Alan Greenspan: Banking
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the Independent Community Bankers of America Convention, San Diego (via satellite),
17 March 2004.
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It is a pleasure once again to participate in the annual meeting of the Independent Community
Bankers Association. I particularly hoped to attend this meeting in person, but events made such a trip
infeasible.
I wanted to be at your meeting to join in honoring the contributions of Ken Guenther. As everyone
knows who has ever received Ken's notes - known fondly to one and all as "Guenther-grams" - he
thinks deeply and broadly about banking and financial matters.
Having reflected on the kinds of issues that Ken has on his mind, I thought it would be fitting today if I
shared with you some ideas about where the banking industry is today and about a few trends we see
evolving.
Asset growth and quality
The weakness in credit quality that accompanied the recent recession has clearly been mild for the
banking system as a whole, and the system remains strong and well positioned to meet customer
needs for credit and other financial services. During the past three years or so, the industry extended
its string of high and often record quarterly earnings, retained its historically high equity and risk-based
capital ratios, and generally enjoyed robust asset growth. The industry and its supervisors had begun
exceptionally early to address slippage in credit standards that accompanied the maturing of the last
expansion, and their timely intervention was reflected in modest subsequent write-offs relative to
earnings. Indeed, for each of the past several quarters the volume of problem assets at commercial
banks has declined, and the size and the number of bank failures in recent years have been
exceptionally small.
Although the demand for business loans has remained weak, the banking industry has continued to
benefit from strong demand for household credit, not least for residential mortgage products. The
outlook for asset quality is also favorable. As economic activity continues to grow and businesses
become more confident about their customers' demands, business loan demand should increase, and
pressures on banking margins should begin to ease.
During the period of weakness and recovery, quite a large amount of core deposits flowed back into
banks of all sizes reflecting lower interest rates on alternative assets, the softness of the stock market,
and the public's desire for safe assets. As a result, banks had ample liquidity and the resources to
fund asset growth. More recently, with renewed interest in market securities and a slowing of
mortgage re-financings - and their associated buildup in deposits - core deposits have weakened.
History suggests that, as the economy strengthens further, deposit substitutes again will become more
attractive to bank customers, requiring competitive responses in bank deposit offering rates and
reliance on non-core sources. Community bankers in the last half of the nineties demonstrated their
skill in competing successfully in such markets.
Although their deposit patterns have been similar, community and larger banks have seen some
interesting differences developing in their portfolios in the past two or three years that are worth noting.
Banking commentary generally has emphasized the extent to which residential mortgage finance and
consumer credit extensions have dominated the portfolio expansion of the banking industry. In fact,
that growth, which dominates the aggregate statistics, has been mainly a large bank phenomenon.
At community banks, the residential mortgage, credit card, and consumer installment loan portfolios
have declined in each of the last three years. To be sure, this change may be a matter of choice. The
data suggest, for example, that community banks have originated a significant volume of mortgage
loans for securitization by others, continuing to acquire in the process a large amount of
mortgagebacked securities. But some observers have noted that in the market for new originations of
mortgages community banks are also under continued competitive pressure from mortgage bankers,
nationwide mortgage lenders, and real estate agent relationships with out-of-market lenders, often
through the Internet.
The declining importance of traditional consumer credit business at community banks appears to stem
from both sustained competition from captive finance companies and community banks' withdrawal
from the credit card market, where significant scale is required to service the resultant portfolios.
Community bankers, however, continue to have success with home equity loans as a substitute for
more traditional consumer lending and have experienced growth in such loans comparable to that at
larger institutions.
Particularly noteworthy is the longer-term trend at community banks that seems to have accelerated in
the past three years - the increasing share of asset growth accounted for by nonresidential real estate
finance, particularly construction and land development loans and commercial and industrial real
estate financing. Last year these categories accounted for more than 90 percent of the net asset
growth of banks with less than $1 billion in assets; multifamily real estate and farmland finance would
bring the total to more than 100 percent, offsetting the declines in other categories.
Such credit exposures are a natural evolution of community banking and are quite profitable, helping
to sustain both the earnings and growing equity capital of community banks. Moreover, the evidence
suggests that community banks have avoided the underwriting mistakes that led to so many problems
ten to fifteen years ago. Borrower equity is much higher and credit criteria are much stricter. In the last
recession and during the early weak recovery, we saw very few delinquencies in these credits.
Nonetheless, bankers need to be aware of the historical real estate cycle that, in the past, placed such
exposures under severe stress. One hopes these improvements in underwriting standards are lasting.
But the painful lessons of banking history underscore the ever-present need for vigilance in managing
geographic and business line concentrations.
Consolidation
Mergers and acquisitions in banking continue, driven by technology, reduced barriers to entry,
relaxation of interstate banking restrictions, and globalization. Although attention has been focused on
the larger banks, roughly 90 percent of mergers over the past decade have involved a target with less
than $1 billion; three-quarters have involved an acquiree with assets of less than $250 million. Largely
as a consequence, the number of banking organizations with assets of less than $1 billion has fallen
since the mid-1990s by more than one-fifth.
