Mr. Meyer discusses the Federal Reserve and bank supervision and
Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the
regulation
US Federal Reserve System, presented before the "Spring 1998 Banking and Finance Lecture",
Widener University, Chester, Pennsylvania, on 16/4/98.
It is a pleasure to continue what is becoming a tradition of Federal Reserve
Governors speaking at Widener University.
When you think of the Federal Reserve, I am pretty sure that, in addition to
speakers at your university, most of you think of monetary policy, interest rates, international
finance, and the Fed's macroeconomic responsibilities in all of these areas. And, of course,
macroeconomics lies at the core of what any central bank does. However, for a variety of
reasons that I will discuss shortly, the Federal Reserve plays a major role in the supervision and
regulation of banks. Moreover, I believe that the connections between bank supervision and
macroeconomic policy are not only little understood, but also quite close. No economy can
grow and provide an increasing standard of living for its citizens without also having a stable and
efficient banking system. Recent events in Asia are just the most current reminder of this truth.
I will begin my remarks today by summarizing, very briefly, why and how banks
are regulated in the United States. Then I will outline the key trends that I see affecting the
banking and financial sector, and the challenges that these trends pose for bank supervisors. In
the final portion of my remarks, I will suggest some directions that I believe we should consider
when thinking about how bank supervision should evolve over time.
Bank Supervision and Regulation in the United States
Why do we supervise and regulate banks? The reasons are very straightforward.
First and foremost, problems in only a small number of banks can, under the right circumstances,
become problems in the entire banking and financial systems, with potentially major risks to the
real economy. Traditionally, this meant protecting against a panic-driven flight to currency
otherwise known as a contagious series of bank runs, that caused a catastrophic decrease in the
money supply and the collapse of financial intermediation. Today, largely because of deposit
insurance and the Federal Reserve discount window, flights to currency are not a real concern in
the United States. Rather, the stability of the electronic, large dollar payments system, which
moves trillions of dollars a day and in which banks play a pivotal role, is critical in limiting
systemic risk. Other potential pressure points, in all of which banks play a key role, include the
liquidity of securities, financial derivatives, and interbank funding markets.
Our very success at virtually eliminating the risk of bank runs in the United States
has led to a second major reason for supervising and regulating banks. Deposit insurance, the
discount window, and Federal Reserve payment system guarantees - the very things that have
eliminated bank runs - create what is called a "safety net" for banks. The existence of this safety
net gives the government a direct stake in keeping bank risks under control, just as a private
insurance company has a stake in controlling the risks of policyholders. Because deposit
insurance and other parts of the safety net can never be fully and accurately priced, it is
necessary for us to monitor and sometimes to act to control bank risks in order to protect the
potential call on taxpayer funds. An equally important, if unintended, consequence of the safety
net is that it creates what economists term "moral hazard" incentives for some banks to take
excessive risks. That is, the safety net creates incentives for banks to take larger risks than
otherwise, because the safety net, and potentially taxpayers, may absorb most of the losses if the
gamble fails. Such incentives are especially strong if the bank is close to failure since, at this
point, bank stockholders have virtually nothing to lose. Moral hazard is surely not much of a
problem today, when banks are healthy and bank capital ratios are high. But back in the late
1980s when over 200 banks were failing each year, moral hazard was a serious concern.
All right, you may say, I understand why we supervise and regulate banks. But
why do both the federal and state governments regulate banks, and why do three federal
government agencