger age groups. 

Also compared with younger age groups, they will 

hold a greater proportion of their wealth in liquid 

assets, including bank deposits. At the same time, 

baby boomers may be less averse to risk than similar age groups that had experience with the Great 

Depression. Therefore, the composition of the 

baby boomers’ wealth is likely to be affected not 

only by their stage in the life cycle but also by 

their overall motives for saving and their investment experience with equities and other market 

instruments. Baby boomers will live longer than 

the preceding generation and may find that their 

post-retirement incomes will be inadequate to 

support costs such as health care. Many, though, 

will inherit wealth from their parents and will 

need financial services for their retirement planning. Banks will therefore be able to profit by 

broadening their services to meet baby boomers’ 

financial preferences. 

Since 1990, the United States has attracted 9 

million immigrants. Of the total U.S. population, 

33 million, or 11 percent, are immigrants. 

Though the number of new immigrants is expected to increase, immigrants as a whole may not 

supply a proportional amount of funds for bank 

deposits because of low incomes and lack of legal 

documentation. In addition, immigrants often 

send large remittances back to their home countries. Low rates of home ownership and reliance 

on borrowing from informal sources such as family 

and friends are other factors likely to keep 

demand for bank credit low. Immigrants demand 

fewer mortgage loans because of their lower rate 

of home ownership and tend to make larger down 

payments than native-born Americans. Banks 

now earn service fees for transferring remittances 

and, in connection with this activity, may be able 

to provide incentives for immigrants to open 

3 This section is based on the FOB paper by Jiangli. Long-term reductions in 

population in some rural areas also have implications for banks and are discussed in the section on community banks. 

FDIC BANKING REVIEW 3 2004, VOLUME 16, NO. 1 
The Future of Banking 

bank accounts. Banks are tailoring their products 

to meet immigrants’ unique characteristics—for 

example, by offering low-fee transaction accounts 

and flexible mortgage packages. As immigrants 

reside longer in the United States, their incomes 

will rise, more of them will buy homes, and they 

will generally merge into the financial mainstream. 

Both baby boomers and immigrants will increase 

their supply of deposits to banks, but for different 

reasons. Baby boomers will desire to hold safe and 

liquid assets when they get older, whereas immigrants will likely become wealthier as they stay 

longer in the United States. As for the effects of 

aging baby boomers and immigrants on the 

demand for bank loans, the two groups tend to 

offset each other. Immigrants now demand fewer 

bank loans because of low incomes and a reliance 

on informal banking, but when they live long 

enough in the United States, they tend to 

become home buyers. In the next 10 to 20 years, 

however, increased loan demand from immigrants 

may not fully compensate for retiring baby 

boomers’ decreased loan demand. 

Regulatory Environment 

As in the recent past, future deregulation of bank 

powers is more likely to start from developments 

in the marketplace or actions by individual states 

than from initiatives by Congress or the executive 

branch. However, Congress and the executive 

branch may be more receptive to proposals for 

legislation designed to protect consumers, prevent 

serious misconduct by bank personnel, or advance 

national security objectives. The provision of a 

bank safety net and the existence of regulatory 

agencies to enforce compliance make banking a 

politically attractive vehicle for furthering such 

objectives. The results have been substantial 

reporting and other regulatory burdens on banks. 

These requirements frequently involve fixed costs 

that tend to be proportionally heavier on small 

banks. Although, as noted below, we regard community banks as a viable business model, the disproportionate impact of regulatory burden on 

smaller banks places them at a competitive disadvantage. Excessive regulatory burdens may not 

only hurt existing banks but may also discourage 

new entrants, thereby depriving bank customers 

of the benefits of increased competition from 

newly established banks. This prospect highlights 

the importance of reducing reporting burdens 

wherever possible. 

The FDIC established a special task force to 

reevaluate its examination and supervisory practices in an effort to improve operations and 

reduce regulatory burden without compromising 

safety and soundness or undermining important 

consumer protections. Over the last several years 

the FDIC has streamlined examinations and procedures with an eye toward better allocating 

FDIC resources to areas that could ultimately 

pose greater risks to the insurance funds—areas 

such as problem banks, large financial institutions, high-risk lending, internal controls, and 

fraud.4 

The FDIC is also leading an interagency effort to 

identify and eliminate restrictions that are outdated, unnecessary, or unduly burdensome. This 

effort is pursuant to the Economic Growth and 

Regulatory Paperwork Reduction Act of 1996. 

Comments are sought from the banking industry 

about which regulations are the most burdensome 

and which regulations place the industry at a 

competitive disadvantage. The agencies have 

jointly published the first two of a series of 

notices soliciting comment on regulations in a 

number of areas and have been conducting outreach sessions with bankers, consumer groups, and 

community groups. Armed with input from these 

efforts, the agencies will conduct a comprehensive 

review of banking regulations and will report to 

Congress on their findings and on the actions 

they have taken, or plan to take, about the level 

of burden. The agencies also expect to send Congress a list of legislative areas for consideration. 

4 Actions taken by the FDIC, as well as interagency efforts to reduce regulatory burden, were outlined in congressional testimony by the Vice Chairman of 

the FDIC (Reich [2004]). 

2004, VOLUME 16, NO. 1 4 FDIC BANKING REVIEW 
Summary and Conclusions 

Technological Environment 

The banking industry is now more dependent on 

technology than ever before, with annual industry 

expenditures for technology topping an estimated 

$30 billion.5 In recent decades, the focus of largebank technology developments has shifted. 

These decades began with a large number of 

mergers and acquisitions after restrictions on 

interstate banking and branching were lifted, and 

the technology component of merging two entities proved to be a challenging task for acquirers. 

Lessons were learned over time by institutions 

that experienced numerous rounds of acquisitions. 

By the late 1990s, Y2K concerns dominated technology planning and, to an extent, restrained the 

level of mergers and acquisitions. Y2K work also 

had the effect of benefiting banks by requiring 

planning for business continuity and disaster 

recovery. Meanwhile, the world of technology 

continued to change, with rapid adoption of the 

Internet and increases in the market capitalization of Internet-related companies. Bankers 

invested heavily in Internet products and services. 

More recently, the technology focus of banks has 

moved to cost cutting, consolidation, and rationalization. Large banks will continue to develop 

new technologies and adapt to legislative and regulatory changes, such as Basel II and Check 21. 

Imaging, increased bandwidth, wireless networking, and Web services are innovations likely to 

have an impressive effect on the use of bank technology. For large banks, security and operational 

resiliency remain major concerns. 

Community banks also depend on technology, but 

more as users of proven technology than as creators or innovators. By using proven technologies 

as they become available, community banks now 

offer a wide variety of products and services, often 

matching large banks in the scope of their offerings to retail customers. As a result of competitive 

pressures, even small banks now find it mandatory 

to have sophisticated, well-functioning technology to support customer service, administration, 

and financial reporting. But managing technology 

is a challenge for community banks, and among 

FDIC-supervised banks, only slightly more than 

half perform core processing in-house; the 

remainder outsource this function. Thus, thirdparty service providers play a critical role in the 

efficiency and security of technology operations at 

community banks. 

Objective assessments of community bank information technology (IT) operations are available 

through the examination process and from a survey of FDIC IT examiners. The vast majority of 

FDIC-supervised banks receive sound composite 

IT examination ratings. Examiners report that 

community banks are using technology to provide 

customers with more and better-quality products 

and services. Examiners also note vulnerabilities 

at FDIC-supervised banks in the areas of risk 

assessment and audit, strategic planning, management of outsourcing, security, and personnel. 

Technology will continue to be a major expense, 

and security will remain a crucial issue for banks 

of all sizes. Responding to an ever more complex 

technology environment will be challenging. 

Nonetheless, proper technology management is 

within the grasp of every bank and can lead to 

better customer service, lower operating costs, 

and a more efficient banking system. 

Payment-System Changes 

Although the much-heralded checkless society 

has yet to arrive, major changes are underway in 

retail noncash payment systems, as the use of 

checks as a means of payment has declined and 

electronic forms of payment have increased.6 

After rising for many years, the number of checks 

used in retail transactions declined from 49.5 billion in 1995 to 42.5 billion in 2000—the latest 

year for which comparable data are available. 

Over the same period, the number of retail electronic payments increased from 14.6 billion to 

28.9 billion. 

5 This section is based on interviews with large-bank supervisory personnel at 

the Office of the Comptroller of the Currency and the Federal Reserve Board 

and on information received from FDIC examiners who have experience performing or reviewing information technology examinations. The results are discussed in detail in the FOB paper by Golter and Solt. 

6 This section is based on the FOB paper by Murphy. 

FDIC BANKING REVIEW 5 2004, VOLUME 16, NO. 1 
The Future of Banking 

Although fewer checks are being written, the 

number is still very large in absolute terms and in 

comparison with the number being written in 

several other countries, some of which have virtually eliminated the use of checks. Therefore, 

efforts are being made to “electronify” checks 

early in the process of clearing and settlement by 

sending the information forward electronically; 

that process is expected to be faster and less 

expensive than current methods, which require 

the physical transportation of large amounts of 

paper. 

Banks will have to adapt their product offerings 

and pricing as well as their back-office processing 

to reflect these payment-system changes. Since 

more electronic transactions are cheaper to 

process, as is the conversion or truncation (or 

both) of checks, banks that do not explicitly 

charge for transaction services on a per-item basis 

will see a reduction in costs. For banks that have 

explicit fees for each service (mainly banks that 

supply cash-management services), it will be necessary to ensure that the profit margins on the 

electronic transaction services are commensurate 

with those on the paper transaction services. 

Banks of all sizes should be able to continue to 

serve their customers with a mix of capabilities, 

including ATMs, on- and off-line debit cards, 

credit cards, and other services. 

Bank regulators must be aware of the risk implications of the changes in payment systems and must 

adapt their approaches accordingly. Operational 

risk is obviously an important issue. In this regard, 

the ownership of fund transfer networks has 

changed dramatically: the number and proportion 

of networks owned and operated by nonbank 

entities has increased, whereas those owned by 

joint ventures of banks have declined. Because 

the operation of these networks directly affects 

the risk exposure of banks, the risk-management 

practices of the network providers may have 

important implications for the banking industry 

and the bank regulatory community. 

Banks and bank regulators also need to be concerned about the market structure of the network 

providers, especially those for ATMs, debit cards, 

and credit cards. Significant consolidation among 

network providers has already occurred, and any 

further concentration raises concerns about pricing, quality of service, and product innovation in 

this segment of the market—one for which bank 

regulators have no direct responsibility. 

Competitive Environment 

The shares of debt held by commercial banks and 

savings institutions as a percentage of the total 

volume of debt have declined compared with the 

shares held in earlier decades of the twentieth 

century.7 Some observers have interpreted this 

decline as a sign of competitive weakness or even 

obsolescence. However, this decline is partly due 

to the proliferation of channels of financial intermediation, which often involve the issuance of 

financial instruments to fund other financial 

instruments rather than the channeling of funds 

to nonfinancial sectors of the economy—households, businesses, and governments. 

In this regard, the overall volume of borrowing in 

credit markets has apparently increased permanently. During the 1980s the volume of borrowing 

by nonfinancial sectors of the economy rose from 

1.3 times annual GDP to nearly 1.9 times annual 

GDP, an increase reflecting the rising indebtedness of households and nonfinancial businesses, in 

tandem with deficit spending by the federal government. 

The growth of debt in our economy during the 

1980s was associated with a decline in the share 

of domestic nonfinancial borrowing that is directly funded by commercial banks (the share 

declined from 30 percent in 1974 to a low of 20 

percent in 1993). But when debt growth leveled 

off in the early 1990s, commercial banks’ share of 

this credit-market pie also leveled off, and since 

the early 1990s it has remained generally stable. 

The continued need for bank financing on the 

part of many borrowers reflects their inability— 

owing to their small size and idiosyncratic risk— 

7 Trends in the importance of banks in U.S. credit markets are discussed in 

the FOB paper by Samolyk. 

2004, VOLUME 16, NO. 1 6 FDIC BANKING REVIEW 
1

1

Summary and Conclusions 

to access financial markets directly and cost effectively. 

The reduction in banks’ share of the credit-market pie reflects a dramatic shift in the way loans 

are being financed. Specifically, asset securitization (the pooling of loans and their funding by 

the issuing of securities) has allowed loans that 

used to be funded by traditional intermediaries, 

including banks, to be funded in securities markets. The securitization of home mortgages and 

consumer credit has reduced the extent to which 

these types of loans are directly funded by commercial banks and has had an even more adverse 

effect on savings institutions. 

Nonetheless, commercial banks continue to play 

a significant role in funding business borrowers. 

The average share of nonfinancial business borrowing that commercial banks hold on their balance sheets has remained relatively stable for five 

decades. At the same time, there has been a clear 

shift in how banks lend—a shift from shorterterm lending to loans secured by business real 

estate. This shift may reflect banks’ continuing 

comparative advantage in real estate lending, a 

form of lending less well suited to the standardization necessary for asset securitization. 

The savings institution share of total household, 

business, and government debt has also stabilized 

in recent years, but at levels much lower than 

those of earlier post–World War II decades. The 

reasons for the decline are the liquidation of a 

substantial portion of the savings and loan industry during the 1980s and early 1990s, the absorption of numerous savings institutions by 

commercial banks, and the rapid growth of mortgage-backed securities. 

Banks’ importance relative to capital markets is 

lower in the United States than in many other 

countries. However, some countries are moving 

closer to the U.S. model as a result of forces that 

have increased the efficiency of “arms-length” 

financial markets, including improvements in the 

processing of information, increases in international trade and capital flows, and political integration.8 Thus, the lower market share of banks 

in the United States may be seen as a sign of the 

advanced development of capital markets and IT 

in the United States rather than as a sign of terminal weakness in the banking industry. 

Of course, market-share data based on balancesheet totals underestimate the continuing importance of banks in financial markets precisely 

because they do not include off-balance-sheet 

activity. Through backup lines of credit, loan 

origination, securitization, and other means, 

banks support lending by other entities and earn 

fee income. An alternative measure of the importance of banks in the financial system is provided 

by the bank share of total net income of financial 

sector firms, which reflects income and expense 

from both on- and off-balance-sheet activities. 

During 1992–2002 net income of publicly traded 

commercial banks and savings institutions 

accounted for an average of 44 percent of total 

profits of all publicly traded financial companies—about the same proportion as in 1985, 

before the banking crisis of the late 1980s and 

early 1990s.9 Moreover, the net income of the 

largest individual banks was far greater than that 

of the largest nonbank financial companies.10 

The ability of the banking industry and the 

largest individual banks to earn high net income 

relative to other financial firms is hardly a sign of 

competitive weakness. 

The Environment for Banking: 

Summary 

In general, the environment for banking in the 

next five to ten years is likely to remain favorable. 

The economic environment appears conducive to 

good banking industry performance, assuming 

that recessions are mild and that we avoid speculative bubbles similar to those that contributed 

8 Rajan and Zingales (2003). 

9 Tabulations by the FDIC, based on data from Standard and Poor’s Compustat. For other measures of banks’ market share, see the FOB paper by 

Samolyk, and Boyd and Gertler (1994). 

10 In 2002 Citicorp earned net income of $10.7 billion from banking operations, and Bank of America Corp. earned $9.2 billion, whereas the four largest 

nonbank financial companies earned net income ranging from $4.6 billion to 

$5.8 billion (tabulations by the FDIC, based on data from Standard and Poor’s 

Compustat). 

FDIC BANKING REVIEW 7 2004, VOLUME 16, NO. 1 
The Future of Banking 

to widespread failures during the 1980s. The 

banking industry’s market share has stabilized, 

according to a number of measures. Reduced use 

of checks and increased use of electronic payments are likely to exert downward pressure on 

costs of the banking system as a whole. Over 

time, banks will have increased opportunities to 

serve two growing segments of the population— 

retired baby boomers and immigrants. 

Potential problems in the environment are likely 

to be associated with inadequate safeguards in the 

use of technology. Consolidation and increased 

nonbank ownership of fund transfer networks— 

especially networks for ATMs, debit cards, and 

credit cards—may expose banks to new operational risks. Outsourcing certain functions, 

including moving work offshore, involves political, business-continuity, and security risks. Inadequate IT staffing may make some banks 

vulnerable to attacks on the software they use, 

with customers exposed to inconvenience and 

banks to weakened reputations and weakened 

competitive positions. 

For community banks, in particular, the burden of 

reporting and other regulatory requirements poses 

a significant threat to future prosperity. Efforts to 

address this problem are described above. 

Prospects for Banking Sectors 

As is well known, the U.S. banking system is 

characterized by large differences in the size of 

institutions; the system includes some of the 

world’s largest banking organizations as well as 

thousands of relatively small banks. Institutions 

also differ in the extent to which they are affected 

by local rather than national economic forces and 

in the business strategies they have adopted to 

cope with their environments. Individual banks 

or groups of banks have, to some extent, different 

business opportunities, risk exposures, and future 

prospects, and many of these differences are associated with size. In this study, banks are divided 

into the following groups: 

� Large, complex banking organizations— 

defined as the top 25 organizations in 

terms of assets; 

� Community banks—defined as institutions with less than $1 billion in assets; 

� Regional and other midsize banks— 

defined as banks that fall between community banks and the top 25 (in other 

words, banks with assets greater than $1 

billion but less than the assets of the 

smallest of the top 25 organizations—currently about $42 billion); and 

� Special-purpose banks—includes credit 

card banks, subprime lenders, and Internet banks. 

Except when specifically noted, “banks” and 

“banking organizations” refer to independent 

commercial banks and savings institutions and to 

the holding companies of such institutions. 

“Assets” when used to denote the size of different 

groups of institutions means the assets of commercial banks and savings institutions combined. 

Asset limits of size groups are adjusted for inflation as measured by the GDP price deflator. 

Large, Complex Banking Organizations 

Over the past 20 years the structure of the U.S. 

banking system has changed enormously in 

response to changes in the legal, regulatory, and 

financial landscape.11 At the end of 2003, the 25 

largest insured banks and savings institutions held 

56 percent of total industry assets, with the 10 

largest holding almost 44 percent, up from 19 percent in 1984. For the next 15 banks, the growth 

has been much less dramatic: the combined assets 

of the banks ranked 11 through 25 have risen 

only 2 percentage points, from about 10 percent 

in 1984 to 12 percent at the end of 2003. 

11 This section is based on the FOB paper by Reidhill, Lamm, and McGinnis. 

Information on individual institutions is based on publicly available data. 

2004, VOLUME 16, NO. 1 8 FDIC BANKING REVIEW 
Summary and Conclusions 

Why did these institutions grow to be so large? 

Has the elimination of restrictions on branching 

and ownership been the main driving force? Do 

larger banking organizations enjoy economies of 

scale? Does management simply want to control 

ever-larger organizations? Do investors exert pressure to increase asset size, revenues, or net 

income? To some extent, all of these appear to be 

true. 

The passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 

undoubtedly helped spur large banks to spread 

across state lines and to grow. This development 

helped create large, geographically diversified 

branch networks that stretch across large regions 

and even coast-to-coast. The Gramm-LeachBliley Financial Services and Modernization Act 

of 1999 (GLB) allowed the largest banking organizations to engage in a wide variety of financial 

services, acquiring new sources of noninterest 

income and further diversifying their earnings. 

Contributing to these developments were 

advances in IT that facilitated control of far-distant operations and fostered new products, services, and risk-management techniques. 

As these banks have grown, have they gained efficiencies from their growth? The conclusions 

reached in the economic literature on bank 

economies of scale are mixed; some studies have 

found economies of scale and scope, and some 

have not.12 With respect to market power, studies of mergers that resulted in high concentrations 

in local markets did not find significant gains to 

the acquiring firm. On the other hand, consolidation that leads to geographic diversification seems 

to be associated with increased profits and 

reduced risk. Some studies have also concluded 

that banks may seek growth in an attempt to be 

regarded by the market as too big to fail.13 

According to this view, the funding costs of a 

bank would be lower if holders of uninsured 

deposits, bonds, and other credits assumed they 

would be protected if the bank failed. 

Although the academic literature does not provide conclusive evidence that greater size leads to 

cost and other advantages, there appears to be 

continual pressure on bank management from 

shareholders and market analysts to show growth 

in both revenue and earnings. Bigness is apparently regarded as advantageous. Nevertheless, the 

wave of mergers and acquisitions that occurred 

after enactment of the Riegle-Neal Act and GLB 

has probably passed. The large number of deals 

within the recent past partly reflects the backlog 

created by a restrictive legal environment; in a 

less-restrictive legal environment, many of the 

recent mergers and acquisitions would have 

occurred earlier and over a longer period. 

Although Riegle-Neal prohibits mergers when the 

merged bank’s domestic deposits would exceed 10 

percent of total domestic deposits (or 30 percent 

of the deposits in any state), only the Bank of 

America is close to the 10 percent limit (as a 

result of the recent merger with FleetBoston); 

other members of the top 25 group are much further from the limit and are not prevented from 

undertaking mergers by this legal provision. Further mergers among large banks may be expected 

in the immediate future, although not in the volume experienced after geographic and product 

deregulation. 

Large banking organizations have widely different 

business strategies. Among the eight largest companies, some have extensive foreign operations, 

while others are essentially domestic commercial 

banks.14 Some have major credit card operations, 

and others do not. Some have large trading operations and are active in securities markets, while 

others do not and are not. Some focus on loans to 

businesses, while others have major consumer 

operations. Some concentrate on commercial and 

industrial loans, while a few are very active (or 

even specialize) in mortgage finance. They also 

12 These studies consider the cost structures of the bank as a whole. This is 

not to deny that there may be scale efficiencies in specific business lines, 

such as credit card operations. See the section on limited-purpose banks. 

13 “Too big to fail” is a misnomer. The question for investors is whether unsecured and uninsured creditors of such a bank would be protected if the bank 

were to fail. 

14 The eight largest banking organizations, in descending order of asset size as 

of January 2004, are Citigroup, J. P. Morgan Chase, Bank of America, Wells 

Fargo, Wachovia, Bank One, Washington Mutual, and FleetBoston. In the 

aggregate, these institutions account for 41 percent of total banking industry 

assets. 

FDIC BANKING REVIEW 9 2004, VOLUME 16, NO. 1 
The Future of Banking 

differ in geographic reach within the United 

States. 

With some exceptions, the larger the institution, 

the more likely it is to engage in a wide range of 

activities. The smaller institutions are more likely 

to concentrate on growing their retail and consumer banking franchises, either internally or 

through mergers, and entering the investment 

banking business by purchasing smaller brokerage 

firms or building on a proprietary mutual fund 

business. At least in the near term, widespread 

entry into the property and casualty insurance 

underwriting business is unlikely. Life insurance 

underwriting and insurance brokerage show more 

promise, with less risk. 

Despite the variety of business models, some of 

the ways in which large banks have changed are 

similar across all or many of them. They have 

increased their fee income as a percentage of total 

income, possibly to reduce their vulnerability to 

cyclical interest-rate changes. Most of them have 

increased income from deposit charges, and some 

have taken advantage of the new powers under 

GLB to increase trading revenues, investment 

banking income, and insurance commissions and 

fees. Much of the noninterest income from new 

powers is concentrated in the top two or three 

banks. These banks have also shifted from 

deposits to collateralized borrowings. Large banks 

also appear to have been successful in limiting 

their exposure to credit losses by improving their 

risk-management practices. 

The experience of the eight largest banks during 

the recent economic recession has been mixed. 

Four of these banks had fairly consistent returns 

on book equity over the period, while the other 

four had large declines in earnings, with one bank 

experiencing an actual loss in 2000. In no case 

was the solvency of an organization threatened. 

This mixed record may illustrate the advantages 

and disadvantages of large, complex organizations. 

In some cases, geographic diversification, international diversification, product diversification, and 

risk-management practices seem to have paid off 

well. Although some of the success was undoubtedly due to a very favorable interest-rate environment, loan losses during the period were low. In 

other cases, there were evident problems in managing large, complex organizations and in managing the process of acquiring and merging 

organizations. It appears, therefore, that the various strategies for capitalizing on size, geographic 

diversification, and product diversification can be 

successful—but that size itself does not guarantee 

consistent success. 

It seems clear that for the immediate future, the 

large banks will continue to try to grow through 

internal growth and acquisitions. As these institutions grow and expand the breadth of their products, potential problems of managerial 

diseconomies and corporate governance may 

arise. The sheer size and complexity of today’s 

large institutions place a heavy burden on their 

financial and operational risk-management systems. Undoubtedly many of these problems are 

being addressed. Permitted single-company exposures are reportedly being reduced at almost all 

large banks, and exposures are being tracked 

across business units. Financial risk models are 

being implemented in response to both the business need for better risk management and a presumption that Basel II will eventually be 

implemented. 

What can be learned from the recent experience 

of the top 25 banks? The success of the best-performing organizations might argue that large 

organizations can be efficient and effective. The 

large losses sustained by the worst performers suggest that the risk of failure in these banks, 

although very small, is greater than zero. However, the size and diversification of these organizations help them absorb losses. 

If larger and larger banks become a reality, how 

will the FDIC’s risk profile be affected? First, if 

more institutions come up against the 10 percent 

deposit concentration limit, efforts to raise that 

limit may be expected over time and may raise 

concerns about the concentration of economic 

resources and power. Second, the possible failure 

of large banks, however unlikely, represents a risk 

not only to the insurance funds but also to the 

2004, VOLUME 16, NO. 1 10 FDIC BANKING REVIEW 
 

Summary and Conclusions 

banking system itself because of the large increases in deposit insurance premiums that might be 

required. Over the past 19 years the size of the 

largest banks has grown dramatically compared 

with the relevant deposit insurance fund. At yearend 1984 the Bank Insurance Fund (BIF) balance 

was $16.3 billion, and the largest BIF-member 

bank was about 7 times larger than the BIF. At 

year-end 1996 the largest single bank was about 9 

times greater than the BIF. By the end of 2003 

the largest single bank was almost 19 times larger 

than the BIF ($33.8 billion). 

Basel II will effectively create a different capital 

standard for the largest banks. Should the deposit 

insurance system be changed to isolate small 

banks from the effects of the failure of large 

insured institutions? If so, how? How will the 

FDIC and the regulatory agencies meet the challenges of mitigating the concentration of risk created by these very large and still-growing 

organizations? Capital adequacy standards and 

vigilant supervision present the greatest promise. 

Optimally pricing deposit insurance, creating separate safety-net arrangements for large and small 

institutions are ideas that deserve discussion and 

research. 

Regional and Other Midsize Banks 

For purposes of this study, banks that have assets 

of more than $1 billion but less than the assets of 

the smallest of the 25 largest banking organizations (currently about $42 billion) are designated 

“regional and other midsize” banks.15 As a group 

they are heterogeneous, not only in asset size but 

also in geographic reach. A quarter of them are 

truly regional in the sense that they have a significant presence in a number of markets, while the 

remaining three-quarters are sizable banks concentrated in one market—either located in only 

one state or having more than 60 percent of their 

deposits in only one market (as measured by metropolitan statistical areas [MSAs]), or both. This 

study has divided banks in this in-between size 

group into two subgroups depending on the geographic concentration of their deposits: one subgroup consists of the truly regional banks, and the 

other consists of the other midsize banks (i.e., 

those considered to be large local banks rather 

than regional institutions).16 

In the past seven years, both subgroups have consistently outperformed community banks in terms 

of average return on assets (ROA) and have often 

outperformed the top 25 banks. During the same 

period the number of regional and other midsize 

banks increased by 13 percent. In terms of assets, 

however, the midsize sector lost market share 

between 1996 and 2003, largely because of the 

top 25 banks’ dramatic growth through mergers 

and acquisitions. 

The regional and other midsize banks may be 

small enough to avoid any diseconomies that may 

be associated with managing distant facilities and 

heterogeneous product lines but large enough to 

attract qualified employees, diversify their portfolios, and take advantage of IT to offer a wide variety of services and to manage risk. Within this 

group, banks that are concentrated locally have 

had somewhat better earnings than those whose 

offices are dispersed. Whether locally concentrated banks will continue to outperform regionally 

dispersed banks is uncertain. If economic conditions should significantly worsen in some local 

markets, banks concentrated in these markets 

might be hit hard. 

Despite the whole group’s strong performance, 

some commentators have predicted the decline or 

even the disappearance of these banks. This view 

reflects a judgment that, in order to thrive, a 

bank needs either the close community ties of a 

small bank or the geographic scope, marketing 

power, and product lines of a megabank. 

However, it is hard to imagine that one of the 

best-performing banking sectors is slated for outright disappearance. Like other good performers, 

regional and other midsize banks have a number 

of practical options. They may acquire communi15 This section is based on the FOB paper by Gratton.
 

16 According to this definition, a bank would be considered a “true” regional
 

bank if it operated in more than one state and had less than 60 percent of
 

its deposits in one MSA.
 

FDIC BANKING REVIEW 11 2004, VOLUME 16, NO. 1 
The Future of Banking 

ty banks, merge among themselves, or seek to be 

acquired by larger banks that remain below the 10 

percent deposit concentration limit. And rapid 

growth and mergers among some community 

banks may augment the number of in-between 

banks. We expect the number of banks in the 

regional and other midsize group to remain significant. 

Community Banks 

Community banks (defined here as institutions 

with less than $1 billion in aggregate bank and 

thrift assets) were not swept away by larger banks 

following product and geographic deregulation, as 

some observers had expected.17 Community 

banks represent about 94 percent of all banks in 

the United States—nearly the same as their 95 

percent share in 1985, when the recent wave of 

consolidation began.18 The persistently large 

number of relatively small banks is characteristic 

of the U.S. banking system and reflects longstanding public policies based on concern about 

the concentration of economic power, the desire 

to maintain local ownership and control, and 

efforts to protect local banks from competition. In 

some cases, these considerations had led to a prohibition of branching; for example, in 1985 42 

percent of all community banks were located in 

12 states that previously had unit banking. 

The picture has changed greatly as a result of the 

banking crisis of the 1980s and geographic deregulation. The number of community banks has 

declined by 47 percent since 1985, as a result 

both of failures (in the earlier part of this period) 

and (more recently and more significantly) of voluntary mergers. Moreover, the community bank 

shares of total banking industry assets, deposits, 

and offices have also declined. 

Perhaps the most notable feature of the decline in 

the number of community banks has been its pervasiveness: the number has declined across geographic areas, across both growing and declining 

markets, and among community bank size groups. 

