Remarks
Mr. Ferguson speaks on the future of the financial services sector
by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve
System, at the College of Management of the University of Massachusetts in Boston,
Massachusetts on 27/10/98.
Some Observations on the Future of the Financial Services Sector and Related
Public Policy Issues
Let me first thank you for your invitation to speak today at this very topical
conference. The future of the financial services sector holds great interest for industry
participants as well as bank regulators, given the remarkable changes affecting the industry.
Developments in this sector will affect all of us.
We are all acutely aware of the trend toward the blurring of lines that have
separated the various parts of the financial sector, particularly commercial banking, investment
banking, and insurance. Most recently, we are faced with the prospect of the formation of huge
financial conglomerates, composed of amalgams of firms that have previously operated within
the roughly defined boundaries of their respective industries. In addition, we have witnessed a
substantial degree of consolidation through mergers in the commercial banking and other
industries.
I will begin my remarks today by discussing historical experience with
conglomeration in the US, and the underlying conditions necessary for conglomeration to be a
successful business strategy. I will then offer some thoughts regarding what the financial services
sector may look like in the future. Finally, I will address some of the issues that the Federal
Reserve as a supervisor and regulator will need to consider.
There are several conclusions that I would like to highlight. The first is that the
movement to financial conglomerate may prove to be transitory. Second, basic financial and risk
management skills will likely remain the most important determinant of a company's viability
and success. Third, even in a world of financial conglomerates there will be room for smaller,
and more nimble, participants. Finally, the supervisory and regulatory structure will need to
evolve to meet these new challenges, but regulatory authorities should remain vigilant to carry
out our duties, particularly in enforcing the antitrust laws.
II. Will Financial Service Conglomerates be Successful?
The Historical Context of Conglomeration
The concept of the financial conglomerate is receiving a great deal of attention at
this time because of the diminishing distinctions across financial industries. However, the
success of such conglomerates is certainly not guaranteed, based on historical experience. For an
illustration, one need only look back to the conglomerate merger movement in the industrial
sector during the 1960s. Large conglomerate firms such as LTV, Gulf and Western, Textron, and
Litton Industries became conglomerates through numerous mergers, heralded with great fanfare
from the business press. By the 1970s, such proclamations sounded hollow, as many
conglomerate firms' equities were pummeled as their corporate structure proved unsuccessful.
This period was followed by a decade of spin-offs as the conglomerates sought to streamline
their operations and return to their original areas of expertise - and this reversal of strategy was
greeted with considerable enthusiasm by the business press.
Much closer to home, we should also recall that the retail financial sector went
through a phase of conglomeration about 15 years ago, in the movement toward the "financial
supermarket". The acquisitions of Coldwell Banker and Dean Witter by Sears, Shearson by
American Express, Schwab by Bank of America, and Bache by Prudential come to mind. Despite
the enthusiasm for the financial supermarket in the early 1980s, by the end of the decade the
concept had stagnated, and the press instead reported the benefits of specialization and the
provision of niche services.
I believe this past experience with business conglomerates in the US should
temper our views of the inevitability of today's financial conglomerates. There are clearly
challenges to managing much larger, more diversified firms, as well as benefits. This business
strategy is surely not for all financial services firms.
Business Conditions Necessary for Financial Conglomerates to Succeed
The difficulties associated with operating a financial conglomerate are suggested
by the business conditions that are necessary for such a conglomerate to succeed. We have heard,
of course, of the potential economies of scale and scope in managing information that may allow
large firms to reduce the unit costs of doing business. We are also aware of the potential for cross
marketing, where economies of scope on the supply side allow firms to sell multiple products to
their customers, and on the demand side allow consumers to conveniently purchase bundles of
services. Since a number of conglomerates of the past have been unable to improve upon
separate delivery of services - including financial services - it is unclear whether technological or
other changes have altered the nature of financial products or managerial capabilities sufficiently
to result in significantly improved exploitation of scope economies.
The potential benefits of reducing risk through sectoral and geographic
diversification are another motivation for conglomeration. I have little doubt that in many cases
the potential for diversification gains exists. However, we have heard very little about the
expertise needed to merge the risk management practices of previously separate financial firms.
