Mr. Ferguson speaks on the future of the financial services sector  (Central Bank Articles and Speeches, 27 Oct 98)
Central bank: fed | Type: speech | Date: 1998-10-27

Mr. Ferguson speaks on the future of the financial services sector Remarks by Mr. Roger W.

Ferguson, Jr., a member of the Board of Governors of the US Federal Re System, at the College of Management of the University of Massachusetts in Bos Massachusetts on 27/10/98.

## Some Observations on the Future of the Financial Services Sector and Related Public Policy IssuesLet

me first thank you for your invitation to speak today at this very conference.

The future of the financial services sector holds great interest fo participants as well as bank regulators, given the remarkable changes affecting the Developments in this sector will affect all of us.We are all acutely aware of the trend toward the blurring of lines th separated the various parts of the financial sector, particularly commercial banking, banking, and insurance.

Most recently, we are faced with the prospect of the formation financial conglomerates, composed of amalgams of firms that have previously operated the roughly defined boundaries of their respective industries.

In addition, we have w substantial degree of consolidation through mergers in the commercial banking and industries.I will begin my remarks today by discussing historical experience conglomeration in the US, and the underlying conditions necessary for conglomeration successful business strategy.

I will then offer some thoughts regarding what the financ sector may look like in the future.

Finally, I will address some of the issues that Reserve as a supervisor and regulator will need to consider.There are several conclusions that I would like to highlight.

The first i movement to financial conglomerate may prove to be transitory.

Second, basic financial management skills will likely remain the most important determinant of a company's vi and success.

Third, even in a world of financial conglomerates there will be room for and more nimble, participants.

Finally, the supervisory and regulatory structure wil evolve to meet these new challenges, but regulatory authorities should remain vigilan out our duties, particularly in enforcing the antitrust laws.

## II.

Will Financial Service Conglomerates be Successful?

## The Historical Context of ConglomerationThe concept of the financial conglomerate is receiving a great deal of att this

time because of the diminishing distinctions across financial industries.

How success of such conglomerates is certainly not guaranteed, based on historical experien illustration, one need only look back to the conglomerate merger movement in the in sector during the 1960s.

Large conglomerate firms such as LTV, Gulf and Western, Textro Litton Industries became conglomerates through numerous mergers, heralded with great f from the business press.

By the 1970s, such proclamations sounded hollow, as conglomerate firms' equities were pummeled as their corporate structure proved unsucc This period was followed by a decade of spin-offs as the conglomerates sought to str their operations and return to their original areas of expertise - and this reversal o greeted with considerable enthusiasm by the business press.Much closer to home, we should also recall that the retail financial sect through a phase of conglomeration about 15 years ago, in the movement toward the 'fin supermarket'.

The acquisitions of Coldwell Banker and Dean Witter by Sears, Shearso American Express, Schwab by Bank of America, and Bache by Prudential come to mind.

Desp the enthusiasm for the financial supermarket in the early 1980s, by the end of the d concept had stagnated, and the press instead reported the benefits of specializatio provision of niche services.I believe this past experience with business conglomerates in the US s temper our views of the inevitability of today's financial conglomerates.

There ar challenges to managing much larger, more diversified firms, as well as benefits.

This strategy is surely not for all financial services firms.

## Business Conditions Necessary for Financial Conglomerates to SucceedThe difficulties associated with operating a financial conglomerate are su by the business conditions that are necessary for such a conglomerate to succeed.

We ha of course, of the potential economies of scale and scope in managing information that m large firms to reduce the unit costs of doing business.

We are also aware of the potent marketing, where economies of scope on the supply side allow firms to sell multiple pr their customers, and on the demand side allow consumers to conveniently purchase bund services.

Since a number of conglomerates of the past have been unable to improve separate delivery of services - including financial services - it is unclear whether te other changes have altered the nature of financial products or managerial capabilities to result in significantly improved exploitation of scope economies.The potential benefits of reducing risk through sectoral and geogr diversification are another motivation for conglomeration.