The number declined in rural areas, small metropolitan areas, and large metropolitan areas, and, 

within the latter, in suburban as well as urban 

areas,19 with the pace of the declines during the 

period since 1985 falling within a fairly narrow 

range. Moreover, in areas that suffered net reductions in population (mostly rural counties), the 

decline in the number of community banks was 

comparable to the decline among community 

banks as a whole.20 

The number of community banks declined somewhat faster in formerly unit-banking states than 

in states that had permitted branching.21 This 

finding suggests that restrictive branching laws 

contributed to the establishment of some small 

banks that could not (or preferred not to) continue as independent entities once branching restrictions were lifted and competition increased. 

However, the difference in rates of decline was 

not very large. Among community banks of different sizes, the largest decline was among banks 

with less than $100 million in assets (where diseconomies of small scale are believed to exist); 

however, this decline resulted not so much from 

more mergers or failures as from the fact that 

numerous small banks grew faster than the rate of 

inflation and “graduated” to a higher size group. 

A striking difference between urban and rural 

areas is in the various cross-cutting forces that 

ended up reducing the number of community 

banks. Urban areas had proportionally more 

mergers and failures than rural areas but also more 

new institutions, with the result that total net 

17 This section is based on the FOB paper by Critchfield, Davis, Davison, 

Gratton, Hanc, and Samolyk. 

18 Bank size groups are adjusted for inflation so that, for community banking 

organizations, the number of organizations with less than $1 billion in 

bank/thrift assets in 2002 is compared with the number that had less than 

about $650 million in 1985. 

19 The location of community banks is determined by the location of the holding company headquarters or, when there is no holding company, the location 

of the institution’s headquarters. Division into rural, small metro, suburban, 

and urban areas depends on whether the bank is located in a metropolitan 

statistical area (MSA) and on population density. 

20 Although banks in counties suffering depopulation showed no greater proportional decline in number than banks in other areas, the performance of 

banks in counties suffering depopulation differed from that of banks in growing areas, as discussed in the FOB paper by Anderlik and Walser, and in 

Myers and Spong (2003). 

21 The 12 states where unit banking existed as of the end of 1977 were Colorado, Illinois, Kansas, Minnesota, Missouri, Montana, Nebraska, North Dakota, 

Oklahoma, Texas, West Virginia, and Wyoming (Conference of State Bank 

Supervisors [1978], 95). 

2004, VOLUME 16, NO. 1 12 FDIC BANKING REVIEW 
Summary and Conclusions 

reductions were roughly the same in rural and 

urban areas. Urban areas are clearly where the 

action is; urban areas are central in terms of both 

merger activity and the establishment of de novo 

banks. The two types of activity are, to some 

extent, related; dissatisfied customers of a merged 

bank may be attracted to a new institution, and 

areas of high population density may be more 

attractive markets for the establishment of new 

banks while also containing more attractive merger targets. 

The pervasiveness of consolidation among community banks casts doubt on, or provides only 

weak support for, some familiar explanations of 

the reduction in the number of community banks. 

The lifting of branching restrictions in states that 

previously prohibited branching, diseconomies of 

small-scale operations, and depopulation and 

weak local economies all have undoubtedly 

affected the fortunes of community banks. However, none of these factors seems to have been the 

main cause of the consolidation among these 

institutions. In time, these factors may produce 

further consolidation, although it is difficult to 

estimate the length of the lags in bank response. 

These lags may reflect, in part, a lack of interest 

on the part of potential acquirers in banks located 

in weak local economies as well as the ability of 

banks in such areas to perform at a level satisfactory to their owners. In the recent past, at least, 

the main impetus for consolidation seems to have 

been individual decisions by shareholders and 

managers in response to intensified competition. 

As noted above, the effect of mergers and failures 

was dampened somewhat by the establishment of 

new banks, mostly in areas of high population 

density. About 1,250 new community banks were 

established between 1992 and 2003, of which 

about 100 have been merged and about 1,100 

remain as independent organizations. Like other 

new and young businesses, they exhibit significant 

risk factors in some cases, but only 4 have failed. 

If real estate and other markets served by these 

banks do not experience serious downturns, these 

institutions will have an opportunity to mature 

and prosper.22 

As a result of both a slowdown in mergers and the 

continued establishment of de novos, the pace of 

consolidation has slowed considerably in the past 

few years. In the near term, some further consolidation may be expected. Low returns on equity 

(resulting partly from higher capital ratios) may 

lead to consolidation among some institutions, as 

stockholders seek higher returns through 

increased leverage at merged institutions.23 

Attracting and retaining qualified employees and 

management succession will pose challenges for 

some of these institutions. Dependence on interest income will periodically squeeze margins 

unless fee income is increased. Regulatory burdens 

may also contribute to consolidation. 

With respect to earnings performance, in recent 

years the before-tax ROAs have been lower for 

community banks than for larger banks. However, 

this gap between community banks and larger 

banks is narrowed after corporate taxes are taken 

into account. Community banks hold a larger percentage of their assets in lower-yield, nontaxable 

municipal bonds. Moreover, about 2,100 community banks were organized as Sub-chapter S corporations as of March 2004 and therefore paid no 

federal corporate income tax if they met certain 

conditions. After taxes, community bank ROAs 

have averaged from 1.0 percent to 1.2 percent in 

recent years, lower than those of larger banks but 

a level of profitability that would have been 

regarded as exceptional in earlier years. As might 

be expected, community banks located in counties experiencing more rapid growth in either 

population or real personal income have experienced higher ROAs and net interest margins, 

22 During the 1980s, failures were higher among new or “young” banks than 

among existing banks. In the early 1980s a large number of new national 

banks were chartered following a change in policy by the Office of the Comptroller of the Currency, a change designed partly to increase competition. At 

the time, banks obtaining a national charter were, by statute, automatically 

insured by the FDIC. In 1991, as a result of the FDIC Improvement Act, the 

FDIC obtained separate authority to approve insurance for national banks. See 

FDIC (1997), 106. 

23 Such reasoning does not apply, or applies with considerably less force, to 

owner-operated banks that do not rely on uninsured or unprotected sources of 

funds. Returns of owner-managers may be augmented by compensation 

received as officers of the bank, and there may be no outside shareholders to 

challenge the decision to remain independent. 

FDIC BANKING REVIEW 13 2004, VOLUME 16, NO. 1 
The Future of Banking 

although expense ratios are currently similar.24 

These results are hardly surprising; what may be 

surprising to some is that even in slow-growth 

areas, the performance of community banks can 

be considered “satisfactory.”25 

In deposit and loan markets community banks 

have faced strong competition, not only from 

within their own ranks but also from larger banks, 

credit unions, and nonbank competitors. The 

community bank share of deposits has declined in 

rural, small metro, suburban, and urban areas, 

with the largest 25 banking organizations showing 

a large increase in market share.26 (These comparisons reflect both internal growth and mergers.) The share held by regional and other midsize 

banks has also declined, while that of credit 

unions has remained relatively stable, increasing 

from 8 to 9 percent since 1994. Within the credit 

union industry, large institutions (assets over $100 

million) have shown an increased share, while 

small credit unions have lost ground. Leaving 

aside the very largest banking organizations, credit unions have increased their market share relative to the smaller banks, a development that many 

would attribute to credit unions’ tax-exempt status and the expansion of their permissible areas of 

operation. Not all community banks face credit 

union competition of the same intensity; credit 

unions are concentrated in urban areas in the 

central and eastern states, whereas community 

banks are located in large numbers in rural, suburban, and urban areas.27 

After adjustments are made for mergers, small 

banks have actually shown more rapid growth 

since the early 1990s than the largest banks.28 

Small banks have paid higher rates, and charged 

lower fees, than large banks in order to attract 

deposits. They have also increased their borrowings from Federal Home Loan Banks in order to 

broaden their sources of funds, as core deposit 

growth has lagged behind demands for credit. 

On the lending side, there have been declines in 

the community bank shares of the increasingly 

standardized consumer, home mortgage, and unsecured business loan markets—markets that large 

lenders, using credit-scoring technologies, have 

penetrated on a nationwide basis. On the other 

hand, community banks appear to be largely holding their own in real estate lending to businesses 

and in farm lending. Community banks hold a 

disproportionately large share of small business 

and farm loans (real estate and operating loans). 

In summary, the number of community banks has 

been halved since 1985, and these banks’ market 

share has declined relative to the largest banks’ 

market share. On the face of it, the declines in 

number and market share would seem to suggest 

that community banks have serious problems. A 

more detailed examination presents a somewhat 

more optimistic view. Community banks still represent 94 percent of the total number of banks, 

not much different from the percentage before 

the recent wave of consolidation began. Moreover, it is impressive that community banks have 

been able to register respectable earnings and 

growth in recent years while facing intensified 

competition from nonbank financial companies, 

as well as from other banks after the removal of 

the branch restrictions that had protected many 

community banks from competition. 

The conclusion we draw is that the community 

bank is a viable business model. Research suggests 

that community banks have certain advantages as 

lenders to small businesses, small farmers, and 

other informationally opaque borrowers; these 

advantages are their ability to assess the risks of 

borrowers who lack long credit histories, their 

24 From 1992 to 2001 community banks located in counties experiencing population declines recorded ROAs ranging from 1.0 percent to 1.2 percent—not 

much lower than the ROAs of banks located in counties experiencing population growth. 

25 Myers and Spong (2003) reached a similar conclusion. 

26 Credit union offices and deposits are classified geographically according to 

the location of the organization’s headquarters. For the large majority of credit 

unions this probably is acceptable, although for large credit unions—such as 

those serving military personnel—this may distort data on the location of credit 

union resources. 

27 Eighty percent of credit unions are located in MSAs, compared with 54 percent of community bank offices. 

28 Bassett and Brady (2001) reached a similar conclusion. It should be noted 

that the more rapid percentage growth rates of small banks may partly reflect 

the fact that the internal growth rates of very large banks may be more limited by the size of markets and the marginal cost of increases in funding. 

2004, VOLUME 16, NO. 1 14 FDIC BANKING REVIEW 
Summary and Conclusions 

ability to use “soft” data (such as borrower reputations) effectively in risk assessment, and their 

ability to operate effectively in situations where 

the proximity of decision makers to customers is 

important.29 The proposition that community 

banks have informational advantages in lending 

to small business is supported by research suggesting that small banks have higher risk-adjusted 

returns on business loans than large banks. The 

willingness of private investors to risk their own 

money to establish new banks is a powerful market test of the viability of small banks, at least in 

areas of population density. Moreover, a concentration of de novos in areas where large and distant banks have taken over local institutions 

suggests, as well, that many customers may be dissatisfied with the more impersonal approach of 

large banks. Although consumer attitudes may 

change and larger banks may seek to emulate the 

personal-service approach of smaller institutions, 

community banks should continue to be important in the banking industry for the foreseeable 

future. 

Limited-Purpose Banks 

Limited-purpose banks are institutions that specialize in a relatively narrow business line. The 

limited-purpose banks examined in this study are 

credit card banks, subprime lenders, and Internetprimary banks.30 Numerically these institutions 

make up a small share of the banking industry. 

Yet their unique production functions and product mixes warrant attention. 

Although the diversification of risks is widely 

regarded as desirable, some institutions have chosen to specialize. Focusing on a limited set of 

activities allows them to develop expertise quickly and become efficient producers. Moreover, 

technological innovations in the financial services industry, which lead to gains in productivity 

and economies of scale, may also have promoted 

specialization. 

The credit card banks provide their customers 

with both convenience and liquidity by offering a 

product that can be used as a payment device and 

as an open-end revolving credit. Credit card 

loans pose unique risks to these lenders, however. 

In addition to being unsecured, credit card loans 

do not have a fixed duration, a lack that complicates the measurement and management of interest-rate risk. Moreover, the mass marketing of 

credit cards may lead to problems of adverse 

selection, and small average balances on individual accounts may make collection efforts cost 

ineffective. Despite such risks, credit card banks 

have managed to offset the effects of potentially 

greater volatility and risk in income: their average 

ROAs are considerably higher than those of the 

industry as a whole. Their high profitability 

results from high interest rates on credit card 

loans, securitization, fee income, successful use of 

technology, and the benefits of scale economies in 

credit card operations. It is reasonable to expect 

that credit card banks will continue to prosper. 

Credit card banks have been undergoing a process 

of consolidation, and whether further consolidation may be expected depends heavily on whether 

they have exhausted the benefits of scale 

economies. 

In this study, “subprime lenders” refers to insured 

institutions that extend credit to borrowers who 

may have had more limited borrowing opportunities because of their poor or weakened credit histories. Not only can these lenders increase 

business volume by serving a new customer base, 

but they can also be profitable by pricing these 

loans accurately to compensate for greater risk. 

Although subprime lenders earn interest income 

higher than the industry average, their lending 

activity involves greater risk and losses. Moreover, 

increased scrutiny from regulators on issues such 

29 The extensive literature on the economic role of community banks is discussed in the FOB paper by Critchfield et al. 

30 This section is based on the FOB paper by Yom. Credit card banks are 

defined as institutions that have more than 50 percent of total assets in loans 

and credit card asset-backed securities (ABS) and have more than 50 percent 

of total loans and credit card ABS in credit card loans and credit card ABS. 

Subprime lenders are institutions with more than 25 percent of tier 1 capital 

in subprime loans. Internet banks’ primary contact with customers is the Internet. Data used in this study are based on 37 credit card banks, 120 subprime 

banks, and 17 Internet banks. 

FDIC BANKING REVIEW 15 2004, VOLUME 16, NO. 1 
The Future of Banking 

as capital adequacy and predatory lending practices may have effectively eliminated the advantage the insured institutions once enjoyed relative 

to other financial firms operating in the subprime 

lending field. In response, subprime lending has 

tailed off recently, and some participants have 

withdrawn from the market. On the basis of the 

evidence to date, it is reasonable to expect bank 

participation in subprime lending to stay at 

reduced levels, if it does not decline further. 

Internet-primary banks are institutions that deliver banking services mainly on-line. By taking 

advantage of the Internet distribution channel, 

these institutions offer convenience to their customers. It was once thought that eliminating 

physical branches and employing fewer employees 

would enable Internet banks to provide banking 

services at lower cost, but in reality, Internet 

banks underperform brick-and-mortar banks. This 

may reflect limited consumer demand for Internet 

banking services. These institutions are also at a 

competitive disadvantage relative to brick-andmortar banks in lending to small businesses 

because they lack the means of building longterm relationships with borrowers. The evidence 

to date indicates that, as a business model, Internet banks have apparently only a modest chance 

of success, given present customer attitudes and 

the present state of technology. 

Although limited-purpose banks have compiled a 

mixed record, their activities can be effectively 

undertaken by larger, more diversified institutions. A number of credit card banks are subsidiaries of large banking companies. On-line 

banking is offered by numerous institutions that 

also offer more traditional forms of access. And 

with appropriate underwriting and capital support, subprime lending can be a useful component 

of a more diversified portfolio. 

Prospects for Banking Sectors: Summary 

Individual banks and groups of banks differ greatly in size, strategy, and operating characteristics. 

They also share some attributes. Operating in a 

generally favorable economic environment, banks 

have responded to intensified competition and 

the expanded opportunities offered by sweeping 

legislative and regulatory change. With some 

exceptions, they have performed at levels of profitability that would have been regarded as 

extraordinary in earlier years. Assuming effective 

macroeconomic and regulatory policies, each of 

the main banking industry sectors—community 

banks, regional and other midsize banks, and 

large, complex banking organizations—should 

prosper in the years immediately ahead. 

Public Policy Issues 

Although the banking industry is likely to continue to be healthy, ongoing trends raise a number of 

public policy issues, mainly related to the 

increased size and complexity of banking organizations. Chief among the issues that policy makers 

need to consider are the safety and soundness of 

banking in an industry dominated by megabanks, 

and concerns related to bank customers and markets. 

The emergence of megabanks has raised the possibility, however remote, that failures could deplete 

the deposit insurance funds, require large premium increases that place a heavy burden on the 

remaining banks, disrupt financial markets, and 

undermine public confidence. Financial and technological risks arise partly from the problems of 

monitoring and controlling multiple business 

lines, geographically dispersed operations, and 

complex corporate structures. Furthermore, the 

diversification of large banks into new financial 

areas exposes these institutions to new reputational risks. The involvement of large financial 

holding companies in recent corporate scandals 

illustrates this exposure. 

The growing importance of large, complex banks 

also raises issues relating to concentration and 

competition in individual markets and the availability of credit for borrowers and local markets 

that were traditionally served by local banks. 

The FDIC’s approach to analyzing the effects of 

large banks in those areas and formulating recom2004, VOLUME 16, NO. 1 16 FDIC BANKING REVIEW 
Summary and Conclusions 

mendations for possible action rests on three principles: 

Banking should evolve primarily in response 

to the consumer and the marketplace rather 

than in response to regulation. The strong 

performance record compiled by the 

banking industry in recent years amply 

confirms what banking can achieve when 

it is allowed to respond to market forces. 

There are, of course, situations when government action is required to make markets work better. One example is the 

establishment of deposit insurance and of 

the bank safety net generally, which has 

contributed to the prevention of the 

extreme instability that characterized 

financial markets during much of the 

early history of the United States. Legislation and regulation to prevent anticompetitive practices are another example. In 

both cases, government action was taken 

to ensure that markets operate safely, fairly, and competitively. 

Risks posed by large, complex banks need to 

be addressed through effective prudential regulation and supervision. Requiring banks to 

maintain adequate capital is central to an 

effective regulatory regime. Effective 

examination, supervision, and enforcement are equally important. Furthermore, 

regulation and supervision should be 

backed by market discipline exerted by 

holders of unprotected bank securities; 

regulation and supervision should also be 

backed by sound governance arrangements adopted by the banks themselves. 

As suggested above, the potential usefulness of a two-tier, large bank/small bank 

supervisory system needs to be considered. 

To help ensure the effectiveness of prudential 

regulation and supervision, the structure of 

the bank regulatory system should be reevaluated. In the fragmented bank regulatory 

system of the United States, the FDIC as 

the deposit insurance agency has no 

direct supervisory responsibility for the 

major risks to which it is exposed. At the 

same time, state and federal primary regulatory- agencies that are funded by examination fees are increasingly exposed to 

financial strains arising from the consolidation of the industry. Within present 

law, or with minimum legislative change, 

it may be possible to coordinate better 

the activities of the various banking agencies, reduce the overall cost of regulation 

and supervision, and help all bank safetynet agencies discharge their responsibilities effectively. 

The discussion that follows is based on these principles. It focuses on major public policy issues 

arising mainly from the consolidation of the 

banking industry and the consequent emergence 

of very large and complex banking organizations. 

The areas covered are the effects of further consolidation, combinations of banking and commerce, large-bank supervisory issues, governance 

issues, financial service regulatory issues, bank liability structure, and the economic role of banks. 

Effects of Consolidation: Safety and 

Soundness, Competition, and 

Small Business Credit 

After decades of relative stability, the number of 

banks in the United States has dropped by about 

one-half from the level of the mid-1980s.31 More 

recently, the pace of consolidation has slackened. 

Although a resumption of the headlong pace that 

followed geographic deregulation seems unlikely, 

further mergers and acquisitions can be expected 

in the period immediately ahead. As noted above, 

investors, market analysts, and managers appear 

to be strongly in favor of mergers as a means of 

achieving revenue and earnings growth, even 

though academic studies do not provide conclusive evidence that greater efficiency will be 

achieved. Some of the anticipated advantages of 

earlier mergers and acquisitions have failed to 

materialize, although it is difficult to say how the 

31 This section is based partly on the FOB paper by Critchfield and Jones. 

FDIC BANKING REVIEW 17 2004, VOLUME 16, NO. 1 
The Future of Banking 

merger partners would have fared if they had not rather than deposits and will be borne more heavcombined. ily by the largest institutions.33 

Yet we can also expect the number of banks to 

remain higher than most recent projections by 

other analysts.32 In the absence of a new shock to 

the industry, it seems likely that the U.S. banking 

industry will retain a structure characterized by 

the existence of several thousand small institutions, a less-numerous group of regional and other 

midsize banks, and a handful of extremely large 

banking organizations. It seems reasonable, also, 

to expect that an eventual balance may develop 

between the number of new-bank startups and 

charter losses through mergers and acquisitions— 

with little net change in the number of banking 

organizations nationwide. 

The public policy issues raised by consolidation 

concern safety and soundness, market concentration and competition, and small business credit. 

The effect of consolidation on safety and soundness. 

The failure of one of the largest U.S. banks is 

generally regarded as a low-probability event. 

Very large banks have greater opportunities to 

diversify, although the resulting reduction in risk 

may be offset by increased risk taking to enhance 

profits and by problems in monitoring and controlling increasingly complex and diverse operations. 

The much greater size of today’s megabanks, compared with their past counterparts, tends to 

increase the prospect that the failure of such a 

bank—although unlikely—would seriously affect 

the banking and financial systems. Depending on 

the condition of the industry and the general 

economy, systemic risk could arise from the failure 

of a bank that is a major player in certain business 

lines, including payments processing, international operations, derivatives, and major marketclearing functions. If it is concluded that the 

least-cost resolution of such a bank represents an 

unacceptable risk to the financial system and if, 

consequently, the bank regulators act to protect 

unsecured and uninsured liability holders, the 

additional cost will be covered by special assessments. These will be based essentially on assets 

Current law contains certain provisions to deal 

with the special issues posed by size. Among these 

are the assessment provision of the systemic-risk 

exception for large-bank failures, the authority for 

the FDIC to create different premium systems for 

large and small institutions, and the authority for 

bank regulators to require more capital based on 

risk. 

Although various options are available, the most 

direct way to deal with the size of the nation’s 

largest banking organizations is to ensure that 

they hold sufficient capital to provide a cushion 

to absorb potential losses. Regulators can accomplish this by establishing minimum regulatory 

capital requirements in addition to requirements 

based on the banks’ internal risk estimates (as 

contemplated by Basel II). 

Effect of consolidation on market concentration and 

competition. As a result of the concentration of 

banking resources, some large banks may be in a 

position to exert their market power to raise 

prices of bank services in some markets. Even 

with the consolidation of the past 15 to 20 years, 

however, the banking industry is less concentrated than either its nearest competitors among 

financial industries—the securities and the insurance industries—or many nonfinancial industries. 

Banking is also less concentrated in the United 

States than in other developed countries. Moreover, the 10 percent domestic deposit limit 

inhibits the creation of a banking monopoly 

through nationwide mergers and acquisitions. 

Although some large banks may have more influence on the prices of banking services in particular markets than they once had, sizable increases 

in prices will invite entry by a variety of bank and 

nonbank firms. Among those entering these markets will be newly established institutions. The 

32 See the FOB paper by Critchfield and Jones. 

33 Current law requires that special assessments in systemic-risk resolutions be 

based on assets less tangible equity and subordinated debt, whereas regular 

assessments are based on domestic deposits. Large banks tend to fund assets 

with nondeposit liabilities and foreign deposits to a greater extent than small 

banks. 

2004, VOLUME 16, NO. 1 18 FDIC BANKING REVIEW 
Summary and Conclusions 

entry of new banks is encouraged by the existence 

of deposit insurance and would be further encouraged if the reporting and other regulatory requirements that currently place heavy burdens on 

small banks were reduced. 

Taking all these factors into account, we foresee 

that competitive forces are likely to continue 

dominating banking markets for the foreseeable 

future. 

Effect of consolidation on small business credit. Concern has been expressed about the effect of banking consolidation on the availability of credit for 

small businesses and small farms.34 This concern 

arises because community banks devote proportionally more of their resources to lending to 

these borrowers than large banks do. Lending to 

small business has often been “reputational” in 

nature, requiring the local expertise that is both 

characteristic of community banks and more 

favorable to some small business borrowers, such 

as new or young firms with limited credit histories. Large banks, on the other hand, are likely to 

focus more on large borrowers and use credit-scoring and other standardized lending methods in 

underwriting loans. 

On the basis of the available evidence, the effect 

of consolidation on small business credit appears 

to be complex and dependent on numerous factors. For example, it has been argued that as 

banks get larger, they are better able to diversify 

their portfolios and therefore increase their lending to all borrowers, including small businesses. 

New credit-scoring models used by large banks 

may identify borrowers who were previously not 

able to obtain credit from small banks. Moreover, 

whether small business lending increases or 

decreases may depend on whether the acquiring 

bank already regards small business lending as an 

important business line. The effect of consolidation on small business credit availability also 

depends on whether there are other lenders in the 

market that can offset a merger-related reduction 

in lending. These effects seem to differ between 

rural and urban markets and between already concentrated and more competitive markets. 

The effect of consolidation on small business 

lending will continue to be the subject of 

research. Although the outcome of such research 

cannot be predicted in detail, one important consideration is the possibility that consolidation 

may create opportunities for the remaining community banks. Any reduction in small business 

lending by large banks should invite increased 

lending by community banks, while also encouraging the formation of new banks to serve the 

needs of these borrowers. The presence of a substantial community bank sector and the prospect 

of new market entrants are potentially important 

safeguards against the possibility that bank consolidation will make small business credit less 

available. 

Combinations of Banking and Commerce 

As is well known, banking consolidation has been 

accompanied by affiliations of banks and other 

financial service firms. GLB permitted combinations of commercial banks, securities firms, and 

insurance companies. Looking ahead, one can 

expect market forces to push in the direction of 

more mixing of banking and commerce. The 

underlying policy issues are whether permitting 

affiliations among banks and commercial entities 

serves the public interest and, if such combinations are to occur, what is the appropriate regulatory framework for them.35 

With respect to the first question, there are two 

dominant views as to the desirability of maintaining a separation between banking and commerce. 

Proponents of one view argue that the failure to 

maintain a line of separation—especially in terms 

of ownership and control of banking organizations—would have potentially serious consequences, ranging from conflicts of interest to an 

unwarranted expansion of the financial safety net. 

34 Evidence on the effect of consolidation on small business credit is discussed in Avery and Samolyk (2003).
 

35 The section on combinations of banking and commerce is based on the FOB
 

paper by Blair.
 

FDIC BANKING REVIEW 19 2004, VOLUME 16, NO. 1 
The Future of Banking 

Proponents of the other view argue that, if adequate safeguards are in place, the benefits from 

affiliations between banking and commerce can 

be realized without jeopardy to the federal safety 

net. Among these safeguards are requirements 

affecting bank capital and the enforcement of 

firewalls to protect the corporate separateness of 

the bank. 

With respect to the appropriate regulatory framework, the Federal Reserve Board maintains that 

supervision of the insured bank’s parent and affiliated companies is necessary if the associated risks 

are to be understood and controlled. The FDIC 

has long argued that national and state-chartered 

banks, regardless of size or holding company affiliation, should be able to choose the ownership 

structure that best suits their business needs if 

adequate protections are present. Thus, at the 

heart of the debate is the question of whether the 

public interest requires federal regulatory oversight of the entire banking organization or just of 

the bank. 

Although the current prohibitions on corporate 

ownership of banks are sometimes defended on 

the grounds that banking and commerce have 

always been separate, the history of U.S. banking 

reveals no evidence of a long-term separation. 

Certainly the activities permitted to banks have 

always been subject to prohibitions, but the prohibitions on affiliations with commercial firms 

that are currently in effect stem from the Bank 

Holding Company Act of 1956 and its amendments. Despite these regulations and prohibitions, 

however, extensive links between banking and 

commerce have existed and still exist. And the 

market pressure for more business combinations 

between banks and commercial firms can be 

expected to continue. Moreover, the potential 

risks of allowing banking and commerce to mix— 

conflicts of interest, concentration of economic 

power, and expansion of the safety net—can be 

contained through the use of adequate safeguards 

and firewalls. Thus, these risks do not appear to 

justify a separation of banking and commerce. 

Does the mixing of banking and commerce constitute good public policy? The evidence suggests 

that the answer is a qualified yes: with adequate 

safeguards in place, the careful mixing of banking 

and commerce can yield benefits without excessive risk. The issue facing policy makers is how 

these combinations of banking and commerce 

will be regulated. Specifically, will increasing 

amounts of commercial activity be subject to 

umbrella supervision, or will the insured entity be 

the focus of supervision? Regulators and policy 

makers should consider what additional powers, if 

any, are needed for regulators to be able to effectively ensure the corporate separateness of the 

insured entity, while also ensuring that banks can 

choose the corporate structure that meets their 

business needs. 

Large-Bank Supervisory Issues 

Large, complex banking organizations pose unique 

challenges to regulators.36 Traditional methods of 

examining banks were suited for smaller institutions, and as financial institutions became larger 

and increasingly complex, bank regulation and 

supervision had to adapt. The regulatory and 

supervisory issues raised by the growth of these 

banking organizations may be considered in the 

context of the New Basel Capital Accord, or 

Basel II. As is well known, the new accord rests 

on three pillars: 

Pillar 1: Minimum Capital Requirements 

Pillar 2: Supervisory Review Process 

Pillar 3: Market Discipline. 

Pillar 1 (capital requirements). On June 26 2004, 

the Basel Committee on Banking Supervision 

released the framework for the new Basel capital 

accord. It outlines the minimum requirements for 

credit, market, and operational risk. The target 

for implementation of the new accord was yearend 2006, with the most advanced approach 

available for implementation by year-end 2007. 

The proposed accord includes two primary 

changes to the current capital standards. First, it 

modifies the approach to credit risk; second, it 

includes explicit capital requirements for opera36 This section is based on the FOB paper by Bennett and Nuxoll. 

2004, VOLUME 16, NO. 1 20 FDIC BANKING REVIEW 
Summary and Conclusions 

tional risk. Most U.S. banks will continue to use 

the existing risk-based capital rules, but all very 

large, internationally active banks will be required 

to adopt the new capital standards and to use the 

Advanced Internal Ratings-Based (AIRB) 

approach to credit risk. Under the AIRB 

approach, the probability of default, loss given 

default, and exposure at default will be estimated 

internally by the banks. With respect to operational risk, the new accord proposes that banks 

using the AIRB approach will also estimate operational risk internally. 