While merging risk management practices may be straightforward for firms consolidating within
an industry, such a readjustment is likely far more complex for firms originating in different
industries.
Furthermore, the challenges of managing a merger of diverse firms and the
operation of the resulting conglomerate are substantial. The operation of a financial
conglomerate requires the ability to integrate the financial activities, research and development
investments, pricing decisions, compensation practices, cost containment activities, and cultures
of an extremely large and diverse organization. Before any steps toward conglomeration are
taken, each potential participant in such a merger must judge whether this extraordinary set of
skills is to be found in any managerial team.
However, having raised the cautionary flags about the prospects for financial
conglomerates, I should add that various considerations suggest that the financial conglomerate
format in the future may be successful for at least some firms. From the management
perspective, technological developments should help provide more detailed information for
monitoring the various activities of the firm and allow the application of more sophisticated risk
management models. Past experience with conglomeration may also provide new insights for
managing product integration more effectively. On the demand side, retail customers may
become more receptive to one-stop shopping as the range of services increases and as new
opportunities for accessing these services become available.
III. How Might the Financial Services Sector Evolve?
The extraordinary changes occurring in the financial sector make projections
about how the sector will evolve quite speculative. Nevertheless, it is useful to consider how the
future might look as both industry participants and regulators plan to meet that future. I would
like to offer some prognostications based both on systematic projections using historical
experience and on analogies and informal observations of current trends.
Systematic Projections on Consolidation
The commercial banking industry, which is the largest single component of the
financial sector, has experienced massive consolidation since 1980. For example, the number of
banking organizations in the US fell from around 12,300 in 1980 to just under 7,200 by the end
of 1997. Not surprisingly, the percentage of banking assets held by the top 10 banking
organizations rose from about 20 percent in 1980 to nearly 35 percent in 1997, while the share
held by the top 25 increased from about 33 to 53 percent. Despite the large amount of
consolidation and increase in banking concentration at the national level, banking concentration
within local market areas (MSAs and non-MSA counties) has, on average, hardly changed over
the past decade. For example, the average Herfindahl-Hirschman Index (HHI) in MSAs
decreased from 1990 to 1949 between 1985 and 1997, while in non-MSA counties it decreased
from 4357 to 4114 (thrifts excluded). The stability of average local market concentration is
noteworthy because research suggests that competition for retail customers takes place
substantially at the local market level, and concentration is a determinant of competition.
Based on these trends and the fact that tremendous new opportunities for bank
mergers have been created by the removal of restrictions on interstate banking under the
RiegleNeal Interstate Banking and Branching Efficiency Act of 1994, I would expect more
consolidation to occur in banking. Based on historical experience, some Fed economists have
projected that in a decade or so about 3,000-to-4,000 banking organizations will remain.
Importantly, most of these firms would be smaller organizations.
In addition to commercial banking, other financial service sectors have also
experienced movements toward consolidation. Insurance companies and securities firms have all
experienced merger waves in recent years, though not to the extent of commercial banking. This
more moderate pace of consolidation in nonbank financial industries is likely due to the absence
of preexisting restrictions on geographic expansion. Like banking, insurance underwriting is
characterized by a broad size distribution of firms, from several large national insurers to much
smaller local or technically specialized firms. Investment banking is more heavily concentrated,
due to the greater geographic expanse of the markets for their services, and due to the
considerable benefits of portfolio diversification. Extending current patterns into the future, we
can only expect a continuation of the trend towards consolidation.
Informal Projections on Conglomeration
As I noted earlier, in addition to a continuing consolidation in banking and
elsewhere in the financial sector, there is also a tendency toward increased conglomeration.
Given the prospects for legislation expanding the product lines available to banks, I would not be
surprised at a wave of cross-industry mergers within the financial sector, particularly among the
largest firms, that results in the formation of financial conglomerates.
In order to consider the form of the financial sector in the future, I believe it is
very important to distinguish between retail financial services (i.e., those for households and
small businesses) and wholesale or large-scale corporate financial services. The customer bases
of these two sectors differ dramatically, as do many of the products used.
