Roger W Ferguson, Jr: The future of financial services - revisited
Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal
Reserve System, at the Future of Financial Services Conference, University of Massachusetts,
Boston, 8 October 2003.
* * *
It is my pleasure to join you again, five years after I first spoke to this conference on the future of the
financial services industry. Today, I want to re-visit the evolution and performance of the financial
services industry, not only in light of what I discussed five years ago but also, more importantly, in light
of a number of significant events and market developments that have occurred since then. Clearly, I
will be able neither to cover all the interesting topics nor to discuss in depth each of those subjects that
I do include. But I believe it is useful to step back occasionally and try to take a broad view of our
detailed and complex financial landscape.
In the interest of full disclosure and for the benefit of those of you who either were not here five years
ago or may not have committed my remarks to memory, I will begin by summarizing the conclusions I
advanced the last time I spoke at this podium. At that time I highlighted four general conclusions. First,
I suggested that the movement toward large financial conglomerates, stimulated by the ongoing
blurring of traditional distinctions between financial products provided by commercial banks,
investment banks, insurance companies, and other financial intermediaries, might prove to be
transitory. Second, I argued that basic financial and risk-management skills would likely remain the
most important determinant of a company's viability and continued success. Third, I maintained that,
even in a world of financial conglomerates, there would be room for smaller and, in some cases,
morespecialized market participants. Last, I indicated that the supervisory and regulatory structure and
practice would need to evolve to meet all of these challenges, and that regulatory authorities would
need to remain vigilant in carrying out our duties, particularly in the area of antitrust enforcement.
These conclusions still seem reasonable to me. That having been said, events and market forces
require that we rethink and refocus our views, and your invitation gives me the opportunity to do so.
So, what have been the major factors that have influenced the financial services industry, and
especially the banking industry, over the past five years? And how should we interpret these
developments with respect to their effects on the recent past and the future? I see at least five broad
topics that are worthy of our attention. First, the recession of 2001 and the unusually slow recovery
over the past two years have clearly affected the banking and financial services industry. Second, the
passage of the Gramm Leach Bliley Act in late 1999 recognized many of the market realities I
discussed with you in 1998 and provided increased opportunity for the formation of large financial
conglomerates. Third, accounting and corporate governance scandals, symbolized by Enron and
WorldCom, and the resulting passage of the Sarbanes-Oxley Act in July 2002, have not left the
financial services industry untouched. Fourth, although the dot-com craze has ended, technological
change has continued, and its influence on the present and future of financial services is pervasive.
Finally, all these developments and others, such as the Russian debt default in the fall of 1998, have
accentuated the importance both of risk measurement and management at individual banks and of the
need for supervisory policies and procedures to reflect and encourage modern risk management.
The Recession of 2001
Turning first to the recent recession and our unusually slow recovery, I think that the most remarkable
fact regarding the banking industry during this period is its resilience and retention of fundamental
strength, even at those institutions whose earnings were negatively affected by the slowdown.
Beginning about the time I last spoke to you, the U.S. financial system suffered a sharp increase in
corporate bond defaults, business failures, and investor losses. At commercial banks, troubled loans,
including charge-offs, classified loans, and overdue credits, climbed. In sharp contrast to other periods
of economic weakness and market volatility, however, during the most recent period the vast majority
of commercial banks remained unusually healthy. Strong rates of return on both equity and assets and
healthy capital ratios were all maintained. Perhaps most tellingly, the period from 1998 through 2002
averaged only five bank failures per year. Today, market measures of bank risk derived from stock
prices, subordinated debt spreads, and credit default swap spreads all signal a healthy banking
industry. In contrast, in the last three years of the 1980s, more than 200 banks failed on average each
year (not to mention a larger number of savings and loans). Even in 1993, two years after the 1990-91
recession ended, slightly more than 100 banks failed. To what can we attribute the recent outstanding
performance, and will it be repeated in future economic slowdowns?