As a member of the Basel Committee, the FDIC 

has three basic goals for Basel II: (1) capital regulations should preserve and maintain minimum 

capital requirements; (2) the standards should be 

designed so that they may be implemented and 

supervised effectively in the real world; and (3) 

any new standards should not produce substantial 

adverse unintended consequences. Among such 

unintended consequences is the possibility that 

smaller banks will be adversely affected compared 

with large banks. As noted above, the FDIC also 

believes that a minimum regulatory capital 

requirement should be adopted in addition to the 

requirements based on the banks’ internal estimates as contemplated by Basel II. This belief is 

consistent with the FDIC’s principle that a strong 

capital base not only is necessary for a safe and 

sound banking industry but also can equip the 

industry to weather downturns in the economy or 

the onset of unanticipated events. 

Pillar 2 (supervisory review). The supervision of 

large banks is challenging because of the complexity of these institutions. Four sources of complexity are size, geographic span, business mix, 

and nontraditional activities. Given the sheer 

volume of transactions and types of assets, it is 

difficult to gather, aggregate, and summarize information in a manner that is meaningful for risk 

management. The wide geographic span of these 

institutions, including both domestic and foreign 

operations, may obscure correlations among exposures. More sophisticated products and a wider 

range of business activities also complicate supervision. As major business units are acquired or 

sold, the risk profile of the organizations may 

change considerably. Supervisors will be strongly 

challenged to develop the expertise necessary for 

monitoring the activities of large, complex banking organizations, as well as to avoid extending 

the safety net to nondeposit products. 

Pillar 3 (market discipline). Investors in the various 

securities issued by banks have interests similar to 

those of supervisors. This similarity of incentives 

has led to a number of suggestions that supervisors rely on market discipline for information 

about and control of the riskiness of banks. As 

also discussed in a later section, there are two 

critical questions about market discipline. First, 

do investors know what the bank is doing? Second, can investors control what the bank is 

doing? Various views have been expressed about 

whether banks are opaque to the investor, and 

recent corporate scandals provide grounds for 

skepticism as to shareholders’ ability to control 

management. The effectiveness of market discipline is likely to remain a subject of further 

research. 

Governance Issues 

Failures of corporate governance can cause enormous financial losses, not only to individual corporations and their stockholders but also to 

society as a whole.37 One widely quoted estimate 

of the cost of U.S. corporate governance failures 

is $40 billion a year, or the equivalent of a $10 a 

barrel increase in the price of oil.38 Enron shareholders alone lost $63 billion in Enron’s failure. 

Recent corporate governance scandals have 

resulted in new legislative, regulatory, and judicial 

initiatives to counteract perceived corporate governance failings. 

Because of their special and important role in 

society, banks need to be particularly careful 

about conflicts of interest, or the appearance of 

37 The section on governance issues is based on the FOB paper by Craig. 

38 Litan (2002). 

FDIC BANKING REVIEW 21 2004, VOLUME 16, NO. 1 
The Future of Banking 

them, so as to maintain public confidence. As a 

result of earlier banking legislation, current bank 

corporate governance standards are higher than 

the standards for nonbank enterprises, and most 

banks to which the Sarbanes-Oxley Act of 2002 

applies have little trouble meeting that act’s 

requirements.39 In fact, many of the provisions of 

this legislation are derived from bank governance 

standards; this law introduces nonbanking businesses to standards that banks have been observing for years. 

However, the combination of the Sarbanes-Oxley 

legislation and new stock exchange rules, recent 

SEC actions and recent court decisions, a new 

activism on the part of blockholders, and heightened public scrutiny of business behavior has produced a changed corporate governance 

environment, one that continues to evolve. The 

major changes in this environment that will 

affect banks are changing norms of board independence, increased shareholder involvement, 

and changing and uncertain standards of board 

accountability. In particular, bank interlocking 

directorships may run up against the changing 

norms for board independence. In addition, public dismay over excessive executive compensation 

is likely to stimulate shareholder scrutiny of 

boards’ compensation policies—and likely to 

increase the pressure on some boards. 

Banks, like other businesses, must be prepared to 

meet these evolving standards of corporate governance. The most effective way to avoid corporate 

governance problems is to select a knowledgeable, 

engaged, and independent board of directors. 

However, increased commitments of time by 

board members, increased liability issues, an 

emphasis on financial expertise, and the trend 

toward more independent boards are likely to 

make it more difficult for banks, and other businesses, to recruit board members. Some observers 

suggest that banks and other businesses will need 

to focus on recruiting people who have traditionally not been members of boards in large numbers—women and both younger and older 

members: for example, more division directors 

rather than sitting CEOs, and more retired people 

who have the time and expertise to devote to 

board membership. In this demanding and changing corporate governance environment, banks 

and other businesses may need to expand their 

vision of what constitutes a qualified board member. 

Financial Services Regulatory Issues 

In the 20 years since the last major study of the 

federal financial regulatory system,40 the financial 

system has continued to evolve and become more 

complex. Yet, its regulatory system remains rooted in the reforms of the 1930s. Regulation and 

supervision of large, mutli-product, internationally active financial organizations that span numerous federal financial regulatory agencies pose 

challenges for a system designed largely to regulate smaller, distinct, locally based organizations 

Although changes have been made—especially 

over the past decade—to improve the regulation 

and supervision of these new financial conglomerates, it is time to take a hard look at the current 

federal financial regulatory structure.41 

As the financial services industry grows larger and 

more complex, the question is increasingly raised 

as to whether our fragmented, piecemeal system 

of regulation is up to the task. Since the mid1980s a number of countries have examined their 

financial regulatory structures and concluded that 

changes needed to be made. Internationally, the 

trend has been to consolidate all—or most— 

financial services regulation within one agency 

and to move that function outside the central 

bank. 

39 The Sarbanes-Oxley Act applies to publicly held institutions—institutions that
 

issue securities registered with the SEC or with a federal financial regulatory
 

agency. In addition, nonpublic banking institutions with more than $500 million in assets are required to comply with the SEC’s definition of auditor independence.
 

40 See The Report of the Task Group on Regulation of Financial Services
 

(1984).
 

41 This section is based on the FOB paper by Kushmeider.
 

2004, VOLUME 16, NO. 1 22 FDIC BANKING REVIEW 
Summary and Conclusions 

Reform of the U.S. financial regulatory structure 

raises complex issues regarding deposit insurance, 

the role of the central bank, and the dual banking 

system. Although many observers would argue 

that in the absence of a crisis, regulatory restructuring is not a topic that will generate much 

political interest in the United States, there are 

issues that will affect how the financial regulatory 

system is organized and operates regardless of 

whether full-scale restructuring is desired. 

Among these issues are funding for the Office of 

the Comptroller of the Currency and the Office 

of Thrift Supervision, federal preemption, the resolution of issues that cross functional regulators, 

and umbrella supervision for all financial conglomerates that own an insured depository institution.42 

The options outlined in the paper on which this 

section is based represent possible ways in which 

reform or restructuring of the federal financial 

regulatory system could occur. They focus on the 

least-intrusive, most easily accomplished reforms 

(those that regulators could undertake themselves 

or that require little legislative change) to a fullscale restructuring of the federal financial regulatory system. There are valid arguments for taking 

either approach or even for finding some middle 

ground, such as a thorough restructuring of the 

bank regulatory system. Within each option 

there is room for debate over how regulation 

might be structured—for example, what entities 

might be included. The paper is designed to provide background regarding issues that will influence the debate over regulatory restructuring and 

to provoke thought and discussion about the 

design of the U.S. federal financial regulatory system. 

Bank Liability Structure 

Growth in core deposits (total deposits less time 

deposits in denominations of more than 

$100,000) has failed to keep pace with the corresponding growth in bank assets.43 There may be 

many reasons, either singly or in some combination, for this phenomenon. The supply of core 

deposits may be growing at a slower rate than 

bank assets, banks may be increasingly using alternative funding sources that have lower costs, and 

some alternative sources may offer risk reducing 

features. As all of these explanations are likely to 

be true, the mix between core deposits and alternative funding sources will continue to change. 

This prospect suggests continued reliance on 

wholesale funding sources (such as Federal Home 

Loan Bank advances and brokered deposits) and 

efforts to expand other nondeposit sources of 

funds. 

These changes in liability structure raise several 

issues for banking regulators. The one that has 

received most attention recently is market discipline—particularly for large, complex banking 

organizations. The research to date shows that 

unprotected investors monitor bank performance 

and respond to changes in risk exposure. Supervisors play an important role in ensuring that markets have accurate data on banks, since troubled 

banks otherwise may overstate capital. The evidence is weaker on the ability of markets to 

encourage banks to reduce their risk exposure 

when trouble arises. And for the very largest 

banks, market discipline may be diminished by 

the perceptions of market participants that such 

banks are too big to fail—that is, the perception 

that uninsured depositors and other creditors 

would be protected if the institution failed. In the 

future, more emphasis should be put on disclosing 

information to the markets as well as on increasing the use of market data to inform and enhance 

the supervisory process. 

Another issue raised by banks’ heavier reliance on 

wholesale funding sources and rate-sensitive 

deposits for funding is liquidity risk exposure, 

which has increased. Regulators have responded 

by updating their examiner guidance on liquidity 

risk. It may also be worthwhile to seek better ways 

42 The last issue has implications for the operation of U.S. financial conglomerates in Europe, where they must meet a requirement for consolidated supervision. 

43 This section is based on the FOB paper by Bradley and Shibut. 

FDIC BANKING REVIEW 23 2004, VOLUME 16, NO. 1 
The Future of Banking 

to measure liquidity risk and better ways to handle the operational challenges associated with liquidity failures. 

A third issue concerns the assessment base, and a 

fourth concerns depositor preference. To the 

extent that asset growth is funded by nondeposit 

liabilities, the exposure of the FDIC tends to 

increase without any increase in the assessment 

base on which premiums are calculated. (The 

assessment base is essentially the amount of 

domestic deposits after certain adjustments.) In 

the past, various proposals were advanced to 

expand the assessment base. And changes in the 

liability structure have highlighted the importance of domestic depositor preference when 

banks fail. Some observers have questioned the 

cost savings attributed to the present priority provision and have pointed to the provision’s potential effects if a multinational banking organization 

were to fail. In light of changes in the structure of 

bank liabilities, it may be useful to consider the 

advisability of revising the assessment base to 

ensure that premiums are properly aligned with 

the risks to which the FDIC is exposed, and the 

advisability of reviewing the effects of the present 

system of domestic depositor preference. 

The Economic Role of Banks 

Historically, banks have been regarded as a special 

class of intermediary because they perform four 

unique functions: (1) they issue transaction 

accounts that have universal acceptability and are 

available at par on demand, (2) they fund idiosyncratic (and illiquid) loans with liquid liabilities, (3) they serve as backup sources of liquidity, 

and (4) they play a key role in the transmission of 

monetary policy.44 Consequently, policy makers 

have maintained a government safety net that 

protects and regulates the banking industry to 

ensure that it operates with minimal disruption. 

Yet, over the past quarter of a century, revolutionary advances in IT and telecommunications have 

combined with the economic and political forces 

of globalization and deregulation to fundamentally alter the operations of financial intermediaries 

(both bank and nonbank) and the markets in 

which they operate. One result of these changes is 

that financial markets are much more complete, 

efficient, and competitive today than they were 

25 years ago. This development has led some 

observers to argue that banks are no longer 

unique among financial institutions and therefore 

do not merit the current level of government protection or regulation. 

This study concludes, however, that banks have 

not lost their importance as financial intermediaries and that they have in fact evolved to meet 

the challenges and demands of the new world of 

finance. Banks, for example, are still at the center 

of the payments system. Indeed, virtually every 

financial transaction that involves a net transfer 

of wealth is still eventually settled through the 

banking system. Banks also continue to play an 

important role in the transmission of monetary 

policy. And despite signs of disintermediation and 

what some see as a decline in the relative importance of banks, banks continue to serve as the primary sources of credit to important segments of 

the economy (such as small businesses and small 

farms). 

Moreover, as the capital markets have become 

more developed, banks have evolved to provide 

important behind-the-scenes support to much of 

the intermediation activity that occurs elsewhere. 

For example, almost all commercial paper issues 

are backed by bank-issued stand-by letters of credit that enhance the paper’s credit rating and 

increase its liquidity. In securitizations, banks are 

involved in originations, servicing, and monitoring and in the provision of credit enhancements. 

In this respect, banks remain an important player 

in the intermediation process even though they 

are no longer the primary lender or the direct 

source of the loaned funds. Finally and perhaps 

most importantly, as has been demonstrated 

repeatedly during a number of financial panics 

and crises in the United States over the last three 

decades, banks play an essential role as emergency 

sources of liquidity to the rest of the financial sys44 This section is based on the FOB paper by Jones. 

2004, VOLUME 16, NO. 1 24 FDIC BANKING REVIEW 
Summary and Conclusions 

tem and to the broader economy as well. Indeed, 

several studies have shown that banks may in fact 

have a comparative advantage in providing liquidity on demand. 

In conclusion, ample evidence is available to support the position that banks (and the business of 

banking) are not fading away. Rather, in the more 

complex, sophisticated, and volatile financial 

world of the twenty-first century, banks’ importance may actually be growing. 

Concluding Comments 

This study views banking as a strong, competitive 

industry that continues to serve useful economic 

purposes. Within the banking industry, we conclude that each of the three main sectors—community banks, regional and other midsize banks, 

and the largest banking organizations—has favorable prospects for the years immediately ahead, 

even though the number of institutions is likely 

to decline further. What could materially diminish these relatively favorable prospects? 

With respect to community banks, a number of 

competitive and regulatory developments could 

diminish their market role and viability. One possibility is that credit-scoring and other financial 

technology used by large banks and nonbank 

financial companies could advance to the point 

that it would supplant the relationship lending 

practiced by community banks in financing local 

credit needs, including those of small businesses 

and small farms. And large banks might adopt 

organizational structures more conducive to reputational lending—for example, by giving branch 

managers more authority. The consequences 

might be analogous to the results in home mortgage lending, where a nationwide market has 

much diminished the role once played by local 

portfolio lenders. Given the heterogeneous nature 

of small business loans and the organizational 

problems of controlling the activities of far-flung 

branch systems, this result does not seem likely in 

the time frame of this study—five to ten years— 

but it cannot be ruled out completely or indefinitely. 

The burden of reporting and other regulatory 

requirements could also threaten the prospects for 

community banks. Although the banking industry 

as a whole is a politically attractive vehicle for 

implementing various nonbanking political and 

social programs, the fixed costs of such requirements fall particularly heavily on smaller banks. 

The resulting regulatory burden could have effects 

analogous to those of earlier regulations that 

weakened the ability of banks to compete with 

credit unions and other nonbank institutions not 

subject to similar burdens. 

Community banks that lack adequate IT staffs are 

also exposed to the possibility of attacks on the 

software products they use. In addition to the 

direct losses they might suffer, the inconvenience 

to their customers and the damage to their reputations could be a serious competitive disadvantage. 

For large banks, the principal issues are the risks 

associated with size and diversity—the very features that are these banks’ main strengths. Problems identifying and mitigating correlated risks, 

reputational risks arising from potential conflicts 

of interest and lapses in governance, and operational risks associated with IT systems are among 

the most prominent of the risks faced by large 

banks. 

For all banks, the possibility of economic bubbles 

in markets where banks participate, like the bubbles in energy, agriculture, and real estate markets 

during the 1980s, cannot be entirely discounted. 

This is particularly so as economic and financial 

decision making related to banking is increasingly 

in the hands of those who have experienced 

nothing but profits. 

We consider these and similar possibilities to be 

low-probability, high-impact events within the 

five- to ten-year horizon of this study. In many 

cases these possibilities are being addressed by 

bank management and bank supervisory agencies. 

Nevertheless, it is important to keep them in 

mind as a cautionary accompaniment to the relatively favorable picture of banking painted in this 

study. 

FDIC BANKING REVIEW 25 2004, VOLUME 16, NO. 1 
The Future of Banking 

At the same time, important policy issues will 

continue to command the attention of bankers 

and bank regulators. The consolidation of the 

banking industry highlights the challenges of 

supervising large, complex banking organizations. 

The possibility of large-bank failures poses risks 

not only to the deposit insurance funds but also 

to the banking system itself. Market forces are 

likely to push for more business combinations of 

banks and commercial firms, raising again the 

issue of how best to regulate such combinations. 

The existing regulatory structure appears to be 

increasingly out of alignment with the rapidly 

changing financial products and markets. The 

nature of the safety net itself may need to be 

reexamined to ensure that it effectively accommodates an industry characterized by a few megabanks alongside thousands of community banks. 

These difficult issues are likely to be prominent in 

discussions of the future of banking in the years 

ahead. 

2004, VOLUME 16, NO. 1 26 FDIC BANKING REVIEW 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Summary and Conclusions 

REFERENCES 

Future of Banking Papers 

Anderlik, John, and Jeffrey Walser. 2004. Rural Depopulation: What Does It Mean for 

the Future of Economic Health of Rural Areas and the Community Banks That 

Support Them? 

Bennett, Rosalind L., and Daniel A. Nuxoll. 2004. Large-Bank Regulatory Issues: 

Examination, Market Discipline, and Capital Standards. 

Blair, Christine E. 2004. The Mixing of Banking and Commerce: Current Policy Issues. 

Bradley, Christine, and Lynn Shibut. 2004. The Liability Structure of FDIC-Insured 

Institutions: Changes and Implications. 

Craig, Valentine V. 2004. The Changing Corporate Governance Environment: 

Implications for the Banking Industry. 

Critchfield, Tim, Tyler Davis, Lee Davison, Heather Gratton, George Hanc, and Katherine 

Samolyk. 2004. Community Banks: Their Recent Past, Current Performance, and 

Future Prospects. 

Golter, Jay, and Martha Solt. 2004. Bank Technology: Past Forces, Current Conditions, 

Future Trends. 

Gratton, Heather. 2004. Prospects for Regional and Other Midsize Banks: Recent Trends 

and Short-Term Prospects. 

Jiangli, Wenying. 2004. The Effect of Baby Boomers and Immigrants on Banks. 

Jones, Kenneth D., and Tim Critchfield. 2004. The Declining Number of U.S. Banking 

Organizations: Will the Trend Continue? 

Jones, Kenneth D. 2004. The Special Nature of Banks: A Reexamination. 

Kushmeider, Rose M. 2004. The U.S. Federal Financial Regulatory System: Restructuring 

Federal Bank Regulation. 

Murphy, Neil B. 2004. The Effect on U.S. Banking of Payment System Changes. 

Reidhill, Jack, Brian Lamm, and Steven McGinnis. 2004. The Future of Large, Complex 

Banking Organizations. 

Samolyk, Katherine. 2004. The Evolving Role of Commercial Banks in U.S. Credit 

Markets. 

Yom, Chiwon. 2004. Prospects for Limited-Purpose Banks: Their Specialities, 

Performance, and Prospects. 

Other References 

Avery, Robert B., and Katherine A. Samolyk. 2004. Bank Consolidation and Small 

Business Lending: The Role of Community Banks. Journal of Financial Services 

Research 25, nos. 2–3:291–325. 

FDIC BANKING REVIEW 27 2004, VOLUME 16, NO. 1 
 

 

 

 

 

 

 

 

 

 

The Future of Banking 

Bassett, William F., and Thomas F. Brady. 2001. The Economic Performance of Small 

Banks, 1985–2000. Federal Reserve Bulletin (November): 719–28. 

Boyd, John H., and Mark Gertler. 1994. Are Banks Dead? Or Are the Reports Greatly 

Exaggerated? Federal Reserve Bank of Minneapolis Quarterly Review 18, no. 

3:2–23. 

Conference of State Bank Supervisors. 1978. A Profile of State-Chartered Banking. 

Conference of State Bank Supervisors. 

Federal Deposit Insurance Corporation (FDIC). 1987. Mandate for Change. FDIC. 

———. 1997. History of the Eighties—Lessons for the Future. Vol. 1, An Examination of the 

Banking Crises of the 1980s and Early 1990s. FDIC. 

Litan, Robert. 2003. Remarks delivered at AEI/Brookings Joint Center for Regulatory 

Studies, Conference on the Future of Corporate Governance. March 5. 

Myers, Forest, and Kenneth Spong. 2003. Community Bank Performance in Slower 

Growing Markets: Finding Sound Strategies for Success. Federal Reserve Bank of 

Kansas City Financial Industry Perspectives: 15–30. 

Rajan, Raghuram G., and Luigi Zingales. 2003. Banks and Markets: The Changing 

Character of European Finance. NBER Working Papers 9595. National Bureau of 

Economic Research, 

Reich, John M. 2004. Testimony on the Impact of Regulatory Burden on America’s 

Community-Based Banks before the Subcommittee on Financial Institutions and 

Consumer Credit of the Committee on Financial Services, U.S. House of 

Representatives, May 12. 

Standard and Poor’s Compustat. 

U.S. Task Group on Regulation of Financial Services. 1984. 	Blueprint for Reform: The 

Report of the Task Group on Regulation of Financial Services. 

2004, VOLUME 16, NO. 1 28	 FDIC BANKING REVIEW 
The Future of Banking in America 

The Evolving Role of Commercial Banks in 

U.S. Credit Markets 

by Katherine Samolyk* 

SUMMARY 

How important a role do commercial banks play 

in funding nonfinancial borrowing? Ten years 

after the end of the industry’s most significant crisis since the Great Depression, does banking 

remain a major player in financing the nation’s 

economic activity? This paper examines the 

evolving role that commercial banks play in U.S. 

credit markets. 

The available data reveal several consistent patterns over the past two decades. First, there has 

been a permanent increase in the overall borrowing capacity in credit markets—in other words, an 

increase in the credit market pie associated with 

the functioning of the economy. This increase 

was associated with a decline in the share of 

domestic nonfinancial borrowing that is directly 

funded by commercial banks. When debt growth 

leveled off in the early 1990s, so did commercial 

banks’ share of this credit-market pie. Banks’ 

smaller share of the credit-market pie reflects a 

dramatic shift in the way loans to households and 

businesses are being financed. Specifically, asset 

* Katherine Samolyk is a senior financial economist in the FDIC’s Division of 

Insurance and Research. 

securitization (the pooling of loans and their 

funding by the issue of securities) has allowed 

loans that used to be funded by traditional intermediaries, including banks, to be funded in securities markets. 

The data also reveal, however, that commercial 

banks still play a significant role in funding business borrowers: we estimate that the share of nonfinancial business borrowing that commercial 

banks fund on their balance sheets has not 

declined notably in five decades. Nevertheless, 

there has been a clear shift in how banks lend—a 

shift from shorter-term lending not secured by 

real estate to loans collateralized by business real 

estate. This shift may reflect banks’ continuing 

comparative advantage in real estate lending, a 

form of lending less well suited to the standardization necessary for asset securitization. 

With respect to borrowing by households, in contrast, we find that the securitization of home 

mortgages and—more recently—of consumer 

credit has reduced the extent to which these 

types of loans are directly funded by commercial 

banks (and savings institutions). This finding is 

consistent with the broadening of household-sector credit markets over time; longer-term increasFDIC BANKING REVIEW 29 2004, VOLUME 16, NO. 2 
The Future of Banking 

es in borrowing by households have generally not 

been associated with greater intermediation 

through banks. The securitization trend, however, has had a more severe effect on savings institutions than on commercial banks. 

At the same time, the commoditization of credit 

markets—that is, the standardization, unbundling, 

and repackaging of payments and risks associated 

with credit flows—makes it harder to measure the 

importance of banks as well as other intermediaries in providing credit-related services. Balance-sheet data on who is funding loans can be a 

poor proxy for who is providing the financial 

services associated with the credit flows. Commercial banks, particularly larger institutions, provide significant services in originating, servicing, 

and enhancing the liquidity and quality of credit 

that is ultimately funded elsewhere. Hence, market-share measures based on balance-sheet data 

are likely to understate the importance of banks 

to a greater extent than even a decade ago. The 

provision of financial services is, however, reflected in bank earnings. And indeed, when one 

looks at income-based measures of market share, 

one does not see any evidence of a secular decline 

in the importance of commercial banking. 

Thus, the conclusion of this study is that 

although the role of commercial banks in U.S. 

credit markets has certainly evolved, banks 

remain a critical part of the modern flow of funds 

that has broadened the availability of credit in 

the U.S. economy. 

Introduction 

Banks have historically been viewed as playing a 

special role in financial markets for two reasons. 

One is that they perform a critical role in facilitating payments.1 The other is that they have 

long played an important, although arguably less 

exclusive, role in channeling credit to households 

and businesses. Commercial banks, as well as 

other intermediaries, provide services in screening 

and monitoring borrowers; and by developing 

expertise as well as diversifying across many borrowers, banks reduce the costs of supplying credit. 

Thus, in their role as lenders, banks are often not 

merely buying someone’s debt; rather, they are 

providing significant financial services associated 

with extending credit to their customers.2 And 

to the extent that investors want to hold bank 

liabilities, banks can fund borrowers directly. 

In the early 1990s, as the U.S. banking industry 

emerged from its most significant crisis since the 

Great Depression, policy makers were asking 

whether the importance of banks in financing 

economic activity had become permanently 

diminished.3 Now, ten years later, the share of 

domestic debt funded on commercial-bank balance sheets stands at just over 20 percent, down 

from 30 percent three decades ago. Commercial 

bank loans now account for only 60 percent of 

short-term borrowing by nonfinancial businesses, 

compared with 75 percent in the mid-1970s.4 

Even now, therefore, when profitability and other 

measures of performance indicate that banking 

has rebounded from the crisis, the role of banks in 

U.S. credit markets remains under scrutiny. 

Other types of financial intermediaries and financial instruments appear to have become more 

important in channeling funds to businesses and 

households. Stories about competition from other 

segments of the financial-services industry continue to be reported in the popular press. For 

1 Banks issue liquid deposit accounts that can be easily used to make payments; banks also make the payments. The special liquidity of bank liabilities and the extent to which they serve as a means of payment are reflected 

in the fact that deposit liabilities are included in various measures of the 

money supply. Seminal works discussing the special role of money and 

banks include Gurley and Shaw (1960), Tobin (1963), Fama (1980), and Diamond and Dybvig (1983). 

2 Two frequently cited papers that analyze the importance of banks as lenders 

are Diamond (1984) and Fama (1985). Of course, banks can and do hold 

credit-market instruments issued by others—including securities issued by the 

U.S. government and government agencies—although in some sense this 

involves less of a provision of banking services per se. When a bank invests 

depositors’ funds in corporate or government securities, it is not providing the 

same banking services as when it originates a loan. Rather, the bank is simply buying securities that were issued in (and could easily be resold in) direct 

capital markets. Mutual funds, as well as individual investors, can do the 

very same thing. 

3 Indeed, one decade ago, the title of the May 1994 Federal Reserve Bank of 

Chicago Conference on Bank Structure and Competition was “The Declining 

[?] Role of Banking.” 

4 These market-share measures are the author’s estimates based on Federal 

Reserve Flow of Funds Account data and are described in more detail below. 

2004, VOLUME 16, NO. 2 30 FDIC BANKING REVIEW 
 

The Evolving Role of Commercial Banks 

example, according to a fairly recent report in the 

Wall Street Journal, 

The financial services arm of General Electric Co. 

[GE Capital] illustrates how nontraditional lenders 

are taking over from banks as suppliers of credit to 

big slices of the U.S. economy. . . . Twenty years ago, 

banks and thrifts supplied 40% of the economy’s 

credit. . . . Today it is down to 19%. Housing financiers Fannie Mae and Freddie Mac own about as 

many residential mortgages as all commercial banks 

combined.5 

This paper assesses the evolving role of commercial banks in U.S. credit markets during the past 

decade. We use available data to quantify the 

importance of banks as credit providers—that is, 

their “market share”—taking a historical perspective in assessing credit-market trends. Not surprisingly, we find that the importance of banks 

depends on the markets one chooses to consider 

and on how one measures banking services. 

However, some consistent patterns emerge. From 

a historical perspective, we now see that the debt 

buildup of the 1980s was actually a permanent 

increase in the volume of debt associated with 

economic activity in the United States. In other 

words, the credit-market pie to be divided up 

among financial-service providers is now substantially larger than it was 20 years ago. And 

although overall the provision of credit by banks 

has kept pace with the growth of the economy, 

the capacity of the broader financial sector has 

grown by much more. Accordingly, the share of 

our economy’s debt that commercial banks fund 

directly has fallen relative to the growth of the 

credit-market pie, reaching its low point in 1993 

and then stabilizing. 

An important dimension of these trends that is 

not always emphasized is the dramatic change in 

the way credit flows in our economy are being 

funded. Traditionally, intermediaries funded portfolios of loans (and bonds) by issuing very different types of liabilities (mainly deposits and 

insurance and pension liabilities) to investors. 

But the growth of credit-market activity in our 

5 Ip (2002). 

economy during the past two decades has been 

associated with the rise of intermediation in the 

form of asset securitization, referring to the pooling of loans and their funding by the issue of 

securities. Asset securitization reflects a fundamental transformation of loan markets, particularly those where households borrow. 

Home-mortgage and consumer-credit markets 

have become commoditized, in the sense that 

these loan products have become more standardized commodities, allowing the attendant creditrelated services to be unbundled, repackaged, and 

provided by a variety of financial-service 

providers. Moreover, standardization extends 

beyond the terms of the loan contracts to the 

underwriting and pricing process, in which characteristics of the borrower are increasingly linked 

to the use of statistical models in extending and 

pricing credit. 

The commoditization of credit often generates 

more layers of intermediation between investors 

and the borrowers who ultimately receive the 

funds. Intermediation funded by issues of securities is often “re-intermediated” (for example, 

through mutual funds, insurance companies, or 

pension funds). The layering makes it harder to 

quantify the importance of banks (as well as other 

intermediaries) in channeling credit from savers 

to borrowers because it makes it more difficult to 

identify who is ultimately funding certain types of 

loans. And quantifying the value-added of the 

additional layers of intermediation is difficult as 

well. 

Nonetheless, according to some fairly standard 

measures, we find that commercial banks still play 

a significant role in channeling credit. With 

respect to business lending, we find that not only 

are banks important for small business borrowers, 

but they also remain remarkably important for all 

business borrowers: we estimate that the share of 

nonfinancial-sector business borrowing that commercial banks fund directly has not declined 

notably in five decades. There has, however, 

been a dramatic shift in how banks lend, a shift 

from shorter-term lending not secured by real 

estate to loans collateralized by business real 

FDIC BANKING REVIEW 31 2004, VOLUME 16, NO. 2 
 

The Future of Banking 

estate. This shift may reflect banks’ continuing 

comparative advantage in real estate lending—a 

form of lending less well suited to the standardization necessary for asset securitization. 