I have little doubt that in the potential for diversification gains exists.

However, we have heard very little expertise needed to merge the risk management practices of previously separate financi While merging risk management practices may be straightforward for firms consolidating an industry, such a readjustment is likely far more complex for firms originating i industries.Furthermore, the challenges of managing a merger of diverse firms and operation of the resulting conglomerate are substantial.

The operation of a conglomerate requires the ability to integrate the financial activities, research and investments, pricing decisions, compensation practices, cost containment activities, a of an extremely large and diverse organization.

Before any steps toward conglomerat taken, each potential participant in such a merger must judge whether this extraordin skills is to be found in any managerial team.However, having raised the cautionary flags about the prospects for fin conglomerates, I should add that various considerations suggest that the financial con format in the future may be successful for at least some firms.

From the mana perspective, technological developments should help provide more detailed informati monitoring the various activities of the firm and allow the application of more sophis management models.

Past experience with conglomeration may also provide new insights managing product integration more effectively.

On the demand side, retail customerbecome more receptive to one-stop shopping as the range of services increases and opportunities for accessing these services become available.

## III.

How Might the Financial Services Sector Evolve?The extraordinary changes occurring in the financial sector make projec about how the sector will evolve quite speculative.

Nevertheless, it is useful to consi future might look as both industry participants and regulators plan to meet that futu like to offer some prognostications based both on systematic projections using h experience and on analogies and informal observations of current trends.

## Systematic Projections on ConsolidationThe commercial banking industry, which is the largest single component of financial sector, has experienced massive consolidation since 1980.

For example, the n banking organizations in the US fell from around 12,300 in 1980 to just under 7,200 by of 1997.

Not surprisingly, the percentage of banking assets held by the top 10 organizations rose from about 20 percent in 1980 to nearly 35 percent in 1997, while held by the top 25 increased from about 33 to 53 percent.

Despite the large amo consolidation and increase in banking concentration at the national level, banking con within local market areas (MSAs and non-MSA counties) has, on average, hardly changed the past decade.

For example, the average Herfindahl-Hirschman Index (HHI) in MS decreased from 1990 to 1949 between 1985 and 1997, while in non-MSA counties it decre from 4357 to 4114 (thrifts excluded).

The stability of average local market concent noteworthy because research suggests that competition for retail customers takes substantially at the local market level, and concentration is a determinant of competitBased on these trends and the fact that tremendous new opportunities for mergers have been created by the removal of restrictions on interstate banking under t Neal Interstate Banking and Branching Efficiency Act of 1994, I would expect consolidation to occur in banking.

Based on historical experience, some Fed economist projected that in a decade or so about 3,000-to-4,000 banking organizations will Importantly, most of these firms would be smaller organizations.In addition to commercial banking, other financial service sectors hav experienced movements toward consolidation.

Insurance companies and securities firms ha experienced merger waves in recent years, though not to the extent of commercial bankin more moderate pace of consolidation in nonbank financial industries is likely due to th of preexisting restrictions on geographic expansion.

Like banking, insurance underwr characterized by a broad size distribution of firms, from several large national insur smaller local or technically specialized firms.

Investment banking is more heavily con due to the greater geographic expanse of the markets for their services, and du considerable benefits of portfolio diversification.

Extending current patterns into th can only expect a continuation of the trend towards consolidation.

## Informal Projections on ConglomerationAs

I noted earlier, in addition to a continuing consolidation in banki elsewhere in the financial sector, there is also a tendency toward increased congl Given the prospects for legislation expanding the product lines available to banks, I w surprised at a wave of cross-industry mergers within the financial sector, particularl largest firms, that results in the formation of financial conglomerates.In order to consider the form of the financial sector in the future, I b very important to distinguish between retail financial services (i.e., those for hou small businesses) and wholesale or large-scale corporate financial services.

