Mark W Olson: The banking industry in 2002 after a decade of change
Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System,
before the First Annual Convention of the Ohio Bankers League, Columbus, Ohio, 12 November 2002.
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Many of us began our careers in the financial services industry during an era when bank and thrift
executives saw each other as both business competitors and political foes. I distinctly remember one
experience I had as a member of the American Bankers Association's Government Relations
Committee in 1979. At our first meeting of the year, the "quarter-point differential" that thrift institutions
were allowed under Regulation Q was the banking industry's top political priority. For those of you too
young to remember, Regulation Q established the maximum allowable interest rate that could be paid
on deposit accounts, which at the time was a quarter point higher for thrifts. This first annual meeting
of the Ohio Bankers League following the merger of Ohio's banking and thrift trade associations is
emblematic of the changes that have taken place in these two industries. And this event presents a
good opportunity to review today's depository financial service industries in the context of a decade of
major change. To begin, let's review the highlights of the past decade.
First, there was the bank and thrift crisis of the late 1980s and early 1990s. Many banks and thrifts
failed, and many others were weakened to the point that they became acquisition targets. The
Congress and the regulators responded forcefully with the Federal Institutions Reform, Recovery and
Enforcement Act (FIRREA) in 1989, and the Federal Deposit Insurance Corporation Improvement Act
(FDICIA) in 1991. These legislative initiatives restricted banking practices, limited the supervisors'
discretion in dealing with weak banks, imposed new regulatory requirements--including prompt
corrective action--and strengthened supervisory oversight overall.
Beyond the bank and thrift crisis in this country, there were also indications that banks of other nations
followed different norms of capital adequacy, which had implications for competitive equity and for the
overall soundness of the global banking system. The G-10 nations responded with the Basel Accord, a
single, fairly simple global standard that was implemented in the early 1990s. The Basel standards
have become somewhat less simple over the years and are again under review. But achieving
international agreement on both components of capital and a risk-based approach to capital adequacy
was a major achievement.
A second force for change was the growing integration of banking markets, both geographically and
functionally. Through the 1980s and the first half of the 1990s, the various states were liberalizing or
eliminating their restrictions on interstate bank ownership. At the same time, nonbanks aggressively
developed and offered products that could compete directly with banking products.
The Reigle-Neal Act of 1994 was the epilogue to the saga of interstate banking, eliminating the
remaining barriers to interstate ownership and interstate branching. As a result, in an era of
consolidation and innovation, banks could pursue merger partners and branching strategies on the
basis of economics rather than geography while also consolidating and rationalizing their own legal
structure.
The boundaries between banking products and other financial service offerings have also become
less clear. Over the past decade, banks were increasingly interested in providing the full range of
products and services available from their nonbank competitors, to create operating efficiencies,
diversify potential revenue sources, and allow these banks to compete effectively with other [nonbank]
full-service financial services firms. The bank holding company structure was one vehicle for doing so,
especially securities underwriting and dealing through section 20 subsidiaries. Although revenues from
bank-ineligible securities activities were initially limited to 5 percent of a BHC's income, the Board
subsequently increased that limit to 25 percent. At this higher level, we began to see significant
merger activity between securities firms and bank holding companies.
In 1999, the Congress passed the Gramm-Leach-Bliley Act, arguably the most significant banking
legislation in the last quarter of the twentieth century. It dismantled much of the Glass-Steagall Act,
which for more than fifty years separated the banking and securities industries.
The most significant changes, however, did not occur in the Congress. Indeed, they occurred in the
marketplace. We experienced unprecedented change, from innovation in market practice to new
technologies that created new products and financial vehicles. In the process, we also spawned a new
generation of more sophisticated and rigorous risk-management practices. The expansion of
securitization and derivative markets allowed for management and transfer of risk, which in turn
created opportunities for banks to specialize increasingly in those phases of the
financialintermediation process in which they have an advantage, while also offering new hedging and
riskmanagement opportunities.
Finally, it is important not to overlook a fourth force for change, a decade of economic prosperity that
provided a rich context for growth and opportunity in the banking industry, and for financial markets
more generally. This prosperity was fueled significantly by capital investment in information technology
and in telecommunications capabilities. Ongoing advances in technology, related in part to this
investment, further supported the level of economic activity. The resulting structural improvements in
productivity allowed for significant growth both in output and in compensation to workers, who in turn
could acquire consumer goods and make financial investments in debt and equity markets.