With respect to borrowing by households, we find 

that the securitization of home mortgages and— 

more recently—of consumer credit has reduced 

the extent to which these types of loans are 

directly funded by commercial banks (and savings 

institutions). This finding is consistent with the 

broadening of household-sector credit markets 

over time; longer-term increases in the debt 

capacity of the household sector have not tended 

to be associated with greater intermediation 

through banks. The securitization trend, however, has had a more severe effect on savings institutions than on commercial banks. 

The evolution of U.S. credit markets and the 

changing role of commercial banks suggest that 

on-balance-sheet market-share measures understate the importance of banks to a greater extent 

than even a decade ago. Commercial banks, particularly larger institutions, often provide important credit-related services to borrowers that are 

ultimately funded elsewhere, but the provision of 

these services is reflected in bank earnings. 

Indeed, when one looks at income-based measures 

of bank market share, one does not see evidence 

of a secular decline in commercial banking. 

Thus, although the importance of banks depends 

on how one defines banking, from a variety of 

perspectives the commercial banking industry 

remains far from extinct as a force in credit markets. 

The next five sections of the paper discuss the 

changing nature of credit-market flows and the 

implications of the changes for using balancesheet data to measure bank market share; an 

overview of the historical trends that culminated 

in the apparent decline of commercial banking 

during the 1980s and early 1990s; what 

researchers had to say about this apparent decline; 

credit-market trends from the early 1990s to the 

present; and alternatives to balance-sheet-based 

measures of bank market share. A final section 

summarizes our findings and their implications for 

the future role of commercial banks in U.S. credit 

markets. 

Credit Market Concepts and Measurements 

To examine trends in the role of commercial 

banks in U.S credit markets, much of this paper 

uses 50 years of quarterly data from the Federal 

Reserve Board’s Flow of Funds Accounts (FFA). 

These accounts provide a detailed and comprehensive picture of quarterly credit flows and balance-sheet outstandings across various sectors of 

the U.S. economy since the early 1950s.6 They 

include a wealth of detail on specific types of 

financial institutions and financial instruments; 

hence, they allow one to study the evolution of 

the financial-services industry over time. However, with these data, one’s findings depend on the 

choice of what to measure. Hence, we begin by 

providing a conceptual framework for thinking 

about how to measure the role of commercial 

banks in U.S. credit markets. 

Standard academic textbooks on banking often 

include a diagram showing how credit markets 

traditionally worked—that is, how funds from primary investors (those having accumulated wealth, 

i.e., savers, lenders) are channeled to primary borrowers (those who need external finance to fund 

their expenditures).7 As figure 1 indicates, primary borrowers include households seeking mortgage or consumer loans; federal, state, and local 

governments financing their outstanding debt; 

and nonfinancial businesses borrowing to finance 

their business activities (larger publicly traded 

corporations also obtain external finance in equity markets). These borrowers are classified in the 

FFA as nonfinancial sectors. Primary investors 

technically consist of the same groups, but it is 

ultimately private individuals—that is, the house6 The Flow of Funds Accounts (FFA), the only truly comprehensive data on 

broad U.S. financial flows, use a wide range of data sources to produce a 

consistent set of quarterly estimates of financial flows and balance-sheet 

stocks for various sectors of the U.S. economy. See Teplin (2001). 

7 For example, see Mishkin (2003). 

2004, VOLUME 16, NO. 2 32 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

hold sector—that accumulate wealth (save) and 

need to invest it. 

The financial sector, which facilitates external 

finance, tends to be conceptually divided into 

“direct credit markets,” where investors directly 

buy and hold securities issued by businesses or 

governments, and “indirect credit markets,” 

where intermediaries pool the funds of many 

investors to fund a pool of borrowers (see figure 

1). Direct finance involves a brokerage function 

but does not require intermediation per se (for 

example, when an investor buys a U.S. Treasury 

security, even from a bank, the transaction does 

not involve intermediation). In contrast, a key 

feature of indirect finance is that it involves the 

funding of financial assets by issuing to investors 

“indirect” claims on these assets. These indirect 

claims can have very different characteristics (in 

terms of promised payments, liquidity, and default 

risks) from the assets that they are funding. The 

process by which a pool of financial assets can be 

funded by issuing claims having different payment 

streams is referred to as asset transformation 

(Gurley and Shaw [1956]; Tobin [1963]). 

The nature of credit markets 50 years ago helps to 

explain some important conventions in the FFA. 

Specifically, the accounts were designed to measure the flow of credit to nonfinancial-sector borrowers and the flow’s link to economic activity. 

Figure 1 

To this end, the FFA defined the set of creditmarket instruments to include the types of claims 

that nonfinancial-sector borrowers use to obtain 

financing in formal credit markets. These include 

loans from intermediaries as well as bonds and 

short-term paper issued in securities markets.8 

The traditional indirect liabilities issued by intermediaries (deposits, and claims on insurance and 

pension funds) are not credit-market instruments 

because nonfinancial borrowers do not issue these 

types of claims. As we discuss throughout this 

study, financial intermediaries can, and increasingly do, raise funds by issuing credit-market 

debt—most often securities—in their role as 

financial middlemen. In the latter case, creditmarket debt issued by the financial sector is used 

to fund other credit-market debt on the intermediaries’ balance sheets. 

The distinction between total debt and nonfinancial-sector debt was not as important 50 years ago. 

As summarized in table 1, credit markets were 

somewhat simpler then: commercial banks funded 

8 The FFA define credit-market debt to include corporate and foreign bonds, 

U.S. government securities, tax-exempt debt and securities, residential and 

business mortgages, consumer credit, bank loans not elsewhere classified, 

open-market paper (commercial paper and banker’s acceptances), loans to 

businesses from nonbank financial intermediaries, loans from the U.S. government or sponsored credit agencies, foreign loans to U.S. nonbank borrowers, 

and customer liabilities on acceptances. Credit-market debt does not include 

security credit, trade credit, and other miscellaneous financial claims. 

Traditional Credit Flows 

INDIRECT FINANCE 

Financial 

Intermediaries 

Securities 

Markets

FUNDS FUNDS 

FUNDS 

FUNDS 

FUNDS 

Primary Lenders 

(Savers) 

1. Households 

2. Nonfinancial

 Business Firms 

3. Government 

Nonfinancial 

Borrowers 

1. Nonfinancial

 Business Firms 

2. Government 

3. Households 

4. Foreigners 4. Foreigners DIRECT FINANCE
 

FDIC BANKING REVIEW 33 2004, VOLUME 16, NO. 2 
The Future of Banking 

their lending by issuing checking and savings 

accounts; savings institutions were largely home 

mortgage lenders that issued saving accounts; 

insurance companies issued insurance polices and 

defined-benefit pension-plan contracts, funding 

future payments on these contracts by investing 

the premiums in securities and commercial mortgages. The financial sector did not raise funds by 

issuing credit-market debt to a great extent; in 

the early 1950s, only 2.5 percent of total creditmarket debt was issued by financial-sector firms. 

In that world, intermediation between a borrower 

and a lender generally involved one middleman 

and tended to involve a high degree of asset 

transformation. Notably, commercial banks funded relatively illiquid, unmarketable loans by issuing extremely liquid demandable deposits. To a 

large extent, the high degree of asset transformation reflected the relatively high costs of processing and tracking information about financial 

transactions. 

Asset securitization as a funding mode did not 

begin until the 1970s, when federally sponsored 

Table 1 

agencies began to pool home mortgages and issue 

mortgage-backed securities. Asset securitization 

by the private sector did not become significant 

until the mid-1980s. And although mutual funds 

have a 60-year history, until the 1980s they 

accounted for only small shares of the financial 

assets held by investors. Until then, investors 

who wanted to hold stocks and bonds tended to 

hold them directly. 

A prominent theme of this paper is that advances 

in the application of information technologies in 

the financial-services industry have dramatically 

changed both the nature of the asset transformation taking place in U.S. credit markets and the 

types of indirect liabilities that are being used to 

fund nonfinancial borrowers. In recent decades, 

the volume of credit-market debt—specifically, 

marketable securities—issued by financial firms 

has grown dramatically. Currently, a third of total 

outstanding credit-market debt is now issued by 

financial intermediaries (see figure 7), and asset 

securitization accounts for a large share of this 

debt. Thus, as lower costs make it increasingly 

feasible to standardize, unbundle, and repackage 

Credit Markets in the 1950s 

Sector Primary assets held Financial source of funding 

INDIRECT FINANCE 

Commercial banks U.S. Treasury securities 

Nonmortgage business loans (C&I, Ag) 

Business mortgages 

Home mortgages 

Consumer credit 

Savings institutions U.S. Treasury securities 

Home mortgages 

Consumer credit 

Finance companies Non-mortgage business loans 

Consumer loans 

Insurance companies U.S. Treasury securities 

Pension funds Corporate bonds 

State and local government securities 

DIRECT FINANCE 

Nonfinancial holders Corporate bonds and paper 

U.S. Treasury securities 

State and local government securities 

Zero-interest bearing checking accounts 

Passbook savings accounts 

Passbook savings accounts 

Bank loans 

Corporate bonds and paper 

Contingent claims of policy holders 

Defined benefit pension claims 

2004, VOLUME 16, NO. 2 34 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

credit flows and risks, loans that used to be funded by traditional lenders are increasingly being 

funded in securities markets. Moreover, the assetbacked securities are often bought by other intermediaries to be held in their portfolios. Thus, 

unlike the traditional flows of credit as diagrammed in figure 1, credit flows to nonfinancial 

borrowers in U.S. credit markets increasingly 

involve more complicated layers of intermediation between nonfinancial “savers” and nonfinancial “borrowers” (figure 2). When financial 

intermediaries hold the claims issued by other 

financial intermediaries, an extra layer of intermediation is created. For example, when a mutual-fund portfolio includes commercial paper or 

bonds issued by a finance company or assetbacked securities issued to fund consumer loans, 

there are two layers of financial intermediation 

between the consumer who is borrowing and the 

mutual-fund investor.9 It is certainly possible for 

there to be more than two layers of intermediation. 

9 Here it is useful to remember that traditional financial-intermediary liabilities 

in the form of deposits, mutual-fund shares, and accrual of pension and insurFigure 2 

The increasing complexity of credit-market flows 

raises methodological issues about how to measure 

bank market share. One very basic issue is simply 

that looking at total credit-market debt increasingly overstates the amount of borrowing associated with economic activity because a growing 

share of this total debt comprises claims issued by 

financial intermediaries just to fund other debt. 

In this regard, the focus on nonfinancial borrowing is useful because it allows us to characterize 

the role of banks in facilitating the flow of credit 

to the economy and to avoid double-counting 

debt issued purely in the context of intermediation. But even with this focus, the growing 

issuance of securities by financial firms has made 

measurement issues more prominent: source data 

for the FFA do not generally allow one to ascertain the extent to which corporate bonds or commercial paper are issued by nonfinancial firms as 

opposed to financial firms. Thus, in measuring 

funds advanced to nonfinancial businesses by 

ance fund reserves are not counted as credit-market debt; hence, they do not 

contribute to the double counting of debt. 

Modern Credit Flows 

INDIRECT FINANCE 

Financial 

Intermediaries 

Securities 

Markets FUNDS FUNDS 

FUNDS 

Primary Lenders 

(Savers) 

1. Households 

2. Nonfinancial

 Business Firms 

3. Government 

4. Foreigners 

Nonfinancial 

Borrowers 

1. Nonfinancial

 Business Firms 

2. Government 

3. Households 

4. Foreigners 

Asset 

Securitization 

F 

U 

N 

D 

S 

FUNDS 

FUNDS 

FUNDS 

DIRECT FINANCE
 

FDIC BANKING REVIEW 35 2004, VOLUME 16, NO. 2 
 

The Future of Banking 

banks, mutual funds, and other holders of corporate debt, we estimate the shares that are nonfinancial issues.10 

Post-War U.S. Credit-Market Trends through 

the Early 1990s 

To understand the dramatic transformation of 

U.S. credit markets, it is necessary to look at historical trends leading up to the banking-sector 

problems of the 1980s and early 1990s and the 

apparent decline in the importance of commercial 

banks as credit providers. 

From the 1950s through the early 1980s, domestic 

nonfinancial borrowing (by households, nonfinancial businesses, and governments) grew roughly at the same rate as economic activity 

(measured in terms of economic output—Gross 

Domestic Product, or GDP). Indeed, the ratio of 

debt owed by domestic nonfinancial sectors to 

GDP was remarkably stable—so stable that it 

became a “stylized fact” used by economists in 

analyzing macroeconomic issues such as the 

effects of federal deficits (Friedman [1978], Friedman [1980]).11 But although total nonfinancial 

debt grew roughly at the same pace as overall economic activity, borrowing by particular nonfinancial sectors did not grow at the same rate: the 

share of borrowing by households and nonfinancial businesses grew faster as the share of debt 

owed by the federal government (accumulated 

during WWII) declined. 

During this time, the number of commercial 

banks in the United States was growing; thus, the 

industry continued to be made up of a large number of banks that tended to be very geographically 

localized (partly because of branching restric10 So, for example, when looking at the commercial banking sector to measure the share of nonfinancial-sector debt that it is funding on the balance 

sheet, we estimate the share of the banking sector’s holdings of commercial 

paper that are nonfinancial issues. Specifically, we use the share of outstanding commercial paper issued by domestic nonfinancial corporations as an 

estimate of the share of commercial banking’s holdings that consist of nonfinancial issues. The same method is used to estimate holdings of nonfinancial corporate bonds. 

11 For an analysis of debt and money growth in the U.S. prior to 1950, see 

Gurley and Shaw (1957). 

tions). Banks also faced public policies that 

restricted entry, oversaw mergers, and regulated 

permissible activities.12 On the liability side, 

commercial banks were limited in terms of the 

types of liabilities they could issue and the rates 

they could pay depositors. They were generally 

relegated to the business of making (primarily) 

business loans and providing transaction accounts 

(or close substitutes) in fairly localized areas. 

They were also an important funding source for 

the federal government. Thus, for investment 

banking and insurance services, individuals and 

corporations had to go to other financial-service 

providers. The phenomenon of the bank holding 

company was a response to restrictions on the 

scale and scope of banking. A larger banking 

organization could be formed if banks were held 

as affiliates, and if nonbank financial firms were 

held as affiliates, the holding company could 

expand the scope of its activities to encompass 

certain permissible lines of financial services. Of 

course, as holding companies evolved, they too 

fell under regulatory scrutiny.13 

The interplay that always exists among policy, 

regulation, and financial-market trends was evident during this three-decade period, particularly 

with respect to interest rates on deposit accounts. 

Rates on these accounts were regulated, but in 

1962 the marketable large certificate of deposit 

(CD) was created to circumvent interest-rate ceilings and enable banks to pay market rates to 

attract funds. On the asset side of the balance 

12 Permissible activities were severely curtailed because of the bank failures 

of the 1930s, but the decentralization of the industry stems more broadly 

from a historical distrust of both centralized political control and concentrated 

market power. The dual banking system allowed banks to choose whether to 

be chartered by state agencies or by the Comptroller of the Currency (the 

choice of charter determined who would regulate a bank). Interstate banking 

was prohibited by the McFadden Act, and states themselves regulated 

intrastate branching. The Glass-Steagall Act prohibited banks from engaging 

in investment banking activities. For a discussion see Wheelock (1993). 

13 The Bank Holding Company Act of 1956 made all multibank holding companies subject to regulation by the Federal Reserve Board and prohibited further 

interstate holding company acquisitions. In 1970, amendments to this act 

reined in the permissible activities of one-bank holding companies, which had 

proliferated as a means of circumventing regulations imposed by the 1956 

act. One effect of these amendments was to remove any disincentives for 

organizations to acquire multiple bank affiliates (albeit within the home state), 

which they did. For a provocative assessment of the 1970 holding company 

amendments as well as a lively overview of post-war U.S. banking history, 

see Chase (1994). 

2004, VOLUME 16, NO. 2 36 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

sheet, after credit crunches in the late 1960s 

threatened the availability of bank credit to commercial firms, the commercial-paper market 

became considerably more active (Judd [1979]); 

in effect, banks were making fewer loans to prime 

corporate clients.14 

Through the mid-1970s, commercial banks continued to be special both in their role as lenders 

and as a transmission mechanism for the implementation of monetary policy (Friedman [1981], 

Fama [1980], Wojnilower [1980]). Of all the 

financial intermediaries issuing claims to raise 

funds from investors, commercial banks were the 

only ones allowed to issue demand deposits that 

could be used as a direct means of payment, 

although demand deposits could pay no explicit 

interest.15 Meanwhile, for most businesses, the 

costs of direct finance—that is, the raising of 

money by issuing and placing bonds or commercial paper—were prohibitive enough that their 

most attractive source of funds remained commercial banks. And of course commercial banks, as 

well as savings institutions, were afforded federal 

deposit insurance. Hence, despite regulatory 

restrictions, periodic credit crunches, and economic downturns, the U.S. commercial banking 

industry performed quite well in the three decades 

following WWII. And although commercial 

banks’ share of nonfinancial-sector debt dipped 

slightly as the war-related federal debt was drawn 

down,16 it rebounded as borrowing by households 

and businesses increased during the 1960s and 

early 1970s (see figure 3). 

14 In the mid-1960s the term credit crunch was coined to refer to periods 

when nominal interest rates rose above regulatory ceilings and banks faced 

disintermediation as depositors withdrew funds to earn higher returns available in direct credit markets. For discussions, see Burger (1969) and 

Wojnilower (1980). 

15 The other direct means of payment was cash held by the public. Savings 

institutions issued passbook savings accounts, which paid interest but the 

rates they could pay were subject to ceilings (and after 1962, savings institutions also issued CDs). Commercial banks, too, could issue passbook savings 

accounts, which were subject to Regulation Q interest-rate ceilings. Although 

savings institutions could issue close substitutes for money (passbook savings 

accounts with liberal withdrawal terms), these institutions had to maintain a 

high ratio of residential mortgage lending to total lending in order to qualify 

as a thrift institution. Meeting the qualified-thrift-lender test allowed a savings institution to borrow at Federal Home Loan Banks, which were an important source of funding during credit crunches. 

16 Commercial banks held large amounts of government debt in their portfolios in the post-WWII years. 

With the mid-1970s came a severe recession 

paired with high inflation; however, relatively few 

banks failed. The number of commercial banks 

(and banking organizations) was still increasing, 

although at a slower pace than banking assets. 

Thus, although there were more banks, banks 

were also, on average, getting larger as the industry established more branches (Savage [1982], 

Rhoades [1985], Amel and Jacowski [1989]). 

Banks were also becoming increasingly “complex” 

in terms of their off-balance-sheet activities (such 

as issuing standby letters of credit that promise to 

pay in the event of nonpayment of a third party), 

which caught the attention of policy makers and 

researchers at the time because of their implications for bank safety and soundness (Lloyd-Davies 

[1979]; Wolkowitz et al. [1979]; Goldberg and 

Lloyd-Davies [1985]; Benveniste and Berger 

[1986]). 

At the end of the 1970s, the pace of financialmarket change escalated significantly (Simpson 

[1988]; Berger, Kashyap, and Scalise [1995]). 

High nominal interest rates, ceilings on the interest that could be paid on deposits, and better 

information processing made the formation of 

money-market mutual funds a cost-effective 

proposition (Mack [1993]).17 These funds added 

to the competition associated with the creation of 

NOW (Negotiable Order of Withdrawal) 

accounts by savings institutions in the mid-1970s. 

Ultimately, deregulation was implemented in the 

1980s to allow banks to compete more effectively: 

interest-rate ceilings were raised (and were later 

eliminated), and commercial banks (and thrifts) 

were allowed to offer a wider range of deposit 

accounts to attract depositors. But in the meantime, evolving financial technologies were permanently altering the way financial markets 

channeled capital to investment opportunities in 

the U.S. economy. Technical innovations in 

information processing reduced the costs associat17 These funds—which held very safe, liquid, money-market assets; maintained 

par value for their shares; and allowed some transaction privileges—became a 

popular alternative to bank deposits. They lack deposit insurance but also 

carry fewer regulatory costs. 

FDIC BANKING REVIEW 37 2004, VOLUME 16, NO. 2 
 

The Future of Banking 

ed with financial transactions, and the result was 

a proliferation of new products and new providers 

of financial services, as well as the growth of 

existing ones. In particular, asset securitization 

became an increasingly important means of funding loans that had been traditionally funded by 

banks.18 

As noted above, the origins of asset securitization 

can be traced to the pooling and funding of mortgages by the government-sponsored agencies 

involved in the secondary mortgage market. But 

by the late 1980s, securitizations of loans by private asset-backed-securities (ABS) issuers had 

become a viable means of funding other types of 

loans, such as consumer loans. 

On the liability side, financial-sector development in the 1980s also increased the competition 

that banks faced (Simpson [1988]). Depositoryinstitution deregulation allowed savings institutions to issue the same types of deposits as banks. 

But more significantly, a growing mutual-fund 

industry in tandem with the regulatory shift 

18 Early articles assessing this phenomenon include Pavel (1986), Cummings 

(1987), and Carlstrom and Samolyk (1993). 

Figure 3 

1952 1955 1958 1961 1964 1967 1970 1973 

.00 

.05 

.10 

.15 

.20 

.25 

.30 

.35 

Share of outstanding domestic 

nonfinancial-sector debt 

Securities issued by 

private borrowers 

Business loans 

Consumer debt and 

home mortgages 

U.S. Treasury securities 

Commercial Bank Holdings of 

Nonfinancial-Sector Debt, 1952-1974 

toward defined-contribution pension plans served 

to channel the funds of smaller investors into 

direct debt (and equity) markets. Not surprisingly, it has been argued that the mutual-fund industry helped to reduce the role of depositories in 

credit markets (see Mack [1993] and Fortune 

[1997], for example). 

The evolution of financial-market technologies 

on both sides of the balance sheet contributed to 

a dramatic increase in credit flows to nonfinancial 

businesses and households, even while the federal 

government was running large deficits (figure 4). 

After three decades of relative stability, nonfinancial-sector borrowing increased sharply as a ratio 

to GDP, from about 1.3 in 1981 to more than 1.8 

by 1989. Financial intermediation—including a 

growing volume of securitized assets—increased in 

tandem with the economy’s appetite for debt. 

From the perspective of researchers and policy 

makers at the time, the debt buildup was of great 

concern, particularly the question of whether it 

was a debt bubble that was going to burst in an 

economically detrimental fashion (Federal 

Reserve Bank of Kansas City [1986]).19 In addition, the transformation of the asset menu available to investors through banks and other 

intermediaries disrupted the historical relationships between monetary aggregates and nominal 

output that the Federal Reserve Board used in 

conducting monetary policy.20 

Commercial banks, once the dominant type of 

financial intermediary, did not appear to share in 

the proliferation of financial-sector activity during the 1980s. The national expansion was 

accompanied by regional economic downturns 

(related to troubled industries, including oil and 

farming) severe enough to take down local banks 

(FDIC [1997]). By the early 1990s the condition 

of the industry was marked by crisis, failures, and 

consolidation; this was an industry under siege by 

19 In 1986, the annual symposium sponsored by the Federal Reserve Bank of 

Kansas City was entitled “Debt, Financial Stability, and Public Policy.” Policy 

research at this time also focused on the growth of borrowing by both nonfinancial businesses and households. For example see Pearce (1985), Faust 

(1990), Altig, Byrne, and Samolyk (1992), and Carlson (1993). 

20 For discussions, see Carlson and Samolyk (1992); Duca (1992); Orphanides, 

Reid, and Small (1994); and Friedman (1993). 

2004, VOLUME 16, NO. 2 38 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

competitors. Banking-sector problems continued 

as real-estate markets collapsed on both coasts, 

taking their toll on exposed institutions. And 

even as the industry returned to a healthier state, 

the consolidation trend did not appear to be abating.21 

In addition, the importance of commercial banks 

measured in terms of credit flows seemed to be 

declining. Between 1974 and 1994, the share of 

domestic nonfinancial-sector debt that was 

advanced by U.S. commercial banks declined 

from 30 percent to just over 20 percent (see figure 

5). Savings institutions—most like banks in 

terms of their funding (deposits), regulations, and 

decentralized industry structure—faced similar 

issues and appeared to be faring even worse. 

21 By year-end 1994, the number of commercial banks had declined from a 

1984 post-war high of over 15,100 to roughly 10,500, and average bank size 

had risen from roughly $250 million to $360 million in inflation-adjusted 

1996 dollars. (The number of savings institutions—savings banks and savings 

& loan associations—was also declining, from more than 3,600 in 1985 to 

just over 2,100 in 1994.) In addition to merging charters, more institutions 

were becoming affiliates of bank holding companies. Thus, if the bank holding company is considered the relevant measure of an individual banking 

organization, the number of firms in the industry declined even more. By 

year-end 1992, 71.7 percent of domestic commercial banks were affiliates of 

bank holding companies. For discussions, see Savage (1993), Samolyk 

(1994a), Holland et al. (1996), and Rhoades (1996). 

Figure 4 

The Declining Role of Banks? 

A host of studies assessing the evolving role of 

banking were published in the wake of the banking crisis of the 1980s and early 1990s. These 

papers were written in the context of what had 

become a decade-long consolidation trend, an 

even longer-term decline in bank market-share 

measures, and concerns about a credit or capital 

crunch.22 Not surprisingly, opinions about the 

“declining” role of commercial banking differed. 

One view was that changes in the financial sector—evidenced by the increasing competition 

from nonbank financial-service firms—reflected a 

decreasing need for banks. From this perspective, 

consolidation could be viewed a response to 

excess capacity in the banking industry.23 Others 

argued that the evidence did not support either 

the popular claims that large banking firms were 

more efficient than smaller firms or the notion 

that the industry was consolidating to eliminate 

excess capacity. Rather it was suggested that pub22 As noted in above, concerns about disruptions to the traditional linkages 

between standard monetary aggregates and output also led to much research 

focusing on the implication for monetary policy. Also see Higgens (1992). 

23 For examples, see Kaufman (1993) and Gorton and Rosen (1995). 

Figure 5 

1952 1962 1972 1982 1992 2003 

0 

0.5 

1.0 

1.5 

2.0 

Ratio to GDP 

State & local governments 

Nonfinancial 

business sectors 

Household sector 

Federal government 

Outstanding Nonfinancial-Sector Debt: 

Ratio to GDP, 1952-2003 

1974 1978 1982 1986 1990 1994 1998 2002 

0 

.05 

.10 

.15 

.20 

.25 

.30 

Share of total outstanding 

nonfinancial-sector debt 

Securities issued by private 

nonfinancial borrowers 

Business loans 

Consumer debt and home mortgages 

U.S. government securities 

Commercial Bank Holdings of 

Nonfinancial-Sector Debt, 1974-2002 

FDIC BANKING REVIEW 39 2004, VOLUME 16, NO. 2 
 

 

The Future of Banking 

lic policies rather than performance gains were 

encouraging banks to merge.24 More sanguine 

observers argued that banking was a battered but 

viable industry that needed industry consolidation 

and regulatory reform if it was to adapt to the 

evolving financial environment. In this environment, such observers argued, larger banks with 

broader banking powers would be able to compete 

by providing more services at lower costs and by 

spreading the costs of new banking technologies 

over more customers. In addition, as banks 

became larger and expanded geographically, the 

geographic scope of their activities would make 

them less vulnerable to the localized economic 

problems that had plagued banks during the 

1980s and early 1990s.25 

Others research argued that when bank balancesheet data were looked at in isolation, they understated the share of financial services provided by 

banks in the broader financial sector. Boyd and 

Gertler (1994b) conducted perhaps the most 

extensive examination in this regard, documenting a host of alternatives to standard measures of 

balance-sheet market share. These alternatives 

quantified activity in the banking sector relative 

to activity in the broader financial sector or in 

the entire economy. The term “activity” is purposely general because Boyd and Gertler quantified banking-sector activity (and the activity of 

other financial-service providers) in numerous 

ways; they used measures that adjusted credit 

flows to reflect off-balance-sheet activities as well 

as measures of profitability, employment, and 

compensation. 

Boyd and Gertler argued that a careful reading of 

the evidence did not support the view that banking was in decline. Although on-balance-sheet 

assets held by commercial banks had declined as a 

24 For examples, see Boyd and Graham (1991) and Boyd and Gertler (1994a). 

These studies suggest that the formation of very large institutions reflected 

regulatory incentives rather than attempts to become more efficient. 

25 For example, see Wheelock (1993). Generally, more sanguine analysts 

argued that institutions had to be larger to meet the competition for traditional 

bank services, to develop new products, and to diversify geographically. 

Samolyk (1994a) presented evidence that regional disparities in economic conditions did indeed explain much of the poor performance of banks (including 

large banks) during the 1980s and early 1990s. 

share of total assets held by intermediaries, they 

noted that this measure ignored the substantial 

growth in banks’ off-balance-sheet activities, in 

offshore lending by foreign banks, and in the size 

of the financial-intermediation sector. They 

found that when measures of bank assets were 

adjusted for these considerations, the measures 

showed no clear evidence of long-term decline. 

Neither did an alternative “value-added” measure, 

constructed with data from the national income 

accounts. As Boyd and Gertler concluded, “At 

most, banking may have suffered a slight loss of 

market share lately. But this loss is a temporary 

response to a series of adverse shocks rather than 

the start of a permanent decline.” Thus, by defining banking more broadly to include financial 

services that do not appear on bank balance 

sheets, the data did not indicate an industry in 

decline. 

Finally, others argued that banks were still important to certain borrowers—particularly households and businesses that continued to rely on 

banks for credit.26 Samolyk (1994b) analyzed 

bank market share from this perspective, distinguishing between bank lending and other asset 

holdings (such as securities holdings) and arguing 

that lending involves more intermediation services than holding securities does. Using FFA data 

to look at the markets where households and 

businesses borrow, that study found shifts in how 

banks were funding private borrowers, but the 

overall decline in market share was less than 

might have been expected. As business lenders, 

banks were facing increased competition from 

finance companies and direct credit markets;27 

the broadening of the commercial-paper market 

26 Small businesses and households have traditionally relied on financial intermediaries (particularly banks) for credit because of these borrowers’ small 

financial size and the information-intensive nature of the task of assessing 

their creditworthiness. 