In truth, our current good fortune stems from many factors, none of which can we count on recurring
but several of which we can somewhat control. One factor is that the most recent recession was
relatively short and weak, even though the recovery has been slow. That the Federal Reserve moved
early and aggressively to lower interest rates has also been very helpful to banks and other
participants in the U.S. economy. I suspect that many of you in this room have refinanced your
mortgages, perhaps more than once, over the past two years. Maybe some of you even cashed out, or
extracted, some of the equity you had accumulated in your house when you refinanced your old loan.
Such mortgage-related activities have helped consumers to maintain their expenditures, have helped
the overall economy to grow, and have contributed significantly to the earnings of the banking system.
These earnings have helped banks absorb losses elsewhere in their portfolios and to maintain loan
loss reserves. Indeed, in the second quarter of this year, the fifty largest U.S. bank holding companies
reported record earnings of more than $20 billion, and annualized rates of return on equity and assets
were very impressive.
Another important factor is that the U.S. banking system entered the current period of stress well
capitalized and with strong reserves. No doubt such balance sheets were due in very large part to the
economic prosperity of the second half of the 1990s. But I believe that other forces were also at work.
Certainly bankers themselves learned many lessons from the banking and thrift crises of the late
1980s and early 1990s, including the importance of having strong capital and reserves and of avoiding
obligor and industry concentration of credit risk. Perhaps equally important were the banking reforms
put in place in the aftermath of those crises. Of the many reforms, I highlight the emphasis on strong
capital positions provided by the Federal Deposit Insurance Corporation Improvement Act of 1991 and
other changes in supervisory policy, such as the move toward risk-based capital standards embodied
in the 1988 international capital agreement known as the Basel Accord. I hope that bankers and their
supervisors will remember these lessons well into the future.
I also point to another reason that the U.S. banking system has performed so well over the current
economic cycle. This factor is the truly impressive improvement in methods of risk measurement and
management and the growing adoption of these technologies by mostly large banks and other large
financial intermediaries over the past five years. To be sure, at most banks the application of these
methods is still in its infancy, if it has begun at all, and even the most advanced banks have room for
improvement. But modern advances in the quantification of risk and in its management have provided
bank management with a far more disciplined and structured process for evaluating loans, pricing
risks, and deciding which risks to retain. Careful judgment by experienced credit officers or risk
managers is still required, but the modern techniques developed by both academics and market
practitioners are tools that facilitate a much deeper evaluation of risk than was possible even a decade
ago.
These developments have been supported and encouraged by the growth of markets for syndicated
loans and securitized assets and the creation of new financial instruments, such as credit derivatives,
that greatly ease the dispersion of risk to those more willing and able to bear it. Do not misunderstand
me. New risk-management techniques and instruments bring their own problems, some of which I will
return to in a moment. But, in my view, the successful application by those banks taking advantage of
these new management tools and techniques has been an important part of the explanation for why
the banking system has remained so strong during our most recent period of stress.
Gramm-Leach-Bliley and the Potential for Financial Conglomerates
When I spoke to you in the fall of 1998, the financial conglomerate was a very hot topic. Indeed, just a
little more than a year after that date, the Congress enacted, and the President signed into law, the
Gramm-Leach-Bliley Act. The act recognized the market reality that it was becoming increasingly
difficult to maintain traditional distinctions between many of the activities of commercial banks,
investment banks, and insurance companies. In response, the Congress relaxed long-standing
restrictions on affiliations among these three types of entities. To avoid extending the subsidy implicit
in deposit insurance and access to the Fed's discount window and payment system guarantees to
these new activities, the act required that most investment banking and insurance business in banking
organizations be conducted in a legally separate financial holding company affiliate of a commercial
bank. In addition, the Congress required that, to be a part of a financial holding company, an institution
must be well capitalized and well managed.