Given the magnitude of the changes over the past decade, how does the reality of the current industry
status compare with our expectations of ten years ago? Let's start with the thrifts. Many, if not most
observers expected the thrift industry to struggle, perhaps never fully recovering from the problems of
the 1980s and early 1990s. Indeed, the future of any financial institution that specialized in originating
and holding residential mortgages seemed somewhat murky. By the same token, many anticipated
that the banking industry would be reined in by heavy regulation, the new regulatory capital standards,
and--perhaps--significant aversion to bold new initiatives. And many expected that gradual movement
toward broader interstate banking would bring about massive consolidation in the banking industry
that would raise serious questions about the future of community banks and the value of the
community banking franchise more generally. Broader interstate banking also raised questions about
the viability of the dual banking system, and the state banking charter in particular. Technological
improvements were expected to dramatically reduce the use of checks and cash. Bricks and mortar
branches were thought to be anachronistic, if not actual impediments, to operational efficiency. Well,
as you all know, forecasting is a difficult business.
In the thrift industry, there has certainly been consolidation. There are now significantly fewer, but
bigger, thrifts. As of June, there were just under 1,000 thrifts, with total assets of $960 billion compared
with 1,952 thrifts with assets of $839 billion in 1992. The average thrift now has assets of about
$960 million--more than twice the average of $430 million in 1992--and has an annual growth rate of
more than 9 percent. Over this period many thrifts merged with each other while many others became
part of bank holding companies, some of these operating as thrifts. Some of those were Ohio thrifts
that were acquired by major banks in the late 1980s in the wake of the state deposit insurance crisis.
Today, the thrift industry continues to be strong and viable. In 2001, the industry generated $10 billion
in earnings, or a return on assets of about 1.09 percent--both about five times the comparable figures
for 1992. The extent to which the banking and thrift industries are intertwined may be best reflected by
the fact that 34 percent of savings institution deposits are now BIF-insured.
The banking industry too has experienced consolidation, as the number of insured commercial banks
declined from about 11,450 in 1992 (with total assets of $3.5 trillion) to about 7,960 in June of this year
(with total assets of $6.7 trillion). Interestingly, the average bank then, as now, was about $120 million
smaller than the average thrift: $310 million in 1992 compared with $840 million as of this June. Banks
have grown both organically and by merger, in many cases combining multiple bank subsidiaries of
the same BHC for efficiency.
These aggregate figures mask some significant differences between large and small banks. Total
assets at the largest banks--that is, those larger than $10 billion--grew most rapidly, reaching
$4.7 trillion compared with $1.4 trillion in 1992. That represents an annual growth rate of nearly
14 percent. One has to be a little careful when comparing size categories over a period of this many
years. Over this period the number of banks over $10 billion grew by half--from 51 to 77--because
some smaller institutions were able to grow or merge their way into this largest-size class. The advent
of interstate banking provided important impetus to this process, as noted earlier.
In contrast, total assets at all community banks--that is, those with less than $1 billion in assets--have
remained essentially unchanged since 1992, at just a bit above $1 trillion. Total assets at regional
banks--those between $1 billion and $10 billion--actually declined over this ten-year period, falling from
about the same level as community banks, to about $900 billion. The number of regional banks fell just
slightly over this period, to about 320, while the number of community banks fell quite sharply under
the influence of consolidation.
Despite the consolidation in the banking industry, more than 8,000 separate banks [and 1,000 thrifts]
remain, and for every four bank charters that have disappeared through consolidation, one new de
novo charter has been approved. While the number of banks has declined, the number of bank
branches and ATM machines has consistently increased over the past decade. As for the future of
state banks, 75 percent of all new charters are state bank charters. The dual banking system, which is
such an important part of our financial heritage, continues, thanks in significant part to our nation's
state banking commissioners, who responded to the Reigle-Neal legislation by developing home/host
state bank supervision accords, which facilitated banks' wanting to branch across state lines.