27 Finance companies, which faced less regulation of the geographic scale and 

scope of their activities, had gained significant ground during the 1980s and 

early 1990s. Some finance companies are captive funding vehicles for large 

conglomerates (e.g., GMAC Finance), whereas others are independent firms 

that extend credit to a particular sector. Some are subsidiaries of bank holding companies and, as such, allow the holding companies to broaden the 

scale or scope of their activities and avoid banking regulations. Within their 

respective specialized lending areas, finance companies diversify across many 

borrowers and develop expertise in transforming the risks associated with their 

particular types of loans. By so doing, they reduce overall portfolio risks and 

2004, VOLUME 16, NO. 2 40 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

provided an alternative to banks as a funding 

source. However, as of the early 1990s, the securitization of business loans had not really taken 

hold yet, and the share of business mortgages 

funded by banks was actually increasing. Meanwhile, the share of home mortgages and consumer 

credit that banks were funding was similar to the 

share they had funded in the early 1960s. Moreover, although asset securitization was becoming a 

more dominant way to fund household-sector borrowing, during the 1980s asset-backed lending 

grew more at the expense of savings institutions 

and finance companies than of commercial banks. 

During the 1990s, survey data obtained from 

households and businesses also became important 

sources of information about the markets in 

which banks competed as lenders. These data 

were particularly useful because they yielded disaggregated pictures of the financial services used 

by households and by businesses. For example, 

data from the triennial Survey of Consumer 

Finances (SCF) were used to study the nature of 

rising household-sector debt ratios during the 

1980s and early 1990s.28 Kennickell, StarrMcCluer, and Sunden (1997) found little evidence of a serious rise in debt payment problems 

even though more families had debt, and more of 

it.29 On the other side of the household balance 

sheet, the share of families who owned equities, 

and the amount of their holdings, were also rising. The FFA data, too, indicated rising debt burdens and equity holdings in the household sector, 

but the SCF data were important because they 

the risk-adjusted costs of funding their activities. In addition, the evolution of 

the commercial-paper market has been viewed as contributing to the success 

of those finance companies that shifted to commercial paper as a dominant 

funding source rather than borrowing from banks (D’Arista and Schlesinger 

[1994]). 

28 The SCF has been gathering data on balance sheets and the use of financial institutions by U.S. households since 1983. For example, see Avery and 

Kennickell (1993) and Kennickell and Starr-McCluer (1996). The most direct 

precursors of the SCF were the 1962 Survey of Financial Characteristics of 

Consumers and the 1963 Survey of Changes in Family Finances. For a discussion of survey evidence regarding small business financing trends from the 

early National Survey of Small Business Finances see Cole and Wolken (1993). 

29 This paper uses data from the 1995, 1992, and 1989 SCFs to examine 

changes in the balance sheets and income of U.S. families and in the kinds of 

institutions where households obtained their financial services. Also see Avery 

and Keninckell (1993) for trends in the SCF data between 1983 and 1986. 

indicated that aggregate increases were associated 

with the use of these financial instruments by a 

broader range of households (as opposed to 

increased usage by previously active households).30 

Another interesting vein of research during the 

1990s examined whether the services provided by 

banks—such as lending—are different from those 

provided by other financial-service firms in ways 

that do not appear on a balance sheet. Using 

data on individual loans, Carey, Post, and Sharpe 

(1996) compared corporate lending by banks with 

corporate lending by finance companies.31 

Although their evidence suggested that both of 

these intermediaries were special in solving informational problems, the two types of institutions 

did not make the same types of loans. Although 

banks and finance companies competed across the 

spectrum of borrower risk, finance companies 

tended to serve observably riskier borrowers, especially highly leveraged ones. 

Passmore and Laderman (1998) investigated 

whether there were differences between savings 

associations and commercial banks that would 

result in reduced lending to traditional mortgage 

borrowers if the savings-association charter were 

eliminated. Their empirical tests did not indicate 

significant differences between savings associations and commercial banks, suggesting that elimination of the savings-association charter would 

not impair home mortgage credit availability. 

A final vein of research that gained prominence 

in the 1990s examined whether the consolidation 

of the banking industry into large organizations 

adversely affected the availability of credit to 

30 The FFA and the SCF do not always paint the same picture of householdsector balance sheets. Avery and Kennickell (1991) and Antoniewicz (1996) 

show that although some asset and liability categories in the SCF and the FFA 

are quite close, measures of liabilities tend to match up better than asset categories. 

31 Although commercial banks have long been viewed as competing with savings institutions and credit unions for deposit funding, finance companies represent competition on the asset side of the balance sheet, for they have a 

long history of lending to businesses and households (although they do not 

fund their portfolios by issuing deposits). 

FDIC BANKING REVIEW 41 2004, VOLUME 16, NO. 2 
The Future of Banking 

small businesses.32 This literature did not directly yield evidence about bank market share vis-àvis the nonbank competition, but it raised the 

important question (somewhat overlooked in 

many bank market-share analyses) of whether 

banks might be willingly reducing the services 

they supplied to certain customers, such as smallbusiness borrowers. If they were (or are), one 

would hope that other financial-service suppliers 

would step forward to meet the credit needs of 

these customers. 

This discussion of some of the research of the 

1990s indicates that by looking at particular markets where banks are thought to play a special 

role for lenders as well as by looking beyond the 

extent to which banks are funding loans on their 

balance sheets, researchers were able to find evidence that the decline in the share of total nonfinancial-sector debt funded by banks could be 

misrepresenting the importance of banks in U.S. 

credit markets. The next two sections examine 

more recent credit-market trends from both of 

these perspectives to better illuminate the evolving role of banks in the twenty-first century. 

Recent Credit-Market Trends: Who Is Funding 

Whom? 

There is no doubt that the share of nonfinancialsector debt directly funded by commercial banks 

declined during the 1980s. More than a decade 

after that decline, it has become clear that the 

debt buildup of the 1980s was actually a secular 

increase in the volume of nonfinancial borrowing 

associated with economic activity in the U.S. 

economy, which can be thought of as a permanent increase in the economy’s financial capacity 

32 After bank data on small loans to businesses and farms were first reported, 

in 1993, numerous studies looked at the importance of large banks compared 

with small banks as small-business lenders, and at the implications of industry 

consolation for the provision of small-business loans by banks. The findings 

of studies using data for the mid-1990s suggested that net consolidation activity among larger institutions tended to result in declines in small-business lending as a share of bank assets, whereas mergers among smaller or more 

focused banks increased the banks’ small-business loan shares. Samolyk 

(1997) and Berger and Udell (1998) discussed some of the small-business loan 

studies done in the mid-1990s. 

(figure 6). Moreover, this increase in financial 

capacity was not associated with intermediation 

funded by banks; hence, banks’ share of the pie 

had declined. However, as the debt capacity of 

the economy’s nonfinancial sector stabilized in 

the 1990s, so did the market share of commercial 

banks. During the past decade, the banking sector has rebounded to record profits, and although 

consolidation has continued, it is occurring in the 

context of a healthy industry.33 Here we look at 

how the players and the instruments used to fund 

nonfinancial borrowers in U.S. credit markets 

have evolved during the past decade. 

Changed Players and Funding 

Instruments 

The types of credit market instruments (loans and 

securities) issued by nonfinancial borrowers to 

obtain funds in formal credit markets have not 

changed as much as the types of instruments used 

to fund these credit flows (table 2). Households 

still obtain credit primarily in the form of home 

33 Consolidation has been related to the relaxation of geographic banking 

restrictions that limited the extent to which banks could expand their geographic reach (Samolyk and Morgan [forthcoming]). 

Figure 6 

1952 1962 1972 1982 1992 2002 

.15 

.20 

.25 

.30 

Commercial bank share of 

nonfinancial-sector debt 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

Bank market share 

Nonfinancial-sector debt 

Ratio of nonfinancialsector debt to GDP 

Bank Market Share and NonfinancialSector Debt Growth, 1952-2002 

2004, VOLUME 16, NO. 2 42 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

mortgages and consumer loans (although the former now include home equity lines of credit, 

which were an innovation of the 1980s). But 

now asset-backed securities—issued by both private asset-backed-securities (ABS) issuers and 

federally related mortgage pools—have become 

an important funding mode. And although nonfinancial businesses still obtain credit primarily in 

the form of (a) loans collateralized by business 

real estate (business mortgages), (b) other (nonmortgage) loans from intermediaries, and (c) corporate securities, business loans are also being 

securitized, and larger amounts of corporate securities are funded by the issuance of mutual-fund 

shares. The appendix discusses changes in the 

composition of investors’ portfolios and the way 

in which these changes relate to changes in the 

funding of credit-market debt. 

Table 2 

All of these changes are reflected in the growing 

extent to which the commoditization of credit 

markets has allowed borrowing by businesses and 

households to be funded in direct credit markets 

by securities issues.34 Roughly one-third of total 

outstanding credit-market debt is now issued by 

the financial sector to fund other credit-market 

debt (figure 7). And whereas during the 1980s 

the growth of securitization largely reflected mortgage funding through federally related mortgage 

pools, during the past decade, securitization by 

private ABS issuers has expanded rapidly. FFA 

data estimate that now almost half of outstanding 

34 Debt issued by government-sponsored enterprises (for example, by Federal 

Home Loan Banks and the Farm Credit System and to fund the on-balancesheet lending of Fannie Mae and Freddie Mac) has also increased, but (as we 

discuss below) much of it funds financial sectors, mainly commercial banks 

and other depository institutions. 

Credit Markets circa 2000 

Sector Primary assets held Financial source of funding 

INDIRECT FINANCE 

Commercial banks U.S. Treasury securities; Other securities 

(includes asset-backed); Nonmortgage 

business loans (C&I, Ag); Business 

mortgages; Home mortgages 

Consumer credit 

Savings institutions U.S. Treasury securities 

Other securities (includes asset-backed) 

Home mortgages 

Consumer credit 

Finance companies Non-mortgage business loans 

Consumer loans 

Insurance companies Corporate bonds 

Pension funds State and local government securities 

Federally related mortgage Home mortgages; Consumer credit 

pools; ABS issuers Business mortgages; Nonmortgage 

business loans 

Money market mutual U.S. Treasury securities 

funds; Mutual funds Agency securities (includes asset-backed) 

Corporate bonds and commercial paper 

DIRECT FINANCE 

Sector Financial assets 

Interest-bearing checking accounts 

Passbook savings accounts 

MMF accounts; 

Nondeposit borrowing 

Interest-bearing checking accounts 

Passbook savings accounts 

MMF accounts; 

Nondeposit borrowing 

Bank loans 

Commercial paper and Corporate bonds 

Contingent liabilities to claims holders 

Defined benefit pension claims 

U.S. agency securities (mortgage pools) 

Commercial paper and corporate bonds 

Mutual fund shares 

Financial liabilities 

Investors Corporate bonds and paper 

U.S. government and agency securities 

State and local government securities 

FDIC BANKING REVIEW 43 2004, VOLUME 16, NO. 2 
The Future of Banking 

corporate bonds have been issued by financial 

firms that fund other credit-market debt, with private ABS issuers accounting for a fourth of the 

corporate bond market (figure 8). The commercial-paper market has always been dominated by 

financial-sector issues;35 during the past decade, 

however, private ABS issuers have become the 

dominant issuers of commercial paper. More than 

half of outstanding commercial paper (roughly 

two-thirds of financial issues) is now funding 

securitized pools of loans—including loans originated by banks (figure 9). 

So who is funding whom? The funding of loans 

through private securities markets and the additional layers involved in modern credit flows have 

made it more difficult for researchers to track the 

flow of funds between primary lenders and primary borrowers. However, we use the FFA to 

examine the extent to which loans to nonfinancial businesses and households are being directly 

35 Finance companies have long used commercial paper as a source of financing, and banks began tapping this market for funds to offset disintermediation 

during periods when market rates rose above the deposit-rate ceilings. 

Figure 7 

funded by commercial banks and other intermediaries. 

Nonfinancial Business-Sector Credit 

Borrowing by nonfinancial businesses can be 

divided into three “markets,” each of which has 

historically accounted for roughly a third of outstanding nonfinancial-sector business debt: corporate bonds, shorter-term nonmortgage loans and 

commercial paper, and loans secured by business 

real estate (business mortgages). Commercial 

banks have tended to hold only small amounts of 

corporate bonds, so here we focus on banks’ role 

in funding shorter-term nonmortgage business 

borrowing and business mortgages. 

Shorter-term business borrowing (depicted in figure 10) is a very heterogeneous credit market. It 

includes all nonmortgage loans to nonfinancial 

businesses—from vehicle or equipment loans to 

business credit lines. It also includes the very liquid commercial-paper issues that fund only the 

largest corporations. Trends in the composition 

of shorter-term business borrowing are also most 

often cited as evidence of the declining imporFigure 8 

Credit-Market Debt Owed by 

Financial Sectors, 1952-2002 

Share of total (outstanding) 

credit-market debt 

.35 

Corporate Bonds Owed by 

Financial Sectors, 1952-2002 

Share of total outstanding 

corporate and foreign bonds 

0.5 

.30 

ABS issuers 

.25 

.20 

Other financial sectors 

0.4 

0.3 

Federally-related 

.15 mortgage pools 

.10 

GSEs 

.05 

Other financial sectors 

0 

1952 1962 1972 1982 1992 2002 

ABS issuers 

0.2 

Commercial banking 

0.1 

Financial companies 

0 

1952 1962 1972 1982 1992 2002 

2004, VOLUME 16, NO. 2 44 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

tance of commercial banking (for example, by 

Herring and Santomermo [2000]). The share of 

shorter-term nonfinancial-sector business credit 

funded directly by banks declined from more than 

75 percent in the early 1970s to just over 50 percent in the early 1990s (it has stabilized during 

the past decade). Meanwhile the share funded by 

finance companies has steadily increased, now 

accounting for 20 percent of shorter-term nonfinancial business-sector credit. ABS issuers have 

made inroads in funding nonmortgage business 

loans, although they still account for only 6 percent of this market. Interestingly, commercial 

paper, one of the widely cited alternatives to bank 

borrowing, accounts only for roughly 7 percent of 

this short-term business credit market. 

Trends in the business mortgage market—defined 

to include loans secured by business real estate, 

including commercial, multifamily residential, 

and agricultural properties—are depicted in figure 

11. Commercial banks now directly fund more 

than a third of outstanding business mortgages, up 

from 20 percent two decades ago (and that was 

before the banking crisis). Private ABS issuers, 

which did not exist 20 years ago, are now the second-leading business-mortgage funding mode, 

Figure 9 

accounting for 15 percent of the market.36 

Meanwhile, direct funding by life insurance companies and savings institutions has declined significantly.37 

Figure 12 depicts commercial bank holdings of 

the three types of business borrowing (combined) 

as a share of total outstanding nonfinancial business-sector debt.38 The figure also relates this 

ratio to the growth of nonfinancial business borrowing over time (measured relative to GDP). As 

the figure indicates, we estimate that commercial 

banks fund roughly a third of nonfinancial business-sector debt. And somewhat surprisingly— 

given discussions about the declining importance 

36 The genesis of markets where business loans can be securitized has been 

linked to the Resolution Trust Corporation’s activity in disposing of assets in 

the wake of savings institution problems. 

37 Insurance companies now hold roughly 12 percent of business mortgages, 

compared with 22 percent 20 years ago and 29 percent 50 years ago. Savings institutions hold less than 8 percent, compared with 22 percent 20 years 

ago and a peak of 27 percent in the 1970s. The share of business mortgage 

loans funded directly by nonfinancial borrowers has also declined. 

38 Nonfinancial business-sector debt held by commercial banks is estimated to 

equal the sum of business mortgage loans, bank loans not elsewhere classified, liabilities on banker’s acceptances, and the estimated holdings by commercial banks of nonfinancial-sector issues of commercial paper and corporate 

bonds. 

Figure 10 

Commercial Paper Owed by 

Financial Sectors, 1952-2002 

Share of total outstanding 

commercial paper 

1.0 

Commercial 

banking 

0.8 

0.6 Other

 financial

 sectors 

0.4 ABSissuers 

Finance companies 

0.2 

0 

1952 1962 1972 1982 1992 2002 

Short-term Nonfinancial BusinessSector Credit, 1952-2002 

Share of total nonmortgage 

loans and commercial Other Nonbank paper owed by the financial holders of NFB sector Commercial institution commercial 

1.0 paper loans paper ABS 

issuers 

0.8 

Finance company 0.6 loans 

0.4 

Commercial banking loans 

and acceptances 

0.2 

0 

1952 1962 1972 1982 1992 2002 

FDIC BANKING REVIEW 45 2004, VOLUME 16, NO. 2 
The Future of Banking 

of banking for U.S. businesses—this market share 

has not exhibited a downward trend during the 

past several decades. But what we do find is a 

notable shift in the type of business loans being 

extended by banks, from shorter-term nonmortgage business loans to loan collateralized by business real estate. Thus if one looks only at 

nonmortgage bank lending, one sees a decline in 

bank market share, seemingly related to the 

growth of nonfinancial business-sector debt. 

However, looking only at this decline is to ignore 

the other markets where banks fund nonfinancialbusiness borrowers. 

These business-sector trends are broadly consistent with more recent evidence offered in the 

Federal Reserve Board’s Report to the Congress 

on the Availability of Credit to Small Businesses 

(2002).39 This report analyzes small-business 

financing trends using a wide range of data 

sources and concludes that the patterns of credit 

use evident in small-business survey data do not 

indicate a decline in the importance of commercial banks (see also Bitler, Robb, and Wolken 

[2001]). Commercial banks remain the leading 

source of credit to small businesses that borrow 

and the most common source of credit products of 

Figure 11 

all types.40 The report also discusses trends in 

asset securitization but notes that the securitization of small-business loans has been modest, and 

it appears unlikely that the securitization of smallbusiness loans will increase significantly in the 

near term. Thus far, the data do not indicate that 

asset securitization has yet to become a dominant 

funding mode for businesses, undoubtedly because 

business lending is less conducive to standardization than other types of lending. 

Household-Sector Credit 

Home-mortgage debt has long been the primary 

type of borrowing for households, and its share of 

total household-sector debt has risen since the 

elimination in 1986 of tax deductions for interest 

paid on nonmortgage credit.41 By the early 1990s 

the secondary mortgage market had already made 

39 This report, produced every five years pursuant to section 2227 of the Economic Growth and Regulatory Paperwork Reduction Act of 1996, can be found
 

on the Internet at www.federalreserve.gov/boarddocs/rptcongress/
 

sbfreport2002.pdf. 
 40 The Survey of Small Business Finances (SSBF) asks respondents to discuss
 

specific types of loans, including vehicle loans, equipment loans, lines of credit, leases, and mortgages.
 

41 See Canner, Durkin, and Luckett (1998).
 

Figure 12 

Business Mortgages, 

1952-2002 

Share of total outstanding GSEs and 

loans collateralized by All other FR mortgage 

business real estate financial pools holders ABS 

1.0 issuers 

0.8 

0.6 Life insurance companies 

0.4 Savings institutions 

0.2 

Commercial banking institutions 

0 

1952 1962 1972 1982 1992 2002 

Nonfinancial Business-Sector Debt, 

1952-2002 

Share of total Ratio of total 

NFB-sector debt NFB-sector debt to GDP 

.40 0.8 NFB-sector debt Total NFB debt to GDP held by (right scale) .35 banks 0.7 

.30 0.6 

.25 0.5 

.20 0.4 

Bank 

nonmortgage .15 0.3 loans to 

business 

.10 0.2 

1952 1962 1972 1982 1992 2002 

2004, VOLUME 16, NO. 2 46 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

enormous inroads into the funding of home mortgages, and the past decade has seen further 

increases in the market share held by federally 

related mortgage pools, government-sponsored 

enterprises (GSEs), and private issuers of assetbacked securities (see figure 13). GSEs and federally related mortgage pools now fund close to half 

of outstanding home-mortgage debt, up from 35 

percent a decade ago and from a mere 10 percent 

in 1983. Commercial banks’ holdings of homemortgage debt have been remarkably stable, 

roughly equal (at 18 percent now) to the level 

they were 20 years ago. Clearly, this is the market 

that manifests the rise and fall of savings institutions, whose share of the home-mortgage market 

has declined from more than 50 percent 20 years 

ago to only 13 percent today. Some of this 

decline in market share (and the stability of commercial banking’s share) reflects the absorption of 

savings institutions into the commercial-banking 

sector through mergers and charter conversions. 

Life insurance companies, which had significant 

home-mortgage holdings in the 1950s and 1960s, 

directly fund almost no home mortgages today.42 

42 Home-mortgage lending has always been mainly funded by financial intermediaries, and the share of such lending held by financial firms now stands at a 

50-year high of 96 percent. 

Figure 13 

Of course, commercial banks, savings institutions, 

and insurance companies can—and do—fund the 

home-mortgage market indirectly when they 

invest in the securities issued in the context of 

secondary market activity. However, we net these 

indirect holdings out of our market-share measures to avoid overstating the flow of credit to 

home-mortgage borrowers. 

In terms of consumer credit, commercial banking’s share of funding has not been so stable (figure 14). From the 1950s through the 1970s, an 

“institutionalization” of the consumer-credit market took place, referring to the increasing extent 

to which consumer credit was funded through 

intermediaries (depository institutions and 

finance companies) rather than directly by nonfinancial corporations (e.g., manufacturing and 

retail firms). In its infancy, asset securitization by 

private ABS issuers represented a shift—rather 

than an increase—in the intermediation of consumer credit. In the late 1980s and early 1990s, 

the shift came at the expense of savings institutions and finance companies rather than commercial banks or credit unions. Indeed, as recently as 

1994, close to half of outstanding consumer credit 

was directly funded by commercial banks, and 

Figure 14 

Home Mortgages, 

1952-2002 

Share of total Other 

outstanding financial ABS 

home mortgage debt GSEs holders issuers 

1.0 

0.8 Life insurance 

Consumer Credit, 

1952-2002 

Share of total outstanding 

consumer credit Savings institutions 1.0 

0.8 Credit unions 

companies Federally related 

mortgage pools 

0.6 

ABS 

issuers Finance companies 0.6 

Savings institutions 

0.4 

Credit 

unions 0.2 

0.4 

Commercial banks 

0.2 

Commercial banks 

0 

1952 1962 1972 1982 1992 2002 

0 

1952 1962 1972 1982 1992 2002 

FDIC BANKING REVIEW 47 2004, VOLUME 16, NO. 2 
 

The Future of Banking 

analysts speculated about the long-run role of 

asset securitization as a funding mode for consumer credit. A decade later, the speculations are 

answered. The funding of consumer credit 

through financial intermediation stands at an alltime high of 97 percent, and securitized pools 

now finance a third of outstanding consumer 

credit. Commercial bank holdings of consumer 

credit have declined to roughly a third of the 

market. Finance companies, savings institutions, 

and credit unions account for the remainder. In 

the evolving consumer-credit market, credit 

unions appear to have fared the best among traditional intermediaries in terms of maintaining 

market share. 

What then do the FFA data indicate about trends 

in the overall importance of commercial banks in 

household-sector credit markets? Figure 15 

relates commercial banking’s market share of 

home-mortgage and consumer debt to the overall 

growth of these types of credit markets (the latter 

measured relative to GDP). Five decades of FFA 

data indicate that commercial banking’s share of 

home-mortgage and consumer credit has tended 

to trend downward when borrowing capacity in 

these markets has been expanding (again, measured relative to GDP). Thus (as with broader 

Figure 15 

nonfinancial-sector debt) although commercial 

bank funding of home mortgages and consumer 

credit has grown, the overall flow of credit to 

households through these markets has expanded 

by much more. 

And Banks’ Competition? 

Our analysis of the markets where households and 

businesses borrow does not seem to validate the 

dire predictions suggested by some analyses. 

Although we certainly find that commercial 

banks’ on-balance-sheet market share is lower 

than it was 20 years ago, the decline we are measuring in the role of banks seems to be smaller 

than the declines advanced by others. Here we 

reconcile our findings with the findings of those 

who suggest a more serious decline in the importance of banks; we then look at the competition 

faced by commercial banks. 

We find less in the way of a decline than other 

researchers for two reasons. First, when we examine the role of commercial banks in channeling 

credit to nonfinancial-sector borrowers, we net 

out credit-market debt issued to fund more debt. 

Netting out financial-sector debt (figure 16) 

yields generally stable market shares since the 

Figure 16 

Household-Sector Borrowing, 

1952-2002 

Share of total home mortgages Ratio of outstanding 

and consumer credit home mortgages and 

funded by commercial banks consumer credit to GDP 

0.29 0.8 

Total household 

sector debt ratio 0.7 0.27 to GDP 

0.6 

0.25 

0.5 

0.23 

0.4 

0.21 

Commercial bank share 0.3 

of total outstanding

0.19 home mortgage and 0.2 consumer debt 

Nonfinancial-Sector Debt Held by 

Commercial Banks and Savings Institutions, 

1952-2002 

Share of total outstanding 

nonfinancial sector debt 

0.5 

0.4 

Held by savings institutions 

0.3 

0.2 

Held by commercial banking institutions 0.1 

0.17 0.1 

1952 1962 1972 1982 1992 2002 

0 

1952 1962 1972 1982 1992 2002 

2004, VOLUME 16, NO. 2 48 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

early 1990s, while market-share measures that are 

based on total debt show further declines through 

2002 (figure 17).43 This indicates that the growing volume of credit-market debt being issued by 

financial firms does not entirely reflect funds 

being issued to displace lending by other financial-sector players. Indeed as we shall see, some 

financial-sector issues of credit-market debt 

(notably those of Federal Home Loan Banks) are 

channeled as sources of funding to other financial 

firms—including banks. 

A second reason we find less of a decline in 

banks’ market share than other researchers do is 

that we focus on commercial banking rather than 

on banking in the sense of all depository institutions. Savings institutions historically have been 

quite different from commercial banks and certainly have had distinctly different experiences in 

the nation’s evolving financial environment.44 

What, then, can we say about the overall marketshare trends for the competition? Figure 18 illustrates the share of nonfinancial-sector debt 

directly funded by sectors commonly viewed as 

the strongest competition for banks in the new 

financial world.45 Finance companies, GSEs, and 

Figure 17 

asset-backed-securities issuers largely fund their 

intermediation by issuing securities in direct credit markets. Mutual funds issue mutual-fund shares 

that may be held directly by individuals or indirectly as assets by defined-contribution pension 

plans. The picture displays some intriguing 

results. 

Not so surprisingly, we find that significant competition has indeed come from asset securitization, both federally related and private. The 

evolution of home-mortgage financing in the 

direction of securitization suggests that large segments of the mortgage market are better suited to 

funding by the issue of long-term debt. Certainly 

this funding mode reduces the interest-rate risks 

43 Netting out holdings of financial-sector debt for commercial banking and 

other financial sectors reported in the FFA requires detailed analysis of each 

sector’s financial asset holdings. When detail is not reported in the FFA, 

specifically for corporate bonds and commercial-paper holdings, we estimate 

holdings of nonfinancial-sector issues using patterns evident for these markets 

in the FFA. 

44 This is particularly true now that asset securitization has become the dominant funding mode for home mortgages—traditionally the primary asset held by 

savings institutions. 

45 For some of these sectors, the flow of funds allows one to directly identify 

holdings of nonfinancial sector debt. For others, such as the sectors that hold 

corporate bonds and commercial paper, we used the patterns evident in these 

markets to impute holdings owed by nonfinancial borrowers. 

Figure 18 

Total Debt Held by Commercial Banks 

and Savings Institutions, 1952-2002 

Share of outstanding domestic 

credit market debt 

0.5 

Nonfinancial-Sector Debt Held by 

the Competition, 1952-2002 

Share of outstanding 

nonfinancial-sector debt held 

0.4 

Mutual funds 

0.4 

Held by savings institutions 

0.3 

0.2 

Held by commercial banks 0.1 

0 

1952 1962 1972 1982 1992 2002 

0.3 

MMMFs 

ABS issuers 

0.2 

0.1 Federally-related GSEs mortgage pools 

Finance companies 0 

1952 1962 1972 1982 1992 2002 

FDIC BANKING REVIEW 49 2004, VOLUME 16, NO. 2 
The Future of Banking 

associated with funding long-term mortgages by 

issuing deposits. As we argue in the appendix, 

mortgage securitization is better suited to attracting long-term investment funds associated with 

the accumulation of pension wealth. At the same 

time, the evolution of home-mortgage funding 

has basically reduced the role of S&Ls (and insurance companies) in funding home mortgages. 

A somewhat more curious source of competition 

for commercial banking appears to be securitization by private ABS issuers. This mode of funding 

has affected the nonmortgage markets where 

households and businesses borrow—most particularly, consumer-credit markets. However, as we 

discuss in the next section, there is some question 

as to whether ABS issuers are competitors of 

banks or merely an alternative mode of funding 

for banks (particularly large ones). 

A third sector that is growing its market share as 

a funder of the nonfinancial sector is the mutualfund industry. Of course, since mutual funds hold 

securities rather than loans, their growth represents less direct competition than the growth of 

federally related mortgage pools and ABS issuers 

for the types of lending that make banks special— 

loans to households and businesses. Indeed, as we 

show in the appendix, the growth of mutual funds 

reflects a shift on the part of investors from holding securities directly toward holding them 

through mutual funds to achieve diversification of 

risks. 

In recent decades two other sectors—ones that 

are often brought up in discussions of the growing 

competition faced by banks—have not measurably increased the share of nonfinancial-sector 

debt they fund. These sectors are finance companies and GSEs. Finance companies may also be 

securitizing some of the more standardized types 

of loans they make to households and businesses. 

GSEs’ share of total credit-market debt has risen 

(see figure 7), but as noted earlier, much of this 

debt funds intermediaries—including commercial 

banks and savings institutions—rather than nonfinancial borrowers. 

Alternative Measures of Bank Market Share 

As discussed above, a decade ago, differences in 

what constitutes banking services led to different 

assessments of the prospect for banks. 

Researchers who tended to define banking services in terms of what one sees on bank balance 

sheets (deposit taking, lending, and investments 

in securities) tended to be more pessimistic about 

the future of banking.46 Alternatively, 

researchers who tended to look beyond traditional 

banking activities—at an extreme, broadly defining banking as including the “measuring, managing, and accepting of risk”—argued that banks 

were not becoming less important.47 From the 

latter perspective, new services provided by 

banks—whether the selling of mutual-fund shares 

to investors or the origination, sale, and servicing 

of loans funded by securitizations—are merely 

banking in different forms. 