An interesting observation is the slow pace of change since 1999. The slow pace is, no doubt, partly a
result of the economic slowdown and the stock market decline. But I suspect that these factors do not
fully explain what has happened. Indeed, I suggest that the financial conglomerate, or the financial
supermarket, or whatever you want to call it, is in fact much more difficult to implement than many may
have thought. True, there were about 600 domestic financial holding companies of the end of 2002.
But less than one-third reported actually engaging in any new activities authorized by
Gramm-Leach-Bliley, and about 80 percent of these report engaging in insurance agency activities,
probably the least "new" and least risky of all the possibilities provided by the act. Only about forty
institutions reported broker-dealer assets, around thirty reported insurance underwriting assets, and
less than twenty said they held significant merchant banking assets using Gramm-Leach-Bliley
authority. Even accounting for the fact that some of these activities are conducted primarily at the
largest financial holding companies, and recalling that large bank holding companies were already
engaging in some of these activities through the previously authorized section 20 affiliates, we have
not been able to uncover any evidence that the overall market structure of these segments of the
financial services industry has substantially changed. Of course, while the overall structure has not
changed, some firms have gained market share in certain segments.
These facts do not suggest that we should be complacent regarding the need to maintain competitive
markets in financial services. It is difficult to overstate the benefits of competition, and thus I stand by
my admonition of five years ago that policymakers should remain vigilant in antitrust enforcement.
Indeed, even though there have not been fundamental changes in the structure, in my judgment what
deserves the emphasis is the persistent and even increasing competitiveness of the U.S. banking and
financial markets. Let me try to illustrate what I mean.
The U.S. banking system has experienced significant consolidation over the past several years.
Between 1994 and 2002 there were slightly more than 3,300 bank mergers in the United States, and
almost $3 trillion in banking assets were acquired. This consolidation led to considerable increases in
national concentration among the largest banking organizations. For example, the share of domestic
banking assets held by the top five banking organizations went from 18 percent in 1994 to almost
32 percent in 2002, and the share of the top twenty-five went from 46 percent to 61 percent.
However, these numbers tend to hide more than they reveal about the competitiveness of the U.S.
banking structure. For example, at the end of 2002 there were still almost 6,500 commercial banking
organizations in the United States, not to mention almost 1,400 savings institutions and almost
10,000 credit unions. Moreover, between 1994 and 2002 more than 1,300 new banks were opened in
the United States, sometimes in direct response to perceived declines in service resulting from a bank
merger. Most importantly, the degree of concentration in local banking markets, both urban and rural,
declined modestly, on average, during this period. Local markets are the very markets that are the
focus of virtually all of our antitrust analysis because they are the markets where most households and
small businesses conduct the vast majority of their banking business.
For all of these reasons, and for others that I do not have time to discuss, I would argue that the U.S.
banking structure has generally remained competitive, and in some cases has become more
competitive, over the recent period of intense merger activity and institutional and legislative change. I
am optimistic that this dynamic competitiveness, helped along every now and then by antitrust
enforcement, will continue.
Accounting and Corporate Governance
Many people, myself included, have found the last few years' revelations of accounting and corporate
governance problems at many of our nation's most well-known corporations both disturbing and
unacceptable. The foundations of an efficient and competitive free market economy in a democratic
society include accounting transparency, a commitment by owners, managers, and employees to high
standards of ethical behavior, and the maintenance of internal organizational structures and incentives
that encourage ethical behavior.
Unfortunately, some of the cases of unacceptable behavior have occurred in the financial services
industry. Inadequate oversight of business lines by boards of directors has been a problem in some
instances. In one recent case, this deficiency resulted in transactions with special purpose entities
without adequate knowledge on the part of the board and without effective identification and
management of risks. More generally, we have seen transactions that elevated form over substance,
violated accounting rules, and created serious reputational and legal risks for the institution, all with
the apparent approval of outside auditors and lawyers.
In an attempt to deal with many of these and other issues, the Sarbanes-Oxley Act was enacted in late
July 2002. In addition, the Securities and Exchange Commission, bank regulators, state attorneys
general, and others have taken many, sometimes well publicized, actions to improve accounting
transparency and corporate governance. Perhaps more important, the market itself has handed out
very harsh punishment to some firms that had lost their credibility with investors and customers. In
principle, it seems to me that these actions should provide powerful incentives for virtually all market
participants to maintain high standards.