Despite their differences, both the retail and wholesale sectors have moved to
expand their product offerings. In retail financial services, the desire by banks to expand their
product offerings is both a response to new products developed by other industries (for example,
the emergence of annuities in the insurance industry), as well as a response to customers'
substitution of other products (such as mutual funds) for traditional bank products (such as
traditional savings accounts).
At wholesale firms, we have witnessed the push into securities underwriting and
the establishment of offices throughout the world in an effort to respond to the financial needs of
large corporate customers. Because of the very large scale required to serve a wholesale market
consisting of a relatively small number of sizable customers, relatively few very large firms will
likely remain active in the wholesale portion of the financial sector. Of course, the large
wholesale institutions may operate in the retail portion as well, although the latter activity does
not necessitate the extraordinary size of these firms. In addition, there are clearly boutique firms
that achieve enviable results by serving just one need, say M&A advice, for large businesses.
The existence of both retail and wholesale institutions will have a direct bearing
on the future of financial services. In contrast to wholesale institutions, retail financial
institutions are able to operate profitably on a small scale. Given the continuing strong preference
of many retail customers to deal with local offices, especially for many services of depository
institutions, small retail financial institutions will likely be able to serve the needs of individuals
and small businesses in local markets.
Such niche players would play an important role in a retail financial sector
composed of perhaps several thousand relatively small retail financial institutions, and a much
smaller number of large financial firms that offer wholesale products, or both wholesale and
retail products. The large firms that offer retail services would likely operate offices throughout
the country. This scenario would not be unlike that which we observe quite frequently in the
nonfinancial retail sector. Restaurants, department stores, convenience stores and supermarkets
are examples of locally based markets with a strong presence of large national or regional firms
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 evolution of
the financial services sector for the Federal Reserve. Clearly the Federal Reserve must adapt
along with the industry it supervises and regulates.
Reducing Moral Hazard through Increased Market Discipline
A key concern, which is a challenge internationally as well as in domestic
supervision, is the well-known "moral-hazard" problem. Moral hazard occurs when a firm takes
on greater risk than is prudent, because it does not bear the full cost of adopting that risk
position. Instead, the cost of this risk is borne by the financial safety net, which in the US
banking system consists of access to federal deposit insurance, the Fed's discount window, and
Federal Reserve payments system guarantees. While this safety net in my judgment will surely
remain firmly in place, incentive-compatible policies should be developed and applied that shift
more of the cost of risk-bearing onto the firms themselves. Such policies would seek to increase
and improve the role of "market discipline" in constraining bank risk taking.
One widely discussed idea for increasing market discipline is to require a bank to
issue a minimum amount of subordinated debt to non-related parties. The basic idea is to create a
set of uninsured bank liability holders who will have risk preferences similar to those of bank
supervisors, and who would thus discipline bank risk taking to a similar degree. In addition,
changes in the price of a bank's subordinated debt might prove to be a useful signal of the
market's evaluation of a bank's financial condition. Such signals could perhaps be used by
supervisors as an aid in identifying problem banks. While a policy of "mandatory subordinated
debt" is not without its problems and implementation difficulties, it is certainly worthy of serious
discussion.
A second way that market discipline could be encouraged is through financial
reporting and transparency guidelines, which provide the market with the information necessary
to make informed transactions. This improved information is essential for market discipline to
function. Greater transparency by itself will not alleviate the moral hazard problem inherent to
insured deposits, since fully informed investors may be willing to make deposits in a bank with
an overly risky portfolio, as long as their deposits are insured. However, transparency can reduce
the need for some types of direct regulation in uninsured financial activities. If the holdings of
financial institutions are apparent to the market, the institutions will adjust their risk positions
optimally to maintain the ability to attract capital. Improved disclosure by domestic as well as
international institutions would increase the information that allows investors to assess the risk
they bear.
Communicating with Other Regulators
If the financial services sector moves further in the direction of conglomeration,
the Federal Reserve will experience an ever greater need for communication with regulators of
different financial industries. Regulators of the banking industry will need to coordinate with
agencies governing the securities and insurance industries. Communication with insurance
regulators will present a particular challenge, since in the US insurance is regulated exclusively
at the state level. Furthermore, international communication among central banks and other
financial regulators is already essential. This need can only become greater as markets for many
financial services continue to extend across national borders. Indeed, the need for crisis
intervention could be reduced through preventive measures that include ongoing communication
and coordinated improvements in supervisory methods.