In this section we broaden our perspective and 

ask how else we might measure the importance of 

banks in the U.S. financial sector. The growth in 

our economy’s debt capacity that has been funded 

through direct credit markets rather than through 

traditional intermediation does not mean that 

intermediaries—particularly banks—do not provide important services that facilitate funding in 

securities markets. Here, therefore, we revisit the 

notion that looking beyond what is measured on 

bank balance sheets may yield a different view of 

the evolving role of commercial banks in facilitating credit flows. 

46 An example of a relatively recent paper arguing that banks have become 

less special is Herring and Santomero (2000). These authors document the 

decline in banks’ funding of credit-card receivables, the rise in banks’ share of 

mortgages that are securitized, and the erosion of banks’ share of the shortterm commercial lending market. They also argue that banks are losing 

ground on the liability side of their balance sheets, as demographic trends 

and technological advances on the payments side make mutual funds an 

increasingly attractive alternative to bank deposits. 

47 This phrase was used by Greenspan (1994) in addressing the conference 

where Boyd and Gertler presented their work on alternative measures of bank 

market share. 

2004, VOLUME 16, NO. 2 50 FDIC BANKING REVIEW 
 

The Evolving Role of Commercial Banks 

As credit-related services have become unbundled, layers of transactions have been added to 

the intermediation process, and each layer (albeit 

just a piece of the overall services associated with 

a given flow of funds) adds value. Banks now 

provide services in originating, servicing, or 

enhancing the creditworthiness of credit flows 

that end up being funded elsewhere. But even 

though the asset is not booked on a bank’s balance sheet, the provision of any and all creditrelated services should be reflected in the income 

of the providers. Accordingly, here we examine 

income-related measures of bank activity, which 

should reflect the flow of services provided over 

time (since income is generated by the production of goods and services in our economy). We 

examine data on income and profitability. We 

also look at estimates of output, employment, and 

annual compensation in the banking sector compared with other sectors in the economy. 

Income and Profitability 

The unbundling of credit-related services (as well 

as the concomitant provision of off-balance-sheet 

financial services that generate income) suggests 

that income-based measures of market share may 

in fact be superior to balance-sheet-based constructs. Ideally one would like to measure the 

income flows associated with the provision of particular types of services (origination, servicing, 

packaging and funding, credit enhancing) in particular types of credit markets (the home-mortgage, consumer-credit, or business-credit 

markets). Unfortunately, comprehensive incomebased equivalents of the FFA do not exist. Hence 

we must piece together evidence about banks’ 

provision of credit-related services both on and 

off their balance sheets and must infer the meaning of such evidence for the evolving importance 

of commercial banking in the U.S. financial sector. 

In both household- and business-sector credit 

markets, the off-balance-sheet roles of commercial 

banks are increasingly important. In home-mortgage and consumer-credit markets, bank off-balance-sheet activities tend to be related to the 

loan-securitization process. More than half of 

home mortgages and an increasing share of consumer debt are funded through asset-backed securities, and commercial banks (particularly large 

ones) play growing off-balance-sheet roles in 

these markets. 

The Survey of Consumer Finances (SCF)—which 

tends to indicate where households obtain credit, 

not necessarily where the credit is funded—does 

not indicate a decline in the share of debt that 

households reported obtaining from commercial 

banks since 1989 (table 3).48 This contrasts with 

the market-share trends in funding we found using 

FFA data. 

48 The SCF data do indicate a dramatic decline in the volume of household 

credit obtained from savings institutions. Ascorbi and Kennickell (2003) report 

trends evident from the 2001 SCF. 

Table 3 

The Survey of Consumer Finances Public Data 

Percentage of debt of all families, distributed by type of lending institution 

1989, 1992, 1995, 1998, and 2001 surveys 

Type of institution 1989 1992 1995 1998 2001 

Commercial bank 28.1 33.1 35.0 32.8 34.1 

Savings and loan or 

savings bank 26.0 16.9 10.8 9.7 6.2 

Credit union 3.8 4.0 4.5 4.2 5.5 

Finance or loan 

company 3.7 3.2 3.2 4.1 4.3 

Brokerage 2.5 3.2 1.9 3.8 3.1 

Mortgage or real estate 

lender 20.8 27.2 32.7 35.5 37.9 

Individual lender 7.8 4.3 5.1 3.4 2.0 

Other nonfinancial 1.6 1.6 0.8 1.4 1.4 

Government 2.0 1.9 1.2 0.6 1.1 

Credit card and 

store card 2.8 3.3 3.9 3.9 3.7 

Pension account 0.1 0.1 0.2 0.4 0.3 

Other 0.9 1.1 0.7 0.3 0.4 

TOTAL* 100.0 100.0 100.0 100.0 100.0 

*Note: Totals may not sum to 100 due to rounding. 

Source: Federal Reserve Board. 

FDIC BANKING REVIEW 51 2004, VOLUME 16, NO. 2 
The Future of Banking 

In terms of consumer credit, the participation of 

commercial banks (particularly large ones) in the 

securitization process tends to involve more than 

loan origination. For credit-card securitizations, 

large commercial banks originate, service, and 

monitor the accounts. Thus, they have the relationship with the borrower. Through a legally 

separate special-purpose-entity they channel their 

receivables into a package that can be funded by 

investors—including mutual and pension funds— 

that are willing to hold asset-backed securities. 

The originating institution manages the assets 

being securitized to maintain the credit quality of 

the pool and often holds a tranche to further 

enhance the pool’s quality. Finally, the bank that 

is sponsoring the pool generally receives any 

residual income earned on these assets in the 

pool, beyond what is promised to the investors 

buying the ABS-issuer’s securities. What creditrelated services is the bank not performing in this 

process? One could, therefore, argue that creditcard securitizations should be included dollar for 

dollar when the share of commercial banks in 

consumer-credit markets is measured, since this 

process is effectively a means of funding the loans 

by the issuance of secured debt (rather than 

deposits). 

As for business credit markets, although securitization plays less of a role than it does in household-sector credit markets, commercial banks 

have long played a role in providing the liquidity 

and credit facilities that support the placement of 

debt in direct credit markets—including debt 

issued by financial firms. This activity was highlighted by researchers a decade ago.49 Thus 

income for services not reflected on banks’ balance sheets extends beyond income connected 

with loans sold into securitized loan pools. 

Noninterest income as a share of earnings has 

received considerable attention from analysts during the past two decades, for the share of net 

operating revenue from noninterest income has 

more than doubled since 1980 (figure 19). Until 

recently, however, it has been difficult to identify 

the extent to which the growth in noninterest 

income has been related to such off-balance-sheet 

activities as asset securitization. Before 2001, 

bank Call Reports asked for detail only on three 

categories of income: service charges on deposit 

accounts, fiduciary (trust) income, and revenues 

from trading operations. All other noninterest 

income was reported in two residual categories: 

Other Fee Income and All Other Noninterest 

Income. Thus, although the relative growth of 

bank noninterest income was driven by these two 

residual categories, it was impossible to discern 

the nature of the activities associated with this 

growth in income. Since the beginning of 2001, 

however, commercial banks (and savings institutions) have reported greater detail about noninterest income.50 

As summarized in table 4, these relatively new 

data indicate some interesting facts about the 

noninterest revenue and the nature of bank off49 Boyd and Gertler (1994b); D’Arista and Schlesinger (1994); Avery and Berger
 

(1991a), and (1991b).
 

50 As reported by Waldrop (2002), “The new report format introduced in the
 

first quarter of 2001 still includes fiduciary income, deposit service charges,
 

and trading revenues, but it now also breaks out income from investment
 

banking services, revenues from venture capital investments, servicing fees,
 

income from asset securitization activities, insurance commissions and fees,
 

and proceeds from sales of loans, other real estate, and other assets.” 


Figure 19 

1973 1979 1985 1991 1997 2003 

0 

10 

20 

30 

40 

50 

Noninterest-income 

as a percentage of

net operating revenue 

0 

50 

100 

150 

200 

Annual noninterest-income 

in thousands of 

2003 dollars 

Source: FDIC 

Note: Net operating revenue is the sum of net interest income and 

noninterest income. 

Noninterest Income as a Percentage 

of Bank Net Operating Revenue 

2004, VOLUME 16, NO. 2 52 FDIC BANKING REVIEW 
 

The Evolving Role of Commercial Banks 

balance-sheet activities.51 About 34 percent of 

noninterest income comes from what can be 

thought of as traditional banking activities. The 

traditional sources include deposit account fees, 

trust activities, and asset sales not associated with 

securitization. The large number of institutions 

reporting and the relatively low concentrations of 

income earned by the five largest income earners 

in these categories suggest that these sources of 

income are used fairly broadly. 

Roughly 15 percent of noninterest income in 

2001 came from sources formerly associated with 

nonbank firms. The activities not generally 

thought of as traditional banking include trading, 

investment banking (fees and commissions from 

investment banking, advisory, brokerage, and 

underwriting services), and insurance services. 

Of these, income from trading activities is conTable 4 

centrated among a relatively small number of 

institutions, but a wide range of banks earn at 

least some income by providing investment banking and insurance services. 

In terms of noninterest income associated with 

the commoditization of credit, about 18 percent 

of noninterest income reported by banks in 2001 

reflected fees for servicing assets funded elsewhere 

and securitization income (net gains on sales of 

securitized assets plus nonservicing fees). As Waldrop (2002) pointed out, “The data show that 

securitization income (net gains on sales of securitized assets plus non-servicing fees), at $16.4 bil51 Table 4, based on data reported by Waldrop (2002), shows the amount of 

noninterest income in each component category, as well as the number of 

banks reporting non-zero amounts in each category. It also shows the share 

of income in each category represented by the combined totals of the five 

largest amounts reported, to indicate how highly concentrated each underlying 

activity was within the banking industry during 2001. 

Noninterest Income of Insured Commercial Banks, 2001 

(Amounts in $ Thousands) 

Combined Share 

Full Percent No. of of 5 Largest 

Noninterest Year of Banks Reported 

Income Category Amount Total Reporting Amounts 

Traditional sources of bank noninterest income 

Net gains/losses on 

sales of other assets1 2,249,208 1.40 2,321 84.60% 

Net gains/losses on 

loan sales 4,642,565 3.00 1,739 47.50% 

Income from fiduciary 

(trust) activities 20,751,226 13.20 1,668 39.40% 

Service charge on 

deposit accounts 26,472,609 16.80 7,909 33.90% 

Trading, investment banking, and insurance 

Trading revenues 12,524,834 8.00 175 82.60% 

Investment banking and 

other fees 9,096,981 5.80 2,178 55.80% 

Venture capital revenue –740,222 –0.50 61 N/M 

Insurance commissions 

and fees 2,874,938 1.80 4,063 38.40% 

Servicing and securitizing loans 

Servicing fees 11,568,730 7.40 1,626 41.50% 

Securitization income 16,349,975 10.40 100 64.00% 

Not identified 

Other noninterest income 51,335,770 32.70 7,983 21.20% 

Total noninterest income 157,171,912 8,050 

Source: Bank Call Reports (FDIC Research Information System). 

1 Excludes gains/losses on sales-of OREO, which accounted for negligible amount of income in 2001. 

FDIC BANKING REVIEW 53 2004, VOLUME 16, NO. 2 
The Future of Banking 

lion for the year, represented the largest amount 

of any of the new categories. The next-highest 

category was servicing fees, at $11.6 billion.” 

Also included in the residual category of “All 

Other Noninterest income” is income from 

unconsolidated subsidiaries, data processing services, ATM usage fees charged to depositors from 

other institutions, and income from other services 

(notably the provision of liquidity and credit 

facilities). This residual category is still the 

largest component of total noninterest income. 

At $51.3 billion in 2001, it represented 33 percent of commercial banks’ noninterest income. 

Income is obviously closely related to profitability, 

and in this regard banking has been holding its 

own. The data on profits, like the data presented 

below on output, employment, and compensation, 

are from the Bureau of Economic Analysis (BEA), 

which constructs estimates of these measures for 

broad sectors of the U.S. economy, including 

financial sectors. One limitation of the BEA data 

series is that the classification of “credit agencies” 

was changed in 1987. Through 1987, commercial 

banking was specifically broken out as a component of credit agencies; other lenders (such as 

savings institutions and finance companies) were 

aggregated simply as “other credit agencies.” 

With the elimination of many of the differences 

between commercial banks and savings institutions, industrial classifications for credit agencies 

were redefined as “depository institutions” and 

“other credit agencies.” Thus, we cannot directly 

observe what is happening to commercial banking’s share of economic activity, but we can draw 

some inferences based on what we observe for all 

depository institutions and on the relative shrinkage of the savings institution industry since 1987. 

A second limitation of these data is that they do 

not contain the same level of detail as the FFA. 

Hence we cannot look at trends for banking visà-vis particular types of other financial-service 

providers. 

Corporate profits for finance and insurance industries have been rising as a share of total corporate 

profits, particularly since the mid-1980s. 

Although the data after 1987 are for all depository institutions, the broad trends do not suggest an 

industry in decline (see figure 20). While banks 

were returning to record-setting earnings in the 

1990s, so were other financial-service providers 

(hence the decline in depository institutions’ 

share of finance and insurance corporate profits), 

but the profitability of the banking sector has outpaced that of other financial sectors during the 

past few years. 

To deal with the lack of detail in the BEA data 

on the performance of other financial-service 

providers, FDIC analysts have compiled and 

tracked profitability data available for publicly 

traded U.S. financial corporations. Because large 

conglomerates are involved, classifying financial 

enterprises into a single financial-service category 

is not always easy. In addition, like the BEA 

data, this information classifies banking to 

include both commercial banks and savings institutions. These estimates yield some very interesting patterns (figure 21). 

First, the category of credit providers accounts for 

roughly three-fourths of the net income of financial corporations. And although this finding no 

doubt reflects declines in stock market valuations, 

this share of profits is comparable to the share in 

Figure 20 

1947 1957 1967 1977 1987 2001 

0 

0.2 

0.4 

0.6 

0.8 

1.0 

Share of total for finance 

and insurance industries 

All credit agencies 

Commercial banking 

(1987 and earlier)/ 

depository institutions 

(after 1987) 

All finance and insurance 

(right axis) 

0 

0.1 

0.2 

0.3 

0.4 

0.5 

Share of total 

for all industries 

Corporate Profits before Taxes, 

1947-2001 

2004, VOLUME 16, NO. 2 54 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

1984—before the growth of U.S. financial capacity and the attendant decline in the share of nonfinancial-sector debt directly funded by banks. 

Second, profitability reflects the amount of intermediation services provided, not just the volume 

of funds brokered to investors. From this perspective, it is not surprising that government-sponsored enterprises have a relatively small share of 

profits compared with the volume of credit they 

channel, both directly and through asset securitization. Finally and most pertinent to the point of 

this paper, the banking industry (here, however, 

defined to include savings institutions as well as 

commercial banks) appears to have maintained its 

market share quite well in terms of profitability, 

rebounding from the problems encountered during the 1980s and early 1990s. 

Output, Employment, and Compensation 

The other economic-activity-based measures of 

bank market share that may tell us something 

about the importance of commercial banking in 

U.S. credit markets include output, employment, 

and compensation. These are useful because they 

indicate the resources allocated to the provision 

of services by banks compared with the resources 

Figure 21 

used in the production of goods and services by 

other sectors. 

Figure 22 illustrates the contribution of the 

finance and insurance industries to GDP (it also 

illustrates credit agencies’ share of the total output of the finance and insurance sectors). Consistent with the growth of credit-market debt in the 

U.S. economy, financial-service firms account for 

a growing share of aggregate output (except for an 

increase during the debt buildup of the 1980s, 

credit agencies’ share of financial- and insurancesector output has been remarkably stable). During the past decade, the estimated output of 

depository institutions has been growing more 

slowly than the estimated output of other credit 

providers (i.e., depository institutions’ share of the 

GDP of finance and insurance industries has been 

declining), but this trend may reflect the continuing contraction of the savings-institution industry. 

Figure 23 depicts employment trends measured in 

terms of full-time-equivalent (FTE) employment. 

Until the mid-1980s, employment in the finance 

and insurance industries grew as a share of total 

employment in the U.S. economy; since then, 

employment growth in finance and insurance 

industries has lagged employment growth in other 

Figure 22 

Net Income of Financial Corporations, 

1984-2002 

Percent of annual net income for 

all publicly-traded financial companies 

1 

Insurance 

Securities 

0.8 brokers 

0.6 Credit/other 

REITs 

0.4 

GSEs 

0.2 

Banks 

0 

-0.2 

1984 1987 1990 1993 1996 1999 2002 

GDP by Industry, 

1947-2001 

Share of total for finance Share of total for 

and insurance industries all industries 

0.6 All credit agencies 0.1 

0.5 0.08 

0.4 

0.06 Commercial banking (1987 and earlier)/ 

depository institutions (after 1987) 0.3 

0.04 

0.2 

All finance and insurance 0.02 0.1 (right axis) 

0 0 

1947 1957 1967 1977 1987 2001 

FDIC BANKING REVIEW 55 2004, VOLUME 16, NO. 2 
The Future of Banking 

industries. This pattern probably reflects the 

application of computer technologies in financialservice industries, technologies that have 

increased the productivity per worker and therefore reduced the person hours needed to produce 

a given level of financial services. Commercial 

banking is an important driver in these trends. 

Until the 1980s, commercial banking’s share of 

total employment in our economy was rising (as 

was employment by other credit agencies, which 

included savings institutions). The share of total 

employment in commercial banking flattened out 

in the early 1980s, when the use of ATMs became 

widespread, and the data for all depository institutions indicate a long-term decline in these institutions’ FTE employment share during the past 15 

years. Although employment growth for insurance industries has also been slowing, banking’s 

Figure 23 

declining share of FTE employment has been 

more pronounced. 

Similarly, data on total compensation (see figure 

24) indicate that although compensation in the 

finance and insurance industries has been steadily 

increasing as a share of total compensation paid 

in the U.S. economy, this increase has not been 

fueled by the growth of compensation in the 

banking sector. Since 1987, compensation paid 

by depository institutions has declined as a share 

of the total financial-sector pie. Nevertheless, 

because both employment and compensation 

trends reflect dramatic changes in the technologies used to deliver financial services, they are 

likely to overstate declines in the contribution of 

credit providers to economic activity. 

Figure 24 

Full-Time Equivalent Employees (FTEs) 

by Industry, 1948-2001 

Share of total for finance Share of total 

and insurance industries for all industries 

0.06 0.7 

0.05 0.6 

All credit agencies 0.04 0.5 

Commercial banking (1987 and 

earlier)/depository institutions 0.03 0.4 (after 1987) 

0.02 0.3 

All finance and insurance 

(right axis) 

0.01 0.2 

1948 1959 1969 1979 1989 2001 

Compensation by Industry, 

1947-2001 

Share of total for finance Share of total for 

and insurance industries all industries 

0.5 

All credit agencies 

0.08 

0.4 Commercial banking (1987 and earlier/ 

depository institutions (after 1987) 

0.06 

0.3 

0.04 

0.2 

All finance and insurance 0.02 0.1 (right axis) 

0 0 

1947 1957 1967 1977 1987 2001 

2004, VOLUME 16, NO. 2 56 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

Conclusions 

This paper assesses concerns that banks are 

becoming less important in U.S. credit markets, 

using available data to quantify the importance of 

commercial banks as credit providers—to quantify 

their “market share.” Certainly as the debt capacity of the U.S. economy expanded in the 1980s, 

the share of nonfinancial-sector debt that was 

directly funded by banks declined. This decline 

was associated with a dramatic increase in the 

extent to which lending to households and businesses became securitized—that is, standardized, 

pooled, and funded by the issue of securities. The 

shift away from traditional intermediation 

towards asset securitization reflects not only 

changing credit technologies but also the activity 

of government-sponsored enterprises. The shift 

towards funding credit though securities markets 

also reflects fundamental changes in how individuals accumulate assets, due to changes in technology, pension regulations, and demographics. 

Long-term instruments such as home mortgages 

are arguably better suited to securitization as a 

funding mode because of the maturity mismatch 

inherent in depository institution funding. However, it is harder to make the same case for the 

private securitization of some other types of 

loans—for example, credit card receivables. Nevertheless, banks play a prominent role in this type 

of securitization activity, so this may be a way for 

banks to fund loans effectively by issuing secured 

debt while they continue to be involved in all 

other aspects of the provision of credit (including 

the relationship with the customer and the 

responsibility for maintaining the quality of the 

pool of loans being funded). This alternative 

funding mode has allowed banks to make more 

loans than they would have been able to if they 

had relied on deposits alone as a funding source. 

Thus, although commercial banking’s on-balancesheet activity has declined as a piece of the credit-market pie, the industry’s off-balance-sheet 

activities are a growing source of income. Hence 

the ultimate finding of this study must be that 

banking is evolving but does not appear to be 

declining. Even according to some fairly traditional measures, the commercial banking industry 

remains remarkably important in funding credit 

flows in the United States—especially credit 

flows to nonfinancial businesses. 

What, then, can we say about the future of banking? Although the extent to which commercial 

banks directly fund nonfinancial sectors in our 

economy has been stable since 1993, such stability does not preclude future declines. Future 

increases in the economy’s debt capacity are not 

likely to take the traditional form of intermediation. Thus, it will continue to be important for 

researchers to study the evolving roles banks play 

in our financial sector, the risks these roles pose 

for the industry, and the implications of these 

evolving roles for broader financial stability. For 

example, policy makers very much need evidence 

about the risks inherent in the unbundling and 

repackaging of credit and about the implications 

of these risks. 

The secular shift by banks toward funding business lending that is collateralized by real estate 

represents a shift to a type of lending that has 

been associated with localized banking-sector 

problems. This association is likely to be most 

problematic for community banks, which are 

more geographically focused in their activities, 

than for larger banking companies operating a 

wide range of profit centers over broader geographic areas. In general, off-balance-sheet activities imply an ever more critical role for large 

banking organizations. 

The services that commercial banks provide in 

enhancing the liquidity and credit quality of 

claims funded elsewhere undoubtedly reflect the 

industry’s unique status in our financial sector. 

The role of banks in making credit marketable 

indicates that commercial banking remains a critical force in the modern flow of funds that has 

contributed to the broader availability of credit in 

the U.S. economy. 

FDIC BANKING REVIEW 57 2004, VOLUME 16, NO. 2 
 

The Future of Banking 

APPENDIX: Investor Portfolio Trends 

On the asset side of nonfinancial-sector balance 

sheets there have also been fundamental changes 

in the way individuals hold financial assets, particularly as changes in pension regulations and 

the availability of mutual funds took hold during 

the 1980s. In addition, changes in mechanisms 

used to conduct transactions and make payments 

over the past several decades appear to have 

reduced the extent to which individuals have to 

hold liquid assets as a share of their financial 

portfolios for transactions purposes.52 Here we 

discuss the extent to which these trends have 

made it easier for the growing volume of securities 

issued by financial-sector firms to be absorbed. 

The growth of the mutual-fund industry can be 

thought of as a commoditization of investment 

opportunities in direct credit (and equity) markets. By pooling many securities, a mutual fund 

can reduce idiosyncratic risks and generate morepredictable risk, return, and liquidity, compared 

with any given securities in the pool. Thus by 

choosing particular types of securities, mutual 

funds can target particular characteristics for 

investors in terms of risk, return, and even the 

social or ecological consciousness of the underlying firms. Not only do personal investors hold 

these funds, but institutional investors—particularly life insurance and pension funds—also hold 

mutual-fund shares indirectly for their claimants. 

Figure A.1 illustrates trends in the financial assets 

held by the personal sector. Because of inherently 

different risks and returns, we distinguish between 

holdings of debt and holdings of equity mutual 

funds by the personal-sector portfolio. The resulting picture shows a dramatic increase in individu52 For example, the increased use of credit cards allow individuals to actually 

pay for the transaction made during a month at a single point in time. Thus, 

individuals can transfer funds to their transactions accounts when they need 

to pay their credit card bills. At other points in times they may hold relatively 

little “money.” Payment system changes are discussed in The Effect on U.S. 

Banking of Payment System Changes by Neil B. Murphy of Virginia Commonwealth University, which follows this article. 

als’ accumulation of financial assets, an increase 

associated with the growth of pension wealth and 

increases in equities values (until the past few 

years, at least). The extent to which individuals’ 

direct holding of mutual funds has facilitated the 

absorption of credit-market debt has been surprisingly modest. And although money-market 

mutual funds (MMMFs) have certainly displaced 

deposits somewhat, the overall level of transactions accounts held by individuals (defined in the 

Federal Reserve Board of Governor’s Survey of 

Consumer Finances to include bank accounts and 

nonbank transactions accounts, such as MMMFs) 

as a share of GDP has remained fairly stable over 

time. However deposits are now a smaller share 

of the total portfolio of financial assets held by 

individuals than thirty years ago. The growth of 

insurance and pension reserves as a component of 

personal financial-asset holdings has been the 

most prominent trend during the past few 

decades. 

In the early 1950s, roughly half of the personal 

sector’s financial portfolio consisted of claims on 

traditional intermediaries, that is, life insurance 

companies, pension funds, and depository 

institutions (figure A.2). And as noted, these 

intermediaries mainly held debt issued by nonfiFigure A.1 

0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

Miscellaneous 

financial 

assets 

Bank 

personal 

trusts 

Direct equity holdings 

Equity 

mutual 

funds 

Life insurance & pension reserves 

Debt 

held in 

mutual 

funds 

Directly held debt securities 

MMMF shares Currency & deposits 

1952 1962 1972 1982 1992 2002 

Personal-Sector Financial Asset Holdings: 

Ratio to GDP 

2004, VOLUME 16, NO. 2 58 FDIC BANKING REVIEW 
The Evolving Role of Commercial Banks 

nancial-sector borrowers; thus, intermediation 

tended to involve a single layer: indirect liabilities 

held by individuals were used mainly to fund nonfinancial borrowers directly.53 The other half of 

the personal-sector portfolio was in the form of 

directly held securities (i.e., stocks and bonds). 

Importantly, equities tended to be held directly by 

individuals—most likely individuals with greater 

financial resources. 

The next few decades saw a shift in the personalsector portfolio toward the indirect liabilities 

issued by intermediaries, including commercial 

banks and savings institutions. By the mid-1970s, 

direct holdings of securities had fallen to around a 

third of the personal sector’s portfolio (we include 

custodial bank personal trusts, first reported in the 

FFA in 1969, in this share). Mutual funds still 

accounted for only 1 percent of the personal sector’s portfolio, and money-market mutual funds 

did not yet exist. Traditional intermediation had 

increased its share of the personal-sector portfolio 

to almost 60 percent (figure A.3), and the market 

share allocated to deposits (and currency) peaked 

at this time at 35 percent. However, an interesting trend was under way as pension and insurance 

sectors were increasing their holdings of equities 

(not depicted in the figures). Thus, the decline 

Figure A.2 

Personal-Sector Financial Asset Holdings:
 

Percentage of Total 1952
 

MMMF Shares 

0% 

in direct equities held by individuals was offset by 

increases in equity investments by these intermediaries.54 

In recent decades, trends evident in the 1970s 

have taken off. As the size of the personal sector’s financial portfolio grew, so did the issue of 

securities by financial intermediaries. Thus even 

though the share of bonds and equities directly 

held by individuals remain close to 30 percent, it 

is now much more likely that holdings of securities are funding financial intermediation. Importantly, this is also true of mutual fund holdings 

(including MMMFs) and claims on pension and 

insurance sectors, which now account for half of 

the personal-sector portfolio. (See figure A.4). 

The bottom line is that households have shifted 

from holding securities directly to investing in 

intermediaries that invest in securities (and in 

53 As noted, the share of total credit market debt issued by financial firms 

was quite small, and insurance and pension funds didn’t hold that much in 

the way of equities fifty years ago (only around five percent of their portfolios 

were in corporate equities). 

54 Credit-market debt issuance by financial intermediaries had also risen to 10 

percent of total outstanding credit-market debt; hence it is important to point 

out that securities directly held by individuals were issued by financial firms 

as well as nonfinancial firms. 

Figure A.3 

Personal-Sector Financial Asset Holdings:
 

Percentage of Total 1977
 

Currency

and 

deposits 

28.6% 

Direct 

holdings of

securities 

15.6% 

Directly

held 

equity 

30.4% 

Debt
 

held in
 

mutual


 funds
 Equity 0.1% held in

 mutual 

funds 

0.6% 

Misc. fin. 

assets 

7.8% 

Life insurance Bank 

and pension personal reserves trusts 

16.9% 0% 

Equity

held in

 mutual 

funds 

0.9% 

Bank 

personal 

trusts 

6.3% 

Misc. fin. 

assets 

5.5% MMMF 

Shares 

0.1% 

Direct 

holdings of 

securities 

7.6% 

23.9% 

0.3% 

funds 

Debt held 

in mutual

Life insurance 

and pension 

reserves 

35.7% 

Currency

and 

deposits 

19.7% 

Directly 

held 

equity 

FDIC BANKING REVIEW 59 2004, VOLUME 16, NO. 2 
The Future of Banking 

mutual-fund shares) that fund financial interme- Figure A.4 

Personal-Sector Financial Asset Holdings:
 

Percentage of Total 2002
 

diaries as well as nonfinancial borrowers. And 

whereas it used to be mainly wealthier households 

that held securities, mutual funds and pension 

plans have broadened the access of the average 

household’s access to direct credit and equities 

markets. Thus personal portfolio trends have 

facilitated the absorption of the greater amount of 

debt being issued by direct credit markets— 

including debt issued by financial sectors— 

including ABS-issuers and federally-related 

mortgage pools. 

MMMF Shares 

Equity held in 4.2% 

mutual funds 

Debt held in 6.7% 

15.4%

Life insurance 

and pension 

reserves 

Currency

and 

deposits 

33.6% 33.6%

Directly

held 

equity 

18.3% 15.4% 

mutual funds 

Bank 3.6% 

personal trusts Direct holdings 3.1% of securities 

Misc. fin. 8.4% 

assets 

6.8% 

2004, VOLUME 16, NO. 2 60 FDIC BANKING REVIEW 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Evolving Role of Commercial Banks 

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———. 1997. Small Business Credit Markets: Why Do We Know So Little about Them? 

FDIC Banking Review 10, no. 2:14–32. 

Savage, Donald T. 1982. Developments in Banking Structure, 1970–81. Federal Reserve 

Bulletin 68, no. 2:77–85. 