Neither the aggregate decline in the number of banking organizations of all sizes nor the increase in
aggregate concentration ratios tells us much about the competitive effects of consolidation.
Competition in banking is fought on the battlefield of the local market, especially for households and
small and medium-sized businesses. By that test, concentration in local markets has actually declined
somewhat since the mid-1990s in both urban and rural local markets. The apparent contradiction
between aggregate consolidation and the virtually unchanged local market structure reflects the fact
that many of the mergers and acquisitions by all sizes of banks have been out-of-market, or
geographic-expansion, mergers. In addition, when consolidation occurs, it often induces de novo entry
to take advantage of the inefficiencies or transition difficulties of the newly consolidated enterprise.
Over the past five years, for every four bank mergers that have been approved, three de novo bank
charters have been granted.
To be sure, expansion by large banks through acquisitions and branching has increased the number
of local markets - urban and rural - in which a large institution is a rival. Last year, 99 percent of the
urban markets and 54 percent of the rural markets had an office of a banking organization with
deposits of $25 billion or more. Such an increase in the presence of large banking organizations at the
local level has occurred while community banks continue to face competition from thrifts, credit unions,
securities firms, and loan production offices from out-of-market lenders, not to mention the Internet.
These trends are irreversible. Nonetheless, as evidenced by their performance, community banks
have the competitive skill of innovation and the competitive edge of local market knowledge not just to
survive against such competition but to continue to prosper.
Basel II
Every indication to date also suggests that the proposed application of Basel II in the United States to
only large banks should not be a matter of concern to community bankers. Indeed, your comments on
our proposal to revise the Basel Accord suggest that you are comfortable, to say the least, with not
having to invest in the institutional infrastructure to be required of the largest banks. The agencies
believe that the generally strong capital position and straightforward balance sheets of most of the
other banks make a wider application of Basel II neither cost effective nor necessary on prudential
grounds. Of course, supervisors will continue reviewing credit-granting and risk-management policies
at banks of all sizes, and I suspect that, in the years ahead, market-driven spin-offs from the new
procedures at larger banks will be adopted by community banks.
Apparently another fear exists. The comments received from some of you indicated a concern that
perhaps the lower regulatory capital that some large banks may incur under Basel II on some
portfolios may distort the competitive balance between adopters and non-adopters of the proposed
new accord. The banking agencies and the Congress take such risks seriously. Indeed, we have
indicated that if we see evidence supporting competitive distortions, we will make the necessary
modifications to blunt them by doing one of the following: changing Basel II rules in the United States,
where national discretion is allowed; modifying the proposed U.S. bifurcated application; or changing
the capital rules that apply to non-adopters. In short, if we have evidence of a potential competitive
problem, we will not be precluded from proposing any measure that we believe is necessary to retain a
more level playing field.
Two weeks ago, the Federal Reserve published the first two of four empirical studies on this issue that
our staff is conducting. One addresses the concern that regulatory capital reductions at adopters of
Basel II might induce more mergers and acquisitions, with the adopters acquiring the non-adopters.
That paper finds little empirical evidence that, in the past, excess regulatory capital at the acquirer had
been a significant factor in boosting consolidation.
The second paper evaluates the fear that the lower on average, risk-based capital charges on loans to
small- and medium-sized enterprises by Basel II adopters would put non-adopters at a competitive
disadvantage. This study concludes that the empirical evidence suggests that, indeed, a competitive
issue in this market might arise between adopters and large bank non-adopters, both of which make
the same types of loans in the same markets. This potential effect must be addressed. But the study
also concludes that, on the basis of empirical review, the types of small business loans generally
made by community banks - relationship-based loans, which community banks do so well - are so
different from the types of loans made by larger banks, and so differently priced, that the competitive
effects on community banks of Basel II application to large banks are likely to be insignificant.
Two other studies, exploring the competitive effects in the residential mortgage and credit card
markets will be available in the next few months. The results of all four studies will be reviewed when
we conduct later this year another Quantitative Impact Study on the revised Basel II now being
developed. And, again, if updates of the completed studies or the analyses in the new studies
demonstrate competitive problems, we will modify the proposals to address them.
Summary
In summary, the banking system is in a strong and profitable position to finance the credit demands of
the current expansion. As that expansion continues, both large and community banks will have to
once again look beyond their core deposit base to fund those demands. The competitive environment
for banks, especially community banks, will continue to intensify. Both history and current behavior
suggest, however, that community banks can innovate and meet these competitive challenges. The
merger trends of both large and small banks will undoubtedly continue, but both public policy and new
entry will also continue to limit concentration in local markets. If evidence shows that a bifurcated
application of Basel II would distort competitive markets in the United States, the agencies are pledged
to make whatever modifications are necessary to either the proposal or the current capital rules. And,
finally, once again: Ken, I wish you a productive and enjoyable retirement.