The custo of these two sectors differ dramatically, as do many of the products used.Despite their differences, both the retail and wholesale sectors have mo expand their product offerings.

In retail financial services, the desire by banks to product offerings is both a response to new products developed by other industries (for the emergence of annuities in the insurance industry), as well as a response to c substitution of other products (such as mutual funds) for traditional bank products traditional savings accounts).At wholesale firms, we have witnessed the push into securities underwritin the establishment of offices throughout the world in an effort to respond to the financ large corporate customers.

Because of the very large scale required to serve a wholesa consisting of a relatively small number of sizable customers, relatively few very large likely remain active in the wholesale portion of the financial sector.

Of course, wholesale institutions may operate in the retail portion as well, although the latter not necessitate the extraordinary size of these firms.

In addition, there are clearly that achieve enviable results by serving just one need, say M&A advice, for large busineThe existence of both retail and wholesale institutions will have a direct on the future of financial services.

In contrast to wholesale institutions, ret institutions are able to operate profitably on a small scale.

Given the continuing stro of many retail customers to deal with local offices, especially for many services of institutions, small retail financial institutions will likely be able to serve the need and small businesses in local markets.Such niche players would play an important role in a retail financial composed of perhaps several thousand relatively small retail financial institutions, smaller number of large financial firms that offer wholesale products, or both whole retail products.

The large firms that offer retail services would likely operate offic the country.

This scenario would not be unlike that which we observe quite frequentl nonfinancial retail sector.

Restaurants, department stores, convenience stores and sup are examples of locally based markets with a strong presence of large national or regi operating alongside a large number of small local sellers.

## IV.

What Do Conglomeration and Consolidation Mean for the Federal Reserve?Now I would like to consider some of the issues that are raised by the evolu the financial services sector for the Federal Reserve.

Clearly the Federal Reserve m along with the industry it supervises and regulates.

## Reducing Moral Hazard through Increased Market DisciplineA

key concern, which is a challenge internationally as well as in dom supervision, is the well-known 'moral-hazard' problem.

Moral hazard occurs when a firm on greater risk than is prudent, because it does not bear the full cost of adopti position.

Instead, the cost of this risk is borne by the financial safety net, whi banking system consists of access to federal deposit insurance, the Fed's discount win Federal Reserve payments system guarantees.

While this safety net in my judgment will remain firmly in place, incentive-compatible policies should be developed and applied more of the cost of risk-bearing onto the firms themselves.

Such policies would seek t and improve the role of 'market discipline' in constraining bank risk taking.One widely discussed idea for increasing market discipline is to require a issue a minimum amount of subordinated debt to non-related parties.

The basic idea is t set of uninsured bank liability holders who will have risk preferences similar to tho supervisors, and who would thus discipline bank risk taking to a similar degree.

In changes in the price of a bank's subordinated debt might prove to be a useful sign market's evaluation of a bank's financial condition.

Such signals could perhaps be supervisors as an aid in identifying problem banks.

While a policy of 'mandatory subo debt' is not without its problems and implementation difficulties, it is certainly wort discussion.A second way that market discipline could be encouraged is through finan reporting and transparency guidelines, which provide the market with the information n to make informed transactions.

This improved information is essential for market disc function.

Greater transparency by itself will not alleviate the moral hazard problem insured deposits, since fully informed investors may be willing to make deposits in a an overly risky portfolio, as long as their deposits are insured.

However, transparency the need for some types of direct regulation in uninsured financial activities.

If th financial institutions are apparent to the market, the institutions will adjust their optimally to maintain the ability to attract capital.

Improved disclosure by domestic international institutions would increase the information that allows investors to as they bear.

## Communicating with Other RegulatorsIf the financial services sector moves further in the direction of conglo the Federal Reserve will experience an ever greater need for communication with regul different financial industries.

Regulators of the banking industry will need to coor agencies governing the securities and insurance industries.

Communication with ins regulators will present a particular challenge, since in the US insurance is regulated at the state level.