———. 1993. Interstate Banking: A Status Report. Federal Reserve Bulletin 79, no. 

12:1075–89. 

Simpson, Thomas. 1988. Developments in the U.S. Financial System since the Mid1970s. Federal Reserve Bulletin 74, no. 1: 1–13. 

Teplin, Allen M. 2001. The US Flow of Funds Accounts and Their Uses. Federal Reserve 

Bulletin 87, no. 7:431–41. 

Tobin, James. 1963. Commercial Banks as Creators of Money. In Banking and Monetary 

Studies, edited by Deane Carson, 408–19. Richard D. Irwin, Inc. 

Waldrop, Ross. 2002. New Reporting Offers Insight into Bank Activities. FDIC FYI, 

April 18. 

Wheelock, David. 1993. Is the Banking Industry in Decline? Recent Trends and Future 

Prospects from a Historical Perspective. Federal Reserve Bank of St. Louis Review 

75, no. 5:3–22. 

Wojnilower, Albert. 1980. The Central Role of Credit Crunches in Recent Financial 

History. Brookings Papers on Economic Activity 2:277–337. 

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Use of Contingencies and Commitments by Commercial Banks, Below the 

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FDIC BANKING REVIEW 65 2004, VOLUME 16, NO. 2 
The Future of Banking in America 

The Effect on U.S. Banking of Payment System Changes 

by Neil B. Murphy* 

Introduction 

It is now three decades since the dawn of the 

“checkless, cashless society” was proclaimed. 

Cash is still in use, although much of it is outside 

the United States, and many checks are still 

being written. It is tempting to dismiss the predictions of those days as being misguided and of 

no major consequence for the structure and financial health of the banking industry in the United 

States. However, major changes in the U.S. payment system as a whole are underway. These 

changes will have an effect on costs, profitability, 

mix of business, and delivery systems that must be 

considered in an assessment of the future of banking in the United States. 

It is traditional for a payment system to be the 

primary concern of the central bank.1 This tradition is related to the central bank’s responsibility 

for monetary policy. After all, the central bank 

creates a nation’s money supply, and the payment 

system influences the velocity of that money and 

its utility when households, businesses, and governmental units make payments. Thus, the focus 

of the central bank’s concern is the efficiency of 

the payment system and the avoidance of any systemic risk arising from its operations. Moreover, 

the central bank is concerned with mitigating any 

moral hazard that may occur because of such 

activities as discount window lending and the 

supplying of intraday credit (daylight overdrafts) 

to participants in the central bank’s large-value 

funds transfer service (Fedwire). Indeed, central 

bankers have been meeting for some time to deal 

with these problems. The Committee on Payment and Settlement Systems (CPSS) is composed of central bankers from the G-10 countries 

and is housed at the Bank for International Settlements in Basle, Switzerland. The CPSS has 

issued many influential reports concerning these 

issues and recently published a set of “best practices” for systemically important payment 

systems.2 The CPSS has also published reports 

that discuss the role of the central bank in retail 

payment systems.3 

* Neil B. Murphy, CTP, AAP, is a Professor of Finance in the Department of 

Finance, Insurance, and Real Estate School of Business at the Virginia Commonwealth University. The research for this paper was funded through a 

grant by the FDIC. 

1 The payment system as a whole comprises a number of component payment systems; thus the word “system” is used in this paper sometimes to 

refer to the overall system and sometimes to refer to the individual components. 

2 See CPSS (2001). 

3 See CPSS (2000, 2003). 

FDIC BANKING REVIEW 67 2004, VOLUME 16, NO. 2 
The Future of Banking 

The focus of this paper is on the changes underway that influence the health of the banking 

industry in the United States. At the outset, it 

should be noted that the United States is somewhat of an outlier among developed nations when 

it comes to the nature of its payment systems: 

� The use of the check as a means of payment 

is far greater in the United States than in any 

other country, even though the number of 

checks has actually declined in recent years 

and the share of checks in total noncash payments has been declining for some time. 

� In the United States, the central bank (the 

Federal Reserve System) owns and operates 

substantial segments of the payment system. 

In most countries, the central bank supervises 

but does not operate the retail payment system. 

Furthermore, the focus of this paper is on payment systems other than the large-value payment 

systems. At the heart of every nation with highly 

developed financial markets is a real-time gross 

settlement system (RTGS) that is operated by the 

central bank. In such a system, funds are wired 

by banks on behalf of their customers to other 

banks. The banks actually transfer funds from 

and to their accounts on the books of the central 

bank. In the United States, the RTGS is Fedwire, which is owned and operated by the Federal 

Reserve System. The gross feature of the system 

refers to the fact that each transaction is settled 

separately. An alternative that requires less liquidity for the banks involved is a netting system 

in which payments to and from banks accumulate 

and only the net difference is transferred. What 

that means is that, on receipt of the funds, the 

recipient bank and its customer do not have 

access to those funds until the accumulated 

inflows and outflows are netted and settled. The 

real-time feature of the system means that the 

funds received are available at exactly the time 

when they arrive. There is no wait for accumulated inflows and outflows to largely offset each 

other, with only a smaller net amount transferred. 

More funds are transferred by Fedwire and the 

Clearing House Interbank Payment System 

(CHIPS), a private sector large-value payment 

system, than by any other payment method. 

However, the number of transactions is small, and 

most of the activity is confined to a small number 

of money-center banks.4 This is not meant to 

downplay the importance of these systems, but 

the proper focus for them has been the risk management associated with either intraday loans 

(daylight overdrafts) or the potential systemic 

effect of unwinding payments in a multilateral 

netting system when one of its participants is 

unable to settle its obligation. These systems are 

highly automated and will probably not change 

too much in the future in response to forces of 

technology or shifts in consumer preferences. 

However, there are changes underway in the 

United States in noncash retail payment systems 

other than the large-value payment systems that 

will affect the future of the banking industry. 

These include a diminution in the number of 

checks written and increases in electronic forms 

of payment. Moreover, even though fewer checks 

are being written, the number is still very large in 

absolute terms and in comparison with the number in most other countries. Therefore, efforts are 

underway to “electronify” the checks early in the 

process of clearing and settlement, sending the 

information contained on the check forward electronically. This is expected to be cheaper and 

faster than current methods, in which large numbers of pieces of paper are transported around the 

country. 

Some Basic Characteristics of Payment Services 

and Banking 

All noncash methods of payment involve interbank transfers of funds. Hence, many basic product lines in banking are tied to the various 

4 For a discussion of wholesale payment systems in general, see FolkertsLandau (1997); and for a discussion of risk management for Fedwire, see 

Coleman (2002). The CPSS best practices, or “core principles,” are appropriately applied to “systemically important payment systems,” and Fedwire 

is certainly such a system. Recently the Federal Reserve published a “Self 

Assessment of Compliance with the Core Principles for Systemically Important Payment Systems” (2001). 

2004, VOLUME 16, NO. 2 68 FDIC BANKING REVIEW 
 

Effect on U.S. Banking of Payment System Changes 

systems by which balances are transferred from 

one bank to another on behalf of customers. 

These products involve either a direct charge to a 

customer’s demand deposit account as a result of a 

transfer, or a payment on behalf of a customer—a 

loan to the customer that will be satisfied at a 

future date. In most of the payment systems, it is 

efficient to have a network that includes all bank 

participants. Thus, all products tied to an interbank transfer network involve the following: 

� The paying customer 

� The bank at which the paying customer has 

an account 

� The receiving customer 

� The bank at which the receiving customer 

has an account (which may not be the same 

as the customer’s bank) 

� An operator of a network in which many 

banks may participate. 

The notion of a network gives rise to the concept 

of network externalities. That is, a product or service tied to a network has value that is enhanced 

by its link to other users. This is especially true 

for communication systems, and it can be argued 

that payment systems are really forms of communication systems.5 Consider the value of a telephone that is not connected to any other callers. 

Clearly, the value of the telephone and a contract 

to use it to communicate depends on the use of 

the same product and service by large numbers of 

other users. This gives rise to a situation in 

which there is a potential trade-off between 

efforts to achieve universality of use to maximize 

these externalities and the concern about limiting 

competition and innovation. It also raises the 

issue of who owns and operates the network. 

Interbank payments, when there is not an instantaneous transfer of funds as there is in a cash 

transaction, involve some risks. In a cash transaction, clearing and settlement of the payment 

occur immediately. For most interbank payment 

systems, there is a delay between the time a payment is initially cleared and the time the participants settle all claims among themselves. All 

participants must be able to meet their net settlement obligations to the network. If one participant cannot settle, many other transactions are at 

risk. In some cases, there is also some counterparty risk in that a customer may not have sufficient 

funds to honor a payment instrument that is presented through a network. This is especially true 

for debit transfer transactions. 

There are two basic types of interbank transfers: 

credit transfers and debit transfers. In a debit 

transfer, a payer sends a payment instrument, usually a check, to a payee. The payee then deposits 

the check in its bank, which collects the check 

through the interbank payment system. Hence, 

the payee has a provisional credit to its account, 

contingent on the payment instrument’s being 

honored upon presentment. The risk is that the 

payer (the counterparty) does not have sufficient 

funds to honor the check. Only when the payment instrument clears is the payee free from the 

counterparty risk.6 In a credit transfer, the payer 

notifies its bank to transfer funds to the account 

of the payee in the payee’s bank. Thus, the recipient of the communication, the payee’s bank, does 

not need to worry about counterparty risk. Either 

the payer has sufficient funds to make the transfer, or the payer’s bank advances sufficient funds 

to make the transfer.7 Note that counterparty 

risk involves payers and payees, whereas settlement risk involves banks in the interbank funds 

transfer system. For debit transfer systems, both 

counterparty and settlement risk exist. For credit 

transfer systems, only settlement risk exists.8 

5 For an extensive discussion of the network characteristics of payment systems, see Lacker and Weinberg (1998). 

6 Not all debit transfers are checks, for debit transfers occur in the Automated Clearing House (ACH) system in the United States. That is, a payer 

authorizes a payee to transfer funds through the ACH system by having the 

payee’s bank present an electronic debit through the ACH and deduct funds 

from the account of the payer in the payer’s bank. There is still counterparty risk in that the payer must have sufficient funds. 

7 Whether something is called a credit transfer or a debit transfer depends 

on the action of the receiving financial institution. If the receiving financial 

institution debits the payer’s account, it is a debit transfer. If the receiving 

financial institution credits the payee’s account, it is a credit transfer. It 

should be noted that only credit transfers occur on the large-value RTGS 

payment systems. 

8 The exception to this, of course, is the RTGS large-value payment systems 

in which settlement occurs instantaneously. However, if the central bank 

advances funds to participants during the day (daylight overdraft), that 

FDIC BANKING REVIEW 69 2004, VOLUME 16, NO. 2 
The Future of Banking 

If a payment system may be viewed as a communications network, all participants must have 

clear agreements as to their duties and obligations 

related to their participation. This is reflected in 

law, in regulations, and in contractual agreements 

among the various parties to the network. In the 

United States, there are a number of different 

legal and regulatory arrangements for the different 

networks, and there are also situations in which 

different transactions in the same network have 

different legal and regulatory arrangements. 

Moreover, there are differences among the networks as to exactly who owns and operates the 

network. 

Payment Systems in the United States 

In the United States, there are a number of different payment networks that have evolved over 

time. These include the following: 

� The system of check payments—a debit transfer system—which is presently paper based and 

the networks for which they are operated by 

both the banking community and the Federal 

Reserve System. 

� The automated clearing house (ACH) system, 

which is an electronic batch-processing system 

in which most of the processing is done by 

Federal Reserve Banks. Transactions can be 

either debit or credit transfers. 

� The debit and credit card systems, whose networks either have evolved from automated 

teller machine (ATM) networks or are owned 

and operated by a few major card organizations, primarily VISA and MasterCard. 

The common element in all these systems is the 

communications link between banks in which 

information regarding payments and customer 

accounts is transmitted from one bank to another, 

with appropriate adjustment to customer account 

balances. In most cases, the customer account is 

a demand deposit account that is adjusted (debited for the payer, and credited for the payee). 

However, there are also cases in which funds are 

advanced through the system on behalf of the 

payer, to be credited to the payee’s demand 

deposit account. In such cases, the bank has a 

receivable from the payer to be settled later 

according to the credit agreement between the 

payer and the bank. This describes a credit card 

transaction.9 

The Check System 

The check system is the oldest interbank payment 

system in the United States. It evolved in the 

second half of the nineteenth century as banks in 

the United States switched from note issue to 

deposit banking as a result of a 10 percent tax on 

notes.10 Indeed, two of the reasons for the establishment of the Federal Reserve System were to 

implement a nationwide check-clearing system 

(since U.S. banking laws precluded any bank 

from having a national network of branches) and 

to eliminate the practice of nonpar banking (the 

bank on which a check was drawn might not 

honor the full value of the check when it was presented for payment).11 

The legal framework for the check system comprises both state and federal laws and regulations. 

The Uniform Commercial Code (UCC) represents an agreement among the states to adopt 

similar laws in the area of commerce. Within 

that code are several parts that deal with payments and settlement: Article 3 (negotiable 

instruments), Article 4 (bank deposits and collections), and Article 4a (fund transfers, including 

wholesale ACH credit transfers). In addition, 

Congress passed the Expedited Funds Availability 

Act of 1987 (EFAA), which gave the Federal 

Reserve System the responsibility of implementtransaction involves some credit risk if the bank to which credit has been 

advanced cannot bring its account back to zero at the end of the settlement period. 

9 There may be some debate as to whether a credit card transaction and 

the credit card networks constitute a payment system, since the payer’s 

demand deposit account is not debited as a result of the transaction. However, payment does occur over an interbank network, and the Committee on 

Payment and Settlement Systems, the ultimate arbiter of things related to 

payment systems, includes credit card transactions in its data on different 

countries’ payment systems in its “Red Book.” 

10 See Friedman and Schwartz (1963). 

11 See Weinberg and Lacker (1998). 

2004, VOLUME 16, NO. 2 70 FDIC BANKING REVIEW 
Effect on U.S. Banking of Payment System Changes 

ing improvements in the check collection system. 

When the Federal Reserve acts on that authority, 

federal law supersedes state law. The Federal 

Reserve has several regulations that affect check 

collection: Regulation CC and Regulation J both 

affect the processing of collections and returns 

through the Federal Reserve System. On October 

28, 2003, Congress passed and the president 

signed the Check Truncation Act of 2003, which 

paves the way for electronic presentment and collection of checks.12 

Within that legal framework, the check collection system does not function through a single 

channel. When a payee receives a check, he or 

she deposits it in a bank. That bank then has a 

number of choices available to collect the check: 

� It is possible that the payer and payee do business with the same bank. In that case, balances are shifted on the books of that bank, 

and there are no interbank transactions. This 

is known as an “on-us” transaction, in which 

there is no delay in settlement. Also, the processing costs are lower. The consolidation of 

the banking industry has increased the probability that any given check will result in an 

on-us transaction.13 

� The bank of first deposit may decide to present the check directly to the bank on which 

the check is drawn. This occurs in situations 

where two banks are in close proximity and 

have a lot of bilateral transactions. This is 

known as a “direct send.” 

� The bank of first deposit may present the 

check to a local clearing house, an arrangement whereby a number banks agree to meet 

for the purpose of presenting checks to each 

other and settling the net differences at the 

end of an agreed-upon period. 

� The bank of first deposit may avail itself of the 

services of another bank—a correspondent 

bank—to collect the check on its behalf. 

� The bank of first deposit may deposit the 

check with its local Federal Reserve Bank, 

which will then collect the check from the 

bank on which it is drawn. 

In 1980, the Depository Institutions Deregulation 

and Monetary Control Act (DIDMCA) required 

that the Federal Reserve charge for its clearing 

and settlement services. Before that time, Federal 

Reserve services were provided without any 

direct, explicit charge. As might be expected, 

however, correspondent banks that competed 

with the Federal Reserve objected to this arrangement. To compete on a comparable basis, the 

Federal Reserve was required to base its prices 

charged for clearing and settlement services on its 

explicit costs and on an adjustment for the cost of 

capital that its competitors must factor into their 

cost structures.14 In addition, the Federal Reserve 

System must recover all its costs in the provision 

of these services. The choice made by the bank 

of first deposit depends on the relative costs and 

benefits of the different channels. 

In 2001, it was estimated that 41.2 billion checks 

were written in the United States. Approximately 43 percent of these checks cleared through the 

Federal Reserve System; 28 percent cleared as 

direct sends, clearing house items, or through correspondent banks; and 29 percent were “on-us” 

checks.15 

It has long been known that the U.S. payments 

system depends more on checks than is the case 

in all other industrialized nations.16 Since a great 

deal of effort, energy, and expense is incurred in 

moving large amounts of paper long distances, the 

12 For a discussion of the legal and regulatory environment of payments in 

the United States, see CPSS (2003). 

13 In Gerdes and Walton (2002), it is noted that the proportion of “on-us” 

checks has not increased much even though the industry has consolidated. 

They attribute this to the reduction in checks written for cash (these are 

being replaced by ATM withdrawals) while on-us checks sent to payees 

have increased. 

14 For a thorough discussion of the methods and rationale for calculating 

the private sector adjustment factor (PSAF), see Green, Lopez, and Wang 

(2003). 

15 It is not the usual practice for the central bank to operate substantial 

segments of retail payment systems, nor is the Federal Reserve’s role as 

both operator and regulator without controversy. The Federal Reserve 

undertook an extensive review of its role several years ago and concluded 

that present arrangements are satisfactory. See Board of Governors of the 

Federal Reserve System (1998). 

16 For an excellent review of comparative developments of payment practices in major industrialized nations, see Humphrey, Sato, Tsurumi, and 

Vesala (1996). 

FDIC BANKING REVIEW 71 2004, VOLUME 16, NO. 2 
 

The Future of Banking 

demise of the check has been seen as inevitable 

and desirable. However, obtaining accurate information on the exact number of checks processed 

in the United States is not easy. Given the number of routes that any check might take and the 

fact that a single check may pass through several 

channels, it has been difficult to collect such data 

every year. However, there are several benchmark years in which exhaustive surveys were 

undertaken. The practice was then to extrapolate 

out from those benchmarks on the basis of incomplete information and assumptions about the proportion of checks going through the various 

channels. Such benchmarks were available as a 

result of surveys undertaken by the Federal 

Reserve System in 1979 and 1995. On the basis 

of those surveys and other fragmentary information, it appears that the number of checks 

processed in the United States was overestimated 

for a number of years. It is instructive to examine 

the report of the Committee on Payment and 

Settlement Systems on the payment systems of 

selected countries. The report is an annual publication with data for a number of wealthy nations, 

prepared in a similar format for purposes of comparative analysis. As late as 2001, when data for 

1999 were reported, it was believed (primarily on 

the basis of extrapolations from the 1995 benchmark) that there were over 67 billion checks 

processed in the United States. However, as a 

result of a substantial survey undertaken by the 

Federal Reserve, it was determined that in the 

year 2000 there were only 42.5 billion checks 

written in the United States.17 In a prescient 

article, Humphrey, Pulley, and Vesala forecast 

that the number of checks written would peak in 

1997.18 It is estimated that in 2001, the number 

declined once again to 40.2 billion checks 

(CPSS, 2002). It had generally been believed 

that check growth had been positive but smaller 

than the growth in alternative electronic payments, resulting in a reduction in the check share 

of noncash payment instruments in the United 

States.19 The latest developments suggest that 

the share of electronic payments has increased 

faster than was originally believed. Further evidence of the decline in checks written arose 

recently, when the Federal Reserve indicated that 

the number of checks processed during 2003 had 

declined at a faster rate than had been forecast. 

Because the Federal Reserve must recover all its 

costs in supplying processing services, it 

announced that it was raising its charges to banks, 

reducing the credits to banks for clearing balances 

maintained at the Federal Reserve, and changing 

the method of calculating imputed income from 

investing the clearing balances. At the same 

time, it announced a reduction in charges for processing electronic automated clearing house 

(ACH) payments.20 This raising of prices for 

processing paper and lowering of prices for processing electronic transactions should reinforce 

the trends already in place. 

However, it should be noted that, notwithstanding the unexpected change in the volume of 

checks processed, the United States is still relatively more dependent on checks than its counterparts. In 2001, the United States wrote 144.6 

checks per capita, more than twice as many as the 

next-highest user of checks—France, with 71.2 

checks per capita. Countries in Continental 

Europe, except France, have virtually eliminated 

checks: Belgium, Germany, Italy, the Netherlands, Sweden, and Switzerland all had 10 or 

fewer checks per capita in 2001. In Sweden, 

there was 0.2 check per capita written in the year 

2001 (CPSS [2002]). 

The latest developments for the check system in 

the United States are related to what might be 

called the “electronification” of checks. There 

are two such strands of this process; one is underway already and the other will probably be available in the near future. First, the ACH system 

has developed three new applications that use the 

check as a device to trigger a debit transfer on the 

17 See Gerdes and Walton (2002). 

18 Their projections were based on data available up to 1996, even though 

the publication date of the article is 2000. 

19 One casualty of this decline is the Federal Reserve System itself, which 

announced in February 2003 that it was consolidating its check-processing 

operations, eliminating this activity from 13 offices and reducing staff by a 

projected net of 400 employees. See Federal Reserve Bank of Boston 

(2003). 

20 See Board of Governors of the Federal Reserve System (2003a, 2003b). 

2004, VOLUME 16, NO. 2 72 FDIC BANKING REVIEW 
 

Effect on U.S. Banking of Payment System Changes 

ACH system. In one of these applications, the 

point-of-purchase (POP) application, a merchant 

receives a check in payment for goods or services. 

Instead of depositing the check in the familiar 

process, the merchant uses a terminal to scan the 

information on the bottom of the check (the 

“MICR” line) and the amount of the sale. The 

merchant then returns the check to the customer 

with the word “void” printed on it and informs 

the customer that the check amounts to authorization for the merchant to initiate a debit transfer 

transaction through the ACH network. There is 

also a legal transformation in which the check is 

no longer a negotiable instrument governed by 

the UCC and Federal Reserve regulations pertaining to checks, but is instead a “source document” for an electronic transaction that is subject 

to the Federal Reserve’s Regulation E (a regulation promulgated as a result of the Electronic 

Fund Transfer Act of 1978). In a similar move 

(the second ACH application), the ACH system 

developed the accounts-receivable check (ARC), 

which is designed to transform checks to “source 

documents” as consumers mail checks to lockboxes in payment of routine bills. That is, the customer is notified that the check is an authorizing 

device allowing the payee to initiate a debit 

transfer transaction through the ACH system. 

Again, the legal status of the check changes, and 

the operative legal and regulatory environment 

changes from UCC/Federal Reserve check rules 

to Electronic Fund Transfer Act/Regulation E 

electronic transaction rules. The ARC application is available only for consumer payments at 

the present time. In the past year, from the third 

quarter of 2002 to the third quarter of 2003, the 

number of transactions in each category (ARC 

and POP) grew substantially. For the ARC transaction, there were 5.3 million transactions in the 

third quarter of 2002, which grew to 43.7 million 

in the third quarter of 2003. In the same period, 

the POP application grew from 28.7 million to 

38.4 million. Another area for check electronification is in returning checks (RCK) via the ACH 

system (the third ACH application). That is, 

when a customer pays with a check, he or she is 

notified that should the check be returned for 

insufficient funds, the payee will initiate a debit 

transfer through the ACH system to collect the 

amount. In this case, the paper process has failed, 

and the payee has access to faster and cheaper 

collection the second time around. This application has increased from 4.8 million transactions 

in the third quarter of 2002 to 5.8 million transactions in the third quarter of 2003. Hence, the 

ACH system has evolved to transform and 

process several new types of application, all 

designed to replace the paper movement of physical checks with electronic collection.21 

The final step in electronification of checks—the 

second of the two strands referred to above—is 

underway at the present time. Instead of piecemeal ACH applications for point of sale or routine consumer bill payments, this step involves a 

complete transformation of the processing of 

paper. This is called the Check Truncation Act 

of 2003, which the president signed on October 

28, 2003. The Expedited Funds Availability Act 

of 1987 had given the Federal Reserve the task of 

making recommendations to improve the payments system—in effect, superseding the UCC— 

and the Federal Reserve System proposed the 

check truncation legislation.22 What is envisioned here is the “truncation” of checks early in 

the process of physical transportation. At that 

step, a digital image of the check will move electronically through the process. This will eliminate the physical transportation of checks and 

allow the images to be retrieved as needed by customers to show evidence of having made payment.23 It is too early to know exactly how this 

development will affect the number of checks 

processed and the channels through which the 

images of checks will pass on the way to collection. 

It is interesting to compare this development with 

some of those in the European Union (EU). The 

EU has moved to a single banking market and a 

21 See NACHA—The Electronic Payments Association (2003).
 

22 See Check 21 Act, Public Law 108-100, October 28, 2003.
 

23 Many banks and thrift institutions have already truncated checks by not
 

returning them to customers. This act will stop the movement of paper earlier in the process. Moreover, for many years, credit union legislation and
 

regulation have made truncation of credit union share drafts mandatory.
 

FDIC BANKING REVIEW 73 2004, VOLUME 16, NO. 2 
The Future of Banking 

single currency.24 While the large-value payment 

system in Euros is connected seamlessly throughout the EU, this was not the case for cross-border 

retail payments. However, the EU and the European Central Bank (ECB) reasoned that the benefits of a single, integrated, competitive banking 

market could not be achieved without an efficient 

retail payment system in which cross-border payments would be made with the same speed and 

fees as domestic payments. The EU and ECB 

encouraged the banks to develop such a system. 

Since developments did not proceed as rapidly as 

the EU and ECB wanted, the EU enacted legislation requiring the banking industry to process 

cross-border payments under the same terms as 

domestic payments. The industry responded by 

setting up a Single European Payments Area concept that is similar to an ACH connecting the 

domestic payment systems in all the member 

nations.25 What is interesting is that the 

EU/ECB focus is on credit transfers in the EU, 

rather than debit transfers, or checks. It appears 

that the EU, in its efforts to complete the single 

market in banking, considers the benefits of the 

credit transfer to be sufficient and therefore 

encourages these transfers while ignoring the 

debit transfer.26 

The Automated Clearing House 

(ACH) System 

The ACH system is a batch-processing electronic 

payment system for small-value payments. Unlike 

the large-value payment systems (Fedwire and 

CHIPS), which process only credit transfers, the 

ACH system processes both credit and debit 

transfer payments. Financial institutions belong 

to one of 29 regional associations and participate 

in the ACH system as either originating depository financial institutions (ODFI) or receiving 

depository financial institutions (RDFI) or both. 

Originators and receivers are customers, and, as 

indicated, the transactions can be either credit or 

debit transfers. The originator prepares a file of 

transfers, delivers it to the ODFI, and the ODFI 

delivers the data to the ACH operator, who then 

transmits the information to the RDFI, who 

either credits or debits the account of the receiver, depending on the nature of the transfer. 

There is a national association of depository 

financial institution members, the National Automated Clearing House Association (NACHA), 

which determines all the rules and regulations 

that govern the network. 

There are a number of laws that provide the legal 

and regulatory framework for the ACH system. 

For corporate transactions, the UCC is the operative law. The Check Truncation Act of 2003 has 

implications for the ACH system as well. For 

consumer transactions, the Electronic Fund 

Transfer Act of 1978 is the operative law, and 

Federal Reserve Regulation E is the operative regulation. In addition, the federal government’s 

role in electronic payments is governed by federal 

law, specifically 31 C.F.R. 31, Part 210. According to the provisions of the EFT Expansion 

Act/Debt Collection Improvement Act of 1996, 

the U.S. government has committed itself to 

using electronic payments for all payments to 

employees, vendors, and recipients of benefits. 

Moreover, federal tax collections are migrating to 

electronic form as well. Most states are following 

the lead of the federal government in this area. 

According to NACHA, in December 2002 almost 

19,500 depository financial institutions participated in the ACH system as RFDIs, while approximately 8,000 participated as OFDIs.27 

From 1992 to 2002, the volume of ACH transactions increased at a double-digit percentage-rate 

change each year, going from 2.2 billion transactions in 1992 to over 8.9 billion transactions in 

2002, a compound annual rate of growth of over 

13.5 percent. In contrast, the number of checks 

actually declined over the same period. In the 

early days of the ACH, a large proportion of the 

volume was attributable to government payments. 

In 1992, government transactions were 24 per24 For a discussion of this, see Murphy (2000).
 

25 See European Central Bank (2003).
 

26 Humphrey, Pulley, and Vesala (2000) note that the European credit transfer systems have been much more amenable to technological change than
 

the check (debit transfer) system in the United States.
 

27 See NACHA (2003).
 

2004, VOLUME 16, NO. 2 74 FDIC BANKING REVIEW 
Effect on U.S. Banking of Payment System Changes 

cent of the total, while in 2002 this declined to 

less than 10 percent. It is reported that 98 percent of federal employees use direct deposit of 

payroll, while 80 percent of all Social Security 

recipients use direct deposit of benefits. As noted 

above, electronic payment to vendors is virtually 

mandatory. Thus, the government is not likely to 

be a future source of major growth in volume. 

One change in the types of applications for the 

ACH system is the movement to nonrecurring 

transactions. In the past, the ACH system developed applications for recurring payments, such as 

direct deposit of payroll and benefits, and for 

recurring debits for the same amount for payments such as mortgages, installment loans, insurance payments, and other such payments. On the 

corporate side, direct payment of vendors, payment of taxes, and corporate concentration of 

funds from a number of banks were all recurring 

repetitive transactions. Once a payment is 

arranged, it is repeated without the need for frequent authorizations and other arrangements. In 

recent years, the ACH community has turned its 

attention to transactions initiated by consumers. 

These include the point-of-purchase (POP) application discussed above, payments authorized over 

the telephone (TEL), and payments initiated over 

the Internet (WEB). These are all transactions 

that require a separate process each time a transaction is initiated. For many traditional applications, such as direct deposit, the consumer enters 

into an agreement one time, and the process is 

opaque to him or her. All that these consumers 

know (when there are no problems) is that balances appear in their accounts at certain times or 

that certain amounts are deducted at certain 

times. The consumers themselves are passive. In 

the newer applications, the initiator is an active 

participant. Since these are new applications, the 

growth rate for them is very high, starting from a 

very low base. 