Ensuring Competition
Also important is the role of encouraging competition through implementation of
the Federal Reserve's bank merger policy. This role is particularly important at a time when
banking and the financial sector in general are experiencing an unprecedented merger movement
that is radically restructuring these industries. Before discussing newer analyses that we might be
called upon to perform, let me emphasize that I think that we must continue to be extremely
vigilant to protect local market competition. Applicants should remember that we measure
impacts on local market structure considering both HHI and concentration ratios. Transactions
satisfying one of those measures may not satisfy the other measure. Small increases in market
share as measured by HHI may mask the high market share of the dominant competitor. In those
cases, I would expect that mitigating factors, even for small increases in market share, must be
extremely strong to gain approval.
The task of enforcing bank merger policy will become potentially more
challenging if financial conglomeration occurs, since the analysis of competition relies on the
correct definition of the relevant geographic and product markets. Thus, increasing numbers of
financial conglomerates that sell traditional retail banking services along with insurance and
securities will make the analysis of competitive effects of mergers more difficult. In addition, it
will remain important to distinguish between markets for large-scale wholesale products and
markets for household- and small-business-oriented retail banking products. We will also need to
consider the effects that networks, such as ATM and point-of-sale networks, and other forms of
electronic banking have on competition for financial services. Finally, as financial relationships
become increasingly complex, we must work to reduce market inertia that could lessen
competition by restricting customers' ability to choose freely among providers of financial
services. Domestic competition is particularly important not only because it increases the welfare
of our fellow citizens, but also because other reforms, such as those based on market discipline,
probably work best in a competitive market. Also, domestic competition is one of the most
powerful forces that gives rise to international competitiveness.
Reducing Systemic Risk through Improved Supervision
Finally, the Federal Reserve must continually improve the bank supervisory
process in order to help manage risk that could be introduced into the financial system by the
changes occurring in the financial sector. The effects of consolidation and conglomeration on
systemic risk cannot be ignored. If risk is not managed properly within the consolidated firm, the
repercussions could extend beyond a single institution and well into the financial sector. Even if
the moral hazard problem could be largely solved, so that financial firms bear the individual
costs of the risks they adopt, these firms may fail to internalize the costs borne by the entire
financial system when their portfolio decisions result in bad financial outcomes. The risk of such
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 efforts
that the Federal Reserve is pursuing in order to improve bank supervision. Much of our effort,
along with that of other bank supervisors, is focused on improving our ability to monitor and
supervise the risk management practices of banks and banking organizations. Closely related
work is aimed at devising capital standards that more accurately reflect the realities of today's
banking world. Through it all, I would emphasize that old-fashioned supervision, the core of
which is the on-site examination, remains central to our supervisory strategy. Improved market
discipline, increased communication with other supervisors, and enhanced stability through
greater diversification are necessary. But improved supervision is also critical, and sometimes
there is simply no substitute for a well-trained and highly motivated examiner "on the ground."
V. Conclusion
In closing, I would like to reemphasize the importance of the basic skills that
remain centrally important in the financial services sector. Regardless of the extent and the
nature of conglomeration, technological development, and new financial instruments, good
fundamental business practices will remain essential: credit underwriting and risk management
skills, cost control, and appropriate pricing practices. While technological improvements are an
aid in nearly all these areas, only sound management practices will allow industry participants to
take advantage of any advances in technology. At the same time, fundamental principles of
supervision and regulation must be applied, including sound credit standards and on-site
examinations, to ensure the safety and soundness of the financial sector. Finally, regulators
should implement antitrust policy in a manner that will ensure competitive prices and services as
the financial sector evolves and consolidates. Despite the importance of vigorous supervision and
regulation, I and my colleagues on the Board are quite sensitive to the fact that it is not our role
to judge the wisdom of management decisions and business strategies beyond ensuring that
public policy standards regarding supervision and regulation are met. I look forward to observing
and participating in this sector's evolution into the next century. I thank you once again for the
opportunity to discuss these issues with you today.