Let me focus for a moment on the performance of commercial banks. Across all size categories, the
banking industry continues to perform well, with strong capital and strong balance sheets. Total bank
profits are at record levels, having reached $73 billion last year, and are on track for even better profits
in 2002. In 2001, the industry's return on assets came in at 1.16 percent, 20 basis points better than in
1992. Community banks came in just a bit below the industrywide total--at 1.10 percent, about the
same as the average thrift. This year, banks--especially community banks--have been aided by low
interest rates and the accumulation of core deposits, together with more recent and modest
resurgence in loan demand.
Efforts to improve earnings on equity have also resulted in differences according to bank size. The
largest banks have most aggressively worked to improve their efficiency ratios and expand their
sources of non-interest revenue. Not surprisingly, these banks have experienced the most
improvement in their returns on equity. The smaller banks have had a much more stable return on
equity--at relatively high levels, I might add. A close examination of community bank performance
reveals a wide range of efficiency ratios among traditional community banks, some of which have
efficiency ratios under 50 percent. The changes in return on assets among various size categories
offer a somewhat different twist. All else being equal, increases in capital will result in improved returns
on assets. Indeed, the banks with the most significant increases in capital are also the banks that have
realized the largest improvement in return on assets.
Mortgage-related banking continues to be attractive, particularly in this interest rate environment.
Although it has taken some toll on the value of mortgage-servicing rights, the recent boom in
refinancings has provided a nice source of fee income. However, acquiring long-term, fixed-rate
assets can also be a risky business, as we all know. Fortunately, bank and thrift managements have
learned much from their experience of a decade or more ago, and financial innovation and advances
in risk measurement have also helped. Financial institutions are much more aware of the complexities
associated with mortgage-related activities than in earlier years and now have at their disposal better
tools for measuring and managing their risks. We hope that interest rate risk will never again be the
problem for depository institutions that it was for some in the 1980s.
Asset quality remains an area for attention today, with nonperforming assets at 1.16 percent of loans
and about 8 percent of tier 1 capital and reserves. These figures simply do not compare with those of
1992 but tend to attract a supervisor's eye. Even at community banks, which have not been affected
so much by the recent spate of highly visible problem borrowers, problem assets have increased to
nearly 1 percent of loans and 6 percent of their capital and reserves. Reserve coverage of problem
loans also declined, to about 1.6 times problem loans compared with about 2.0 times for 2000. The
number of problem smaller institutions has increased, and the costs of several recent bank failures
raise the specter of a return to significant insurance premiums.
While on the subject of the 1990s, I should note that bank lending to finance commercial real estate
has grown rapidly in the last several years, especially among regional and community banks. As of
June, community banks had about one-third of their loan portfolios in construction and nonfarm
nonresidential lending, compared with about one-fifth ten years ago. Commercial real estate lending
is, of course, a natural part of the community banking business. Although few institutions have yet
encountered material problems in these portfolios, declining occupancy rates in some markets
increases the risk. Underwriting practices have been much stronger than in the 1980s, but the level of
concentration at regional and community banks is something that both supervisors and prudent bank
managers should monitor closely.
Let me also make a brief cautionary note about the importance of good internal controls, and the need
for management attention to their upkeep. This is simply good business practice, of course, but it's
more than that. You may recall that a provision of the FDIC Improvement Act of 1991 required that
banks--including many community banks--have external auditors attest to the quality and integrity of
internal controls, as part of their broader program of evaluating and testing these processes.
Unfortunately, in several recent examinations, bank examiners were able to identify clear internal
control weaknesses that neither the banks' own processes nor outside auditors had noted. Some of
these weaknesses raised safety and soundness concerns. Much more progress needs to be made in
this area, and we will be following this matter closely in the coming months.
Overall, it is clear that U.S. depository institutions, including commercial banks, stock and mutual
thrifts, remain sound, with still historically strong profitability, capital ratios, and loan portfolios. Without
becoming complacent, the industry can take comfort, so far, that it has withstood the last decade, and
the more recent economic weakness, quite well. That said, it will be important for bankers to stay on
top of their asset quality and internal controls. The increased sophistication in technology and product
development has actually increased the need for these controls.
In conclusion, I would like to thank you for the opportunity to discuss these issues with you today. The
past decade has been a time of dynamic change in the financial services industry and there are no
signs that the pace of change will abate. The challenge for regulators and the industry is to revisit our
assumptions, views, and policies frequently and to respond in a manner that continues to ensure a
sound and competitive financial system.