Automatic Teller Machines (ATMs) and 

Payments by Debit Cards 

One of the first electronic banking applications 

was the implementation of the ATM. It is 

arguable as to whether this is really a payment 

system in the sense of the other systems discussed 

here. That is, the vast majority of transactions 

are cash withdrawals in which the customer and 

the bank interact, but there is no third or fourth 

party to the transaction, and at the outset of the 

development of this application there was no network. However, this application does allow the 

customer access to cash, which is a payment alternative, and in that sense the banking system is 

allowing the customer to have efficient access to 

using cash to make payments. Also, use of the 

ATM allows the customer to economize on the 

use of currency, and evidence indicates that customers therefore hold higher deposit balances 

than otherwise would be the case.28 

In the early days of the implementation of ATM 

programs, there were questions as to whether 

these would be considered branch offices and 

hence be regulated by the McFadden Act and the 

various state branching laws. If they were, the 

deployment of this new application could be limited. However, in 1985 the U.S. Supreme Court 

upheld a circuit court ruling that an ATM was 

not a branch. As a result of this ruling and the 

popularity of the ATM with customers, especially 

upscale consumers, the number of ATMs 

increased dramatically.29 As the deployment of 

ATMs continued, some banks started networks 

that allowed customers of other banks to access 

their accounts. This required someone, usually a 

large bank at the outset, to operate a “switch” 

that would route transactions among the various 

banks participating in the network. The basic 

idea was to enhance customer convenience by 

expanding the locations at which access was 

available. In addition, networks allowed banks to 

take advantage of scale economies in processing 

by increasing the potential number of transactions per machine. Over time these networks 

expanded and merged. This trend has resulted in 

several large regional networks, a few national 

networks, and a group of smaller networks. The 

28 See Daniels and Murphy (1994a, 1994b).
 

29 For a discussion of the contemporaneous demographic pattern of adoption
 

of ATMs, see Murphy and Rogers (1986).
 

FDIC BANKING REVIEW 75 2004, VOLUME 16, NO. 2 
The Future of Banking 

number of networks peaked at approximately 130 

in the mid-1980s; now fewer 40 are operating. 

Moreover, transaction volume is concentrated in 

a small number of large networks. In 1985, the 

top three networks processed 11 percent of the 

transaction volume; in 2002 that percentage 

exceeded 100 percent (some transactions are 

counted more than once, since they may travel 

over several networks). As these networks 

expanded, they negotiated reciprocity agreements 

with other networks, effectively expanding the 

reach of any single customer’s ATM card. In 

addition, national networks can and do serve as 

bridges between regional networks. Most ATMs 

(over 98 percent) are part of shared networks, and 

as a result of both reciprocity and bridging they 

are national (or international, in the case of the 

Visa and MasterCard networks).30 The ownership structure of the networks has changed dramatically also, with an increase in the number 

and share of networks owned by nonbanks. This 

shift has occurred as the number of networks 

owned by joint ventures of banks has declined. 

As a result of almost 25 years of development, the 

ATM application is the most mature of electronic 

banking services. There are presently over 

350,000 ATMs deployed in the United States. 

The proportion of off-premise ATMs has 

increased dramatically as banking offices that are 

candidates for on-premise ATMs have been saturated. Also, as the cost of machines has declined 

over the years, the break-even volume necessary 

to justify the investment cost has declined. 

Hence, the number of transactions has steadily 

increased while the number of transactions per 

machine peaked in the early 1990s and has 

steadily declined since then. 

As the ATM networks expanded, it became 

apparent that they could be used for other transactions as well. Thus, the ATM networks 

evolved into the point-of-sale (POS) networks 

accessed by debit cards. Customers became familiar with the process of accessing their accounts 

with a plastic card through the ATM, and the use 

of the same cards and networks at the point of 

sale evolved naturally. The customer would 

access the network with a plastic card in a manner similar to the ATM, would identify himself or 

herself with a personal identification number 

(PIN), and funds could be deducted from the customer’s account. The only difference is that the 

funds were not made available in the form of cash 

but instead were transferred to the account of a 

merchant who decided to accept the debit card as 

a way for the customer to pay for goods and services. Of course, with virtual universal network 

coverage through reciprocity and bridging, it was 

possible for the customer to make payment online at the point of sale easily. 

Debit card transactions have been growing rapidly. In 1979, they were virtually nonexistent, 

whereas in 2000, 8.3 billion such transactions 

were recorded. When compared with generalpurpose credit cards, a much more mature product, the relative growth is striking. In 1995, there 

were 1.4 billion debit card transactions and 7.8 

billion general-purpose credit card transactions, 

whereas in 2000 the comparable numbers were 

8.3 billion and 12.3 billion. In 2000, debit cards 

accounted for 11.6 percent of all retail noncash 

payments, up from 2.2 percent in 1995. From 

1995 to 2000, debit card transactions grew at the 

fastest rate of all types of retail noncash payments 

(a 41.8 percent annual rate, compared with a 2.2 

percent growth rate for all payments).31 

Within the debit card industry, there are two 

types of transactions. One is an on-line transaction activated by a PIN at the point of sale, with 

immediate debiting of the customer’s account and 

crediting of the merchant’s account. All this 

information travels over the same networks as the 

ATM transactions, and there are fees involved for 

the merchant, who is charged on a fee-per-transaction basis. There are also point-of-sale transactions that are known as off-line, signature-based 

transactions. In this case, the information flows 

over the credit card networks managed by Visa or 

MasterCard. In the on-line transaction, there is a 

30 For a thorough discussion of the ATM/debit card network industry, see
 

Hayashi, Sullivan, and Weiner (2003).
 

31 See Gerdes and Walton (2003).
 

2004, VOLUME 16, NO. 2 76 FDIC BANKING REVIEW 
Effect on U.S. Banking of Payment System Changes 

PIN to identify the cardholder, whereas in the offline transaction the merchant is responsible for 

verifying the identity of the cardholder. In the 

off-line transaction there is also a delay in transferring the funds, and, most importantly, there is a 

difference in the fee structure. The merchant is 

charged a fee based on the size of the transaction, 

and the fees to the bank are generally larger in 

that case. For that reason, the banks have discouraged the use of on-line debit transactions in 

favor of the off-line debit card. Merchants have 

opposed this. In 2003, a major court case involving Wal-Mart and Visa and MasterCard was settled. In that case, the retailers opposed the 

“honor-all-cards” rule that required any merchant 

accepting either Visa or MasterCard credit cards 

to honor all their cards, including the off-line 

debit cards. Wal-Mart wished to honor the credit 

cards but not the off-line debit cards. The settlement—that merchants no longer have to honor 

all cards—will probably affect the structure of fees 

over all of the varying debit card networks and 

move volume to the PIN-based transactions. 

Credit Cards 

Credit cards are the most mature electronic payments product. Although individual retailers had 

issued cards to their customers for many years, the 

general-purpose credit card dates back to Diners 

Club in 1950.32 At that time, as the name indicates, the basic idea was to have a credit card 

accepted by a number of restaurants in Manhattan, and customers would have to carry only a 

single card to be able to dine. It was assumed 

that businessmen who customarily had business 

lunches and dinners would find this appealing 

and that those restaurants that sought to attract 

their business would also find it appealing. This 

resulted in the Diners Club program. During the 

1950s, a number of banks tried to introduce bank 

credit cards without much success. Not until 

1958 did American Express, Carte Blanche, 

Chase Manhattan Bank, and Bank of America 

enter the field. In 1962, Chase Manhattan left 

the business and American Express reportedly 

considered giving up its travel and entertainment 

card. Not until 1966 did Bank of America establish a franchise operation for its card, then known 

as BankAmericard. Thus, a franchisee bank 

could issue a credit card that could be used 

nationally (and eventually internationally). 

BankAmerica Service Corporation also established a network that allowed payments between 

banks dealing with merchants and banks issuing 

the cards to consumers. This was quickly followed by a consortium of banks that established 

the Interbank Card Association, which established another network and bank card eventually 

known as MasterCard.33 In 1970, Bank of America spun off BankAmerica Service Corporation to 

a (bank) member-based organization that eventually became Visa USA. Thus, both MasterCard 

and Visa USA basically offer a franchise to their 

members and manage the interchange system, 

establishing the pricing of interchange services 

and the rules and regulations governing these 

operations. There was a shaky start that saw huge 

losses due to large-scale unsolicited issuance of 

cards in the late 1960s (a practice that is now 

illegal); there was also a time when rampant inflation and high interest rates made the bank credit 

card business unprofitable. However, the acceptance of bank credit cards at the point of sale 

(which now includes a personal computer 

attached to the Internet) became so widespread 

that it is difficult to imagine that this oldest of 

the widely used electronic payment systems is less 

than 50 years old. 

The legal and regulatory environment for the 

bank credit card industry includes state law 

(mainly usury laws), federal consumer credit law, 

and the outcome of court cases. The maximum 

rate that a lender can charge for consumer credit 

is established on a state-by-state basis. This 

became a difficult problem for the industry when 

interest rates were very high, and in some states 

legal maxima were less than banks’ cost of funds. 

In a landmark court decision in 1978, the U.S. 

Supreme Court ruled that the lender’s location 

determined the operative state usury ceiling no 

matter where the customer may live, even if the 

32 See Mandell and Murphy (1976) and Mandell (1990). 

33 See Evans and Schmalensee (1999). 

FDIC BANKING REVIEW 77 2004, VOLUME 16, NO. 2 
The Future of Banking 

state in which the customer lived had a lower 

usury ceiling. This gave incentive to large card 

issuers to find a lender-friendly state in which to 

establish national operations. Several states, 

especially South Dakota and Delaware, aggressively solicited such bank card operations. In the 

1970s, Congress enacted a number of consumer 

credit protection laws, at least partly as a response 

to the marketing and other practices of the bank 

credit card industry. These laws include the 

Truth-in-Lending Act of 1968, the Fair Credit 

Billing Act of 1974, the Equal Credit Opportunity Act of 1974, the Fair Credit Reporting Act of 

1971, the Fair Debt Collection Practices Act of 

1977, and the Electronic Fund Transfer Act of 

1978. In addition, federal bankruptcy law affects 

bank credit card operations. 

There are now over 1.2 billion credit cards in the 

United States. Of these, 551.9 million are issued 

directly by retailers; the rest are bank credit cards 

or travel and entertainment cards. The number 

of transactions grew from 12.9 billion in 1997 to 

17 billion in 2001, an annual growth rate of 5.78 

percent. The proportion of retailer card transactions for 2001 was 11 percent of the total, down 

from 15 percent in 1997. The number of merchant locations at which these cards may be used 

is over 13 million. 

Summary of Recent Developments in 

Payment Systems in the United States 

In the past 25 years, the nature of the payments 

system in the United States has changed. In part 

the change has been dramatic; in part it has been 

slow. The different payment systems reflect the 

development of competing networks with a variety of legal and regulatory environments. The 

only common theme is that payments are routed 

through an interbank system. There are also a 

variety of owners and operators of the networks, 

including public bodies for checks and the ACH 

(the Federal Reserve System), national membership organizations for open networks of generalpurpose bank credit cards (Visa and MasterCard), 

closed networks for some general-purpose credit 

cards (American Express and Discover), and proprietary (both bank and nonbank) organizations 

for ATM and PIN-based on-line debit card networks. In general, the ACH and the debit card 

transactions have witnessed the greatest growth, 

whereas credit card transaction growth has been 

modest and payments by check have actually 

declined. In table 1, the number of transactions 

for the various categories are shown for 1979, 

1995, and 2000, the years for which accurate data 

are available. 

Table 1 

The Use of Checks Has Declined While the 

Use of Retail Electronic Payments Has Increased 

Type of Payment 1979 1995 2000 

Number (billions) 

Check 32.8 49.5 42.5 

Retail Electronic Payments 5.5 14.7 28.9 

Debit Card 0.0 1.4 8.3 

Credit Card 

General Purpose 1.5 7.8 12.3 

Private Label 3.8 2.6 2.7 

Retail ACH 0.2 2.8 5.6 

Source: George R. Gerdes and Jack K. Walton II, The Use of Checks and Other 

Noncash Payment Instruments in the United States, Federal Reserve Bulletin 88, 

no.8 (August 2002), 361. 

Users of Electronic Banking 

Who uses electronic banking? The answer is 

households, governments, and businesses. 

Households 

A number of studies have examined the determinants of household use of payment services. It 

was found that the adoption process for new electronic banking services followed a predictable 

pattern, one in which demographic factors including income, wealth, education, and position in 

the life cycle (age) were systematically associated 

with the adoption of new payment products and 

services. In an early contribution, Mandell found 

that credit card use was positively associated with 

2004, VOLUME 16, NO. 2 78 FDIC BANKING REVIEW 
Effect on U.S. Banking of Payment System Changes 

income, wealth, education, and age.34 In the 

1980s, a study by Murphy and Rogers and two 

studies by Daniels and Murphy found similar patterns for the adoption of banking and payment 

products and services.35 More recent studies 

found that the patterns remain the same, but the 

trend is toward greater use by all demographic 

groups. Kenickell and Kwast examined the data 

in the 1995 Survey of Consumer Finances and 

found that higher income and financial assets, 

and more years of education were all positively 

correlated with use of electronic banking services. 

Age is more complex because older households 

are less likely to use electronic banking, all other 

factors held constant, for almost all electronic 

banking services except direct deposit—a correlation reflecting the very high acceptance of direct 

deposit by Social Security recipients.36 Stavins 

analyzed the data from the 1998 Survey of Consumer Finances with similar results.37 Using the 

most recent Survey of Consumer Finances (2001), 

Mester showed that over 88 percent of households use some form of electronic payment instrument (ATM, debit card, direct deposit, automatic 

bill paying, or “smart card”). This is an increase 

from 76.5 percent. From 1995 to 2001, debit card 

use rose from 17.6 percent to 47 percent of households, direct deposit rose from 46.8 percent to 

67.3 percent, and automatic bill paying rose from 

21.8 percent to 40.3 percent. The most mature of 

applications, the ATM, rose from 61.2 percent to 

69.8 percent. In Mester’s findings all the previously determined relationships between use and 

demographics remained, but the penetration had 

increased substantially, as reflected in the data on 

the dramatic increase in debit card transactions 

and the reduction in the number of checks written.38 

Governments and Businesses 

As indicated above, in the United States all levels of government have actively pursued the use 

of electronic banking in making and receiving 

payments, including payments to employees, benefit recipients, and vendors. This has been largely 

successful, and the number of checks written by 

all levels of government has declined. As noted 

above, government payments through the ACH 

system have increased modestly in recent years, 

indicating that for government this process is 

largely complete. 

The business sector receives payments from 

households in various ways. Households pay businesses at the point of sale by cash, check, or debit 

or credit card. They pay businesses mostly by 

check in response to invoices through the mail. 

Businesses pay each other usually by check or 

through the ACH, and increasingly businesses 

pay taxes through the ACH as well. There are no 

business databases comparable to the Federal 

Reserve’s Survey of Consumer Finances. Hence, 

one has to seek indirect evidence from numerous 

sources to determine business use of electronic 

banking. First, it is clear that retail businesses 

find it necessary to accept debit or credit cards at 

the point of sale. Casual inspection of retail sites 

combined with a reported total of point-of-sale 

terminals in excess of 13 million in the United 

States is sufficient to indicate that businesses find 

it either convenient and low cost, or a business 

necessity, to accept POS electronic payments.39 

The concept of point of sale has been expanded 

to include the telephone and the Internet, and 

the credit or debit card is the payment instrument 

of choice here. 

NACHA publishes data about the types of transactions processed through the ACH system. It is 

possible to make reasonable assumptions about 

the source and destination of many of these transactions and their use by businesses and governments. First, all direct deposits are considered 

business or government payments to households. 

This is one of the largest applications on the 

ACH system, with over 3.8 billion transactions in 

2002. As indicated in the 2001 Survey of Consumer Finance and reported by Mester (2003), 

34 See Mandell (1970).
 

35 See Murphy and Rogers (1986) and Daniels and Murphy (1994a, 1994b).
 

36 See Kennickell and Kwast (1997).
 

37 See Stavins (2001).
 

38 See Mester (2003).
 

39 It should be noted that the United States ranks high in per capita deployment of EFTPOS (electronic fund transfer point-of-sale) terminals in comparison with other developed countries. See CPSS (2003).
 

FDIC BANKING REVIEW 79 2004, VOLUME 16, NO. 2 
The Future of Banking 

the direct deposit of payroll, Social Security, and 

other benefits, as well as pension and dividend 

payments, has been very popular with consumers. 

As a result its growth from 2001 to 2002 was only 

4.7 percent, smaller than the double-digit-percentage increases in most other electronic transactions. Direct debits through the ACH 

involving recurring payments from consumers to 

businesses were over 2.8 billion in 2002, a 10.08 

percent increase from 2001. These two applications—direct deposits and direct debits—usually 

represent recurring transactions. 

Some of the other new ACH applications involve 

businesses in transactions that are not recurring. 

First, there is the point-of-purchase application in 

which a consumer check is transformed from a 

negotiable instrument to a source document. 

This involves a consumer-to-business transaction 

at the point of sale and is a direct substitute for 

either a debit or a credit card transaction. Other 

nonrecurring payment transactions from consumers to businesses include Internet and telephone-initiated transactions. Finally, a recent 

addition to the consumer-to-business electronic 

transaction menu is the accounts-receivable 

application, in which a check mailed to a lockbox 

is transformed at that point to a source document 

that is processed through the ACH system. All 

these applications have grown at very high rates. 

Finally, within the ACH system there are various 

business-to-business transactions. These include 

trade payments as well as intracorporate payments 

designed to aggregate cash balances from a number of banks into a single account that can be 

used to efficiently make payments and invest surplus funds. These have grown at double-digit 

rates in recent years, in excess of 12 percent from 

2001 to 2002.40 

Another way to gain some insight into business 

use of electronic banking is to examine the findings of a number of surveys of corporate use of 

cash management services. For example, in 2002 

Phoenix-Hecht conducted its annual Cash Management Monitor and received responses from 

1,665 corporations with annual sales in excess of 

$100 million. One of the many findings of the 

survey was that over 97 percent of large corporations and 92 percent of upper-middle-size corporations already used the ACH extensively. Indeed, 

Phoenix-Hecht sees little opportunity for expanded ACH volume in any application except consumer-authorized debits. Another interesting 

finding is the use of sweep accounts by over 75 

percent of all reporting corporations. Sweep 

accounts allow daily movement of funds from 

demand deposit accounts into an overnight repurchase agreement or money market mutual fund. 

This is important for corporate use of electronic 

payment services. That is, corporations move 

funds out of demand deposit accounts where 

explicit payment of interest is prohibited. In this 

case, banks do not offer any earnings credit to offset fees, and therefore corporations have incentives to adopt the lowest-cost payment services.41 

Moreover, respondents indicated that imaging 

technology and Internet applications were important areas being considered.42 Phoenix-Hecht 

also conducts a Middle Market Monitor for companies with annual sales between $40 million and 

$100 million. In 2003, 1,260 companies responded. Over 86 percent of these companies used the 

ACH, and many respondents indicated that initiating transactions over the Internet is one of the 

more important technology applications. Middlesize companies also used sweep products as well. 

In summarizing the results of the middle-market 

company survey, Phoenix-Hecht indicated that 

“although middle market companies typically use 

fewer cash management products than large companies, as a group the middle market usage ‘profile’ is becoming more like that of the larger 

companies.”43 In a similar survey, Treasury 

Strategies, Inc., asked 131 large corporations (less 

than $1 billion to $25 billion in annual revenues) 

many questions about their treasury activities. 

While there were no specific questions on the use 

of particular payment services, there was substantial emphasis among respondents on streamlining 

operations, lowering costs, and aggressively using 

40 See NACHA (2003).
 

41 For a discussion of the use of sweep accounts in cash management, see
 

Cook, Murphy, and Silverberg (2000).
 

42 See Phoenix-Hecht (2002).
 

43 See Phoenix-Hecht (2003), 2.
 

2004, VOLUME 16, NO. 2 80 FDIC BANKING REVIEW 
 

Effect on U.S. Banking of Payment System Changes 

technology to do so. Over 65 percent of all 

respondents used treasury work stations, a process 

that implies intensive management of all aspects 

of treasury operations, including adoption of leastcost methods of making payments.44 

While businesses, especially large and middlemarket businesses, are aggressively using electronic payment methods, they are still involved in 

paper transactions. In a recent Federal Reserve 

study, it was estimated that consumers were the 

largest sector that wrote checks (50.9 percent of 

all checks written), and most of them (almost 2/3 

of all checks written) were sent to businesses.45 

Businesses were the second largest writer of 

checks (32.3 percent of the total), mostly to consumers and other businesses. It would appear that 

the best candidates for further business adoption 

of electronic payment products would be check 

conversion or check truncation at the point at 

which checks are remitted to businesses, in many 

cases a lockbox. Also, there is room for expansion of electronic services to business-to-business 

payments. A recent study by the Association for 

Financial Professionals indicates that while most 

respondents used the ACH for payroll disbursements and cash concentration, payments to other 

businesses was limited by a number of factors, the 

most important of which was internal lack of 

integration of payments and accounting system 

technology.46 

Check Writing and Electronic Banking: 

An International Perspective 

When the United States is compared with 13 

other advanced industrial nations in 2001, an 

interesting pattern emerges. When measures of 

electronic banking are considered, the United 

States has a very high usage factor. For example, 

the United States has a large number of ATMs 

compared with its population. The average for 

the 13 countries is 875 ATMs per million inhabitants, while in the United States there are 1,137 

ATMs per million. The United States has more 

than the average number of POS terminals that 

accept debit cards per inhabitant, more than the 

average number of debit card transactions per 

inhabitant, more than the average number of 

POS terminals that accept credit cards per inhabitant, and more than the average number of credit 

card transactions per inhabitant. The same is 

true for number of cards (debit or credit) issued 

and held by inhabitants. However, the United 

States is still an outlier when it comes to check 

writing. In 2001, there were 144.6 checks per 

inhabitant written in the United States, more 

than twice as many as in France, the next-highest 

user of checks. The United States uses many 

fewer credit transfers as would be expected for a 

country that has been dominated by checks for so 

many years. The combination of high ATM use, 

high card use at the point of sale, and the large 

number of checks written indicates that the number of cashless payment transactions per inhabitant in the United States is much larger than in 

all other countries in this sample. There are 

270.3 cashless payment instruments used per 

inhabitant in the United States and more than 

201.1 cashless payment instruments used per 

inhabitant in France, the next highest.47 Hence, 

the key to adopting a higher proportion of low 

cost transactions in the United States lies with 

reducing the number of checks written, since the 

adoption of most electronic payments has been 

successful, whether one examines trends or international comparisons.48 

Pricing Payment Services and Products 

In the United States, there is a historical link 

between the regulatory environment and the 

nature of pricing for payment services, especially 

checks. For many years, banks were prohibited 

from paying interest to demand deposit customers, 

and there was a ceiling on what could be paid to 

customers with savings accounts or certificates of 

deposit. As interest rates in general rose in the 

post–World War II period, incentives were creat44 See Treasury Strategies, Inc. (2003).
 

45 See Federal Reserve System (2002).
 

46 See Association for Financial Professionals (2002).
 

47 See CPSS (2003).
 

48 A classic review of how payment systems operate in Europe, Japan, and
 

the United States can be found in Humphrey, Sato, Tsurumi, and Vesala
 

(1996).
 

FDIC BANKING REVIEW 81 2004, VOLUME 16, NO. 2 
The Future of Banking 

ed for banks to pay implicit interest on deposits in 

the form of reduced fees on checking (perhaps all 

the way to no service charge), increased convenience through the construction of branch offices 

in many locations, and other means of convincing 

customers to keep funds on deposit when explicit 

interest payments to these customers were either 

zero or below market. This led to a situation of 

cross-subsidies in general and overuse of checks in 

particular. Customers with high balances and 

fewer checks written were cross-subsidizing those 

with low balances and many checks written. 

There were few if any incentives to limit check 

writing.49 At the same time, credit card pricing 

had created cross-subsidies as well. Credit card 

customers generate revenues for card-issuing 

banks in three ways: first, they pay interest on 

unpaid balances; second, they may pay an annual 

fee; and third, their transactions generate interchange revenue. Since interest is not charged to 

many customers who do not carry unpaid balances at the end of the billing cycle, these customers do not pay directly for the costs they 

generate by their credit card activity. In addition, 

at the point of sale the customer is not charged a 

different price for the goods or services depending 

on whether he or she chooses a low- or high-cost 

method of payment. Since the merchant pays a 

fee to the bank (the merchant discount) that is 

based on the size of the transaction and the customer does not benefit from using the low-cost 

transaction, the bank has an incentive to have a 

card transaction migrate to the bank credit card 

or the off-line debit card because the merchant 

discount paid to the bank is higher. Hence, there 

is no explicit pricing incentive for the customer 

to choose the lowest-cost method of making payment.50 

Although the regulation limiting interest payments on deposits was removed in 1980, there is 

still a perceived preference on the part of consumers for pricing arrangements that do not 

involve per-item charges for checks written.51 In 

the Federal Reserve payments project in 2002, it 

was noted that the number of checks written per 

household has increased over time, while the government and the business sector have made more 

progress in replacing checks with electronic payments.52 There is indirect evidence that pricing 

has an effect on decision making by business 

about checks versus electronic payments. First, 

most large and middle-size corporations actively 

manage their cash, and they invest all deposits on 

a daily (overnight) basis, usually through sweep 

arrangements. This may be construed as a market-based innovation to avoid the impact of the 

prohibition of interest payments on business 

demand deposits. Since banks must pay a competitive rate on these balances, they must charge 

fees that cover their costs of providing transaction 

services to these business customers. The 

Phoenix-Hecht and Treasury Strategies, Inc., surveys discussed above support the use of these cash 

management tools. In addition, Phoenix-Hecht 

conducts and publishes surveys on the prices of 

specific transaction services,53 and the surveys of 

corporate cash management practices indicate 

that annual reviews (including of pricing) are 

common. Moreover, the corporate cash management community has worked to standardize formats for categories of services and procedures for 

designing requests for proposals (RFPs) for banks 

offering cash management services.54 As indicated above, in their use of electronic banking services, middle-market corporations resemble larger 

corporations as banks refine their offerings and 

saturate the large corporate market. This migration process to smaller firms will increase the use 

of electronic banking for smaller corporations in 

the future. 

If we accept that pricing incentives have caused 

businesses and governments to economize on 

high-cost methods of payment, is there any evi49 The link between pricing, regulation, and electronic funds transfer is discussed in Murphy (1977). 

50 It should be noted that the total cost of making the transaction is important to the payer, including postal costs if the mails are involved as well as 

the time and transportation costs involved in making the transaction. The 

switch to electronic payments by consumers may reflect changes in the total 

cost even though the explicit transaction costs are not charged directly to 

them. 

51 The Federal Reserve conducts an annual survey of retail fees of depository institutions. For a summary of the findings of these surveys, see Hannan 

(2002). See also Stavins (1999). 

52 See Gerdes and Walton (2002). 

53 See Phoenix-Hecht (2003). 

54 See Association for Financial Professionals (2003, 2003). 

2004, VOLUME 16, NO. 2 82 FDIC BANKING REVIEW 
Effect on U.S. Banking of Payment System Changes 

dence that this would happen on the consumer 

side if explicit pricing were somehow introduced? 

There is very limited evidence, in those instances 

in which per-item pricing is observed for consumers in the United States, that it has the 

expected effect on check writing.55 However, the 

most rigorous, thorough econometric examination 

of the effect of pricing on choice of payment 

instrument was conducted by Humphrey, Kim, 

and Vale for Norway, a country that implemented 

explicit per-item prices for a number of payment 

instruments used at the point of sale. The findings supported a strong substitution effect of electronic for paper transactions at the point of sale.56 

Implications for Banking Profitability and 

Regulatory Oversight 

This review of the development of payment systems in the United States indicates the following: 

� Banks will have to adapt their offerings and 

internal back-office processing to reflect the 

changes underway, leading to greater use of 

electronic banking by consumers. Fortunately, 

although the process of change has recently 

accelerated, the trends should not overwhelm 

the industry. 

� Since more electronic transactions are cheaper 

to process, as is the conversion or truncation 

(or both) of checks, banks that do not explicitly charge for transaction services on a peritem basis will see a reduction in costs. For 

banks that have explicit fees for each service 

(mainly banks that supply cash management 

services), it will be necessary to ensure that 

the profit margins on the electronic transaction services are commensurate with those on 

the paper transaction services. 

� Since cross-subsidization and implicit pricing 

lead to distortions, overuse of some services, 

55 See Murphy (1991). 

56 See Humphrey, Kim, and Vale (2002). Other studies of cross-country 

analyses of payments failed to find significant relationships between pricing 

and use because of poor data and little application of per-item pricing. See 

Humphrey, Pulley, and Vesala (1996). 

and lack of transparency, there is no justification for the remaining restriction on paying 

interest on demand deposits. Interest is 

allowed for consumer accounts, and large businesses have evaded the restriction by using 

sweep accounts. The Federal Reserve should 

pay interest on bank balances, and banks 

should not be restricted in paying interest on 

any demand deposit account. 

� There has been and will continue to be consolidation in the provision of cash management services to large corporations, but banks 

of all sizes will be able to continue to serve 

their customers with a mix of capabilities, 

including ATMs, on- and off-line debit cards, 

credit cards, acting as receivers of ACH payments on behalf of their customers, and other 

services. There should be no reason to believe 

that these trends by themselves will have any 

substantial impact on the market structure of 

the banking industry. 

� Bank regulators must concern themselves with 

operational risk. The developments discussed 

in this paper indicate that regulators must be 

aware of the risk implications of the changes 

in payment systems and must adapt their 

approaches accordingly. 

� Regarding operational risk, one important 

aspect that must be considered by bank regulators is the trend toward nonbank ownership 

and operation of significant portions of the 

payment networks. Since the operation of 

these networks has a direct effect on the risk 

exposure of regulated banks, the risk management procedures of these firms may have significant implications for bank regulators. 

� Banks and bank regulators need to be concerned about the market structure of the network providers, especially those for ATMs, 

debit cards, and credit cards. Significant consolidation among network providers has 

already occurred, and any further concentration raises concerns about pricing, service 

quality, and product innovation in this segment of the market, one in which bank regulators have no direct responsibility. 

FDIC BANKING REVIEW 83 2004, VOLUME 16, NO. 2 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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