Technological Change
Technological change had become a pervasive influence on our lives long before I first spoke to this
conference in 1998. It continues to be so, and surely it will be a force for the foreseeable future.
Virtually all industries that have been profoundly affected, and financial services is no exception.
I have already mentioned the importance of technological change in improving risk measurement and
management at financial institutions as a reason banks have weathered the recent economic
downturn. Moreover, I fully agree with the many observers who have highlighted the role of technology
in breaking down traditional distinctions between commercial banking, investment banking, and
insurance products. In this sense, the Gramm-Leach-Bliley Act can be thought of as a response to
technological change. And, technological change can surely throw us some unexpected curves, as the
successfully navigated but hugely expensive adjustments to deal with the century date change
showed.
I will return in a few moments to the role of technological change in risk measurement and
management and its influence on supervisory policy. But first I want to spend a few moments
discussing some interesting facets of the impact of change on the technologies used by American
households to consume financial services.
The process by which technological change becomes embedded in production and consumption has
long absorbed the attention of economists. Despite this interest, the process remains a considerable
mystery, and households' use of financial services is no exception. For example, many academics,
regulators, and bankers have for many years forecast that technological change would end use of the
paper check and make the brick-and-mortar bank branch obsolete. However, here we are in October
2003 and the paper check is still very much in use, the smart card has not succeeded as predicted,
and the number of brick-and-mortar bank offices is still increasing. Clearly, there is much that we do
not understand.
I am not here today to propose any definite answers to the question of why households adopt new
technologies in financial services more slowly than we sometimes predict. But I would like to present a
few facts that we have gathered over time in our triannual Survey of Consumer Finances that shed
some light on this complex topic.
In 1995, we began asking households about their use of computers to conduct business with their
financial institutions. In that year, barely 4 percent of households with a checking account said they
used a computer to consume financial services. By 1998, the year of the next survey, the percentage
saying they used a computer had risen to more than 6 percent. In contrast, in 1995 the most common
technology used by households for interacting with a financial institution was, by a wide margin, the
inperson visit to an office. In that year, 87 percent of households said they used this technology. By
1998 the percentage of households using in-person visits had declined to 80 percent, but this was still
by far the most common form of access.
Still, the data for 1995 and 1998 suggested change was beginning to occur, and the data for 2001
confirmed that trend. In the 2001 survey, the percentage of households with a checking account that
said they used the computer to consume financial services jumped dramatically to almost 20 percent.
However, use of the most common technology, the in-person visit, declined only modestly, to
78 percent.
While one cannot draw any strong conclusions from this small number of facts, they support the view
that, in matters of finance, households tend to adopt technological change only gradually. In addition,
even when new technologies start to gain more widespread acceptance, old technologies are
abandoned rather slowly and many users perhaps view the old and new technologies more as
complements than as substitutes. Research conducted by the Federal Reserve Board's staff
reinforces the notion that the adoption of technological change is a highly complex process. For
example, it appears that income, education, age, and other factors, perhaps even a household's
attitudes toward risk, play important roles in determining a household's willingness to adopt new
technologies for the consumption of financial services. On balance, I would suggest that strategic
planners at financial institutions will need to take a wide variety of factors into account in planning and
marketing technological innovations.
Risk Measurement and Management and the Implications for Supervisory Policy
In the final section of my remarks to you five years ago, I emphasized the need for the Federal
Reserve to continually improve the bank supervisory process to ensure that banks adequately manage
the risks that could be introduced into the financial system by changes occurring in the financial sector.
I have no doubt that this statement remains valid today, although the risk management challenges
facing banks have certainly evolved. For example, our experiences with the market disruptions that
followed the Russian default and the Asian debt crisis, and the growing importance of financial
markets in the risk management processes of both financial and nonfinancial firms have helped to
accentuate the importance of market liquidity.