Furthermore, international communication among central banks an financial regulators is already essential.

This need can only become greater as market financial services continue to extend across national borders.

Indeed, the need intervention could be reduced through preventive measures that include ongoing communic and coordinated improvements in supervisory methods.

Ensuring CompetitionAlso important is the role of encouraging competition through implementati the Federal Reserve's bank merger policy.

This role is particularly important at a banking and the financial sector in general are experiencing an unprecedented merger mo that is radically restructuring these industries.

Before discussing newer analyses that called upon to perform, let me emphasize that I think that we must continue to be e vigilant to protect local market competition.

Applicants should remember that we m impacts on local market structure considering both HHI and concentration ratios.

Tran satisfying one of those measures may not satisfy the other measure.

Small increases i share as measured by HHI may mask the high market share of the dominant competitor.

In cases, I would expect that mitigating factors, even for small increases in market sha extremely strong to gain approval.The task of enforcing bank merger policy will become potentially mo challenging if financial conglomeration occurs, since the analysis of competition rel correct definition of the relevant geographic and product markets.

Thus, increasing n financial conglomerates that sell traditional retail banking services along with in securities will make the analysis of competitive effects of mergers more difficult.

In will remain important to distinguish between markets for large-scale wholesale produ markets for household- and small-business-oriented retail banking products.

We will als consider the effects that networks, such as ATM and point-of-sale networks, and other electronic banking have on competition for financial services.

Finally, as financial r become increasingly complex, we must work to reduce market inertia that could l competition by restricting customers' ability to choose freely among providers of services.

Domestic competition is particularly important not only because it increases of our fellow citizens, but also because other reforms, such as those based on market probably work best in a competitive market.

Also, domestic competition is one of t powerful forces that gives rise to international competitiveness.

## Reducing Systemic Risk through Improved SupervisionFinally,

the Federal Reserve must continually improve the bank supervi process in order to help manage risk that could be introduced into the financial sys changes occurring in the financial sector.

The effects of consolidation and conglome systemic risk cannot be ignored.

If risk is not managed properly within the consolidate repercussions could extend beyond a single institution and well into the financial sec the moral hazard problem could be largely solved, so that financial firms bear the costs of the risks they adopt, these firms may fail to internalize the costs borne financial system when their portfolio decisions result in bad financial outcomes.

The r damage can be held in check only by sound supervisory practices.I do not have time to do more than quickly mention some of the important ef that the Federal Reserve is pursuing in order to improve bank supervision.

Much of ou along with that of other bank supervisors, is focused on improving our ability to mo supervise the risk management practices of banks and banking organizations.

Closely work is aimed at devising capital standards that more accurately reflect the realitie banking world.

Through it all, I would emphasize that old-fashioned supervision, the which is the on-site examination, remains central to our supervisory strategy.

Improve discipline, increased communication with other supervisors, and enhanced stability greater diversification are necessary.

But improved supervision is also critical, and there is simply no substitute for a well-trained and highly motivated examiner 'on the g

## V.

ConclusionIn closing, I would like to reemphasize the importance of the basic ski remain centrally important in the financial services sector.

Regardless of the exte nature of conglomeration, technological development, and new financial instruments, fundamental business practices will remain essential: credit underwriting and risk ma skills, cost control, and appropriate pricing practices.

While technological improveme aid in nearly all these areas, only sound management practices will allow industry part take advantage of any advances in technology.

At the same time, fundamental princip supervision and regulation must be applied, including sound credit standards and examinations, to ensure the safety and soundness of the financial sector.

Finally, should implement antitrust policy in a manner that will ensure competitive prices and s the financial sector evolves and consolidates.

Despite the importance of vigorous super regulation, I and my colleagues on the Board are quite sensitive to the fact that it i to judge the wisdom of management decisions and business strategies beyond ensuring public policy standards regarding supervision and regulation are met.

I look forward to and participating in this sector's evolution into the next century.

I thank you once opportunity to discuss these issues with you today.