Another significant adjustment in our supervisory emphasis is our ongoing effort to revise the Basel
Capital Accord. Today, I can give you only a taste of what we are trying to do, but over the past five
years, bank supervisors in the United States and other nations have devoted a truly impressive
amount of resources to developing a new set of international capital standards. Indeed, in early
August of this year the Federal Reserve and the other U.S. bank regulators released some very
specific proposals for public comment. The comment period ends in early November. After assessing
these comments together with those already received by the Basel Committee, the U.S. banking
agencies will seek appropriate changes in the proposals.
The need for Basel II, as the proposed revised accord is called, arises because modern risk
measurement and management practices, including the increasing ability to securitize assets, have
made Basel I increasingly out-of-date, or should I just say, increasingly irrelevant, for our largest and
most complex banking organizations. For example, the Basel I capital standards have only four risk
categories, and most loans receive the same regulatory capital charge even though loans made by
banks encompass a wide spectrum of credit quality. The highly limited differentiation among risks
means that regulatory capital ratios are too often uninformative and might well provide misleading
information regarding banks with risky or problem credits or, for that matter, with portfolios dominated
by very safe loans. Importantly, banks own internal capital models increasingly differentiate risks much
more finely than do regulatory capital standards.
Another problem with Basel I is that its overly simplistic risk measures, when combined with advances
in financial engineering technologies and improved risk measurement and management practices,
have given banks the incentive and the means to game the system through so-called regulatory
capital arbitrage. Regulatory capital arbitrage is the avoidance of regulatory capital charges through
the sale or securitization of bank assets for which the capital requirement that the market would
impose is less than the current regulatory capital charge. For example, low-risk residential mortgages
are often securitized rather than held on a bank's books in part because the market requires less
capital than does Basel I. This behavior is perfectly understandable, even desirable, in terms of
improving economic efficiency. But it means that banks engaging in such arbitrage retain the
higher-risk assets for which the regulatory capital charge, calibrated to assets of average quality, is on
average too low.
The Basel II capital standards seek to improve regulatory capital standards via three broad and
interrelated strategies, or "pillars." The most important pillar, Pillar 1, consists of minimum capital
requirements. These requirements are rules by which a bank calculates its minimum capital ratio and
by which its supervisor assesses whether the bank complies with the minimum capital threshold. As
under Basel I, a bank's risk-based capital ratio under Basel II would have a numerator representing
the capital available to the bank, and a denominator that would be a measure of the risks faced by the
bank, referred to as "risk-weighted assets." What would be radically different is the definition of
risk-weighted assets. Under our proposals, the most advanced banks would use modern
risk-management techniques, subject to validation by supervisors, to compute the risks in their on- and
off-balance-sheet portfolios. These procedures would more closely align regulatory capital
requirements with the underlying economic risks of a banking organization. As a result, the safety and
soundness and the efficiency of the banking and financial system should be greatly improved.
Pillar 2 explicitly addresses supervisory oversight. It embodies the concept that a well-managed bank
should seek to go beyond simple compliance with minimum capital requirements to assess whether it
has sufficient capital to support its risks. In addition, on the basis of their knowledge of best industry
practices at a range of institutions, supervisors would provide constructive feedback to bank managers
on their bank's capital adequacy and its risk measurement and management practices.
Lastly, Pillar 3 seeks to complement Pillars 1 and 2 by encouraging stronger market discipline of
banking organizations. An important element here is requiring a bank to publicly disclose key
measures related to its risk and capital positions. Such disclosures should help uninsured creditors of
a bank more accurately assess the risks of investing in the uninsured liabilities of the bank, including
taking the opposite side of financial derivatives transactions.
Conclusion
In closing, I want to thank you again for inviting me to speak to you. The future of the financial services
industry is something that should interest us all. It is certainly something that will affect us all, and I
look forward to observing and participating in its evolution over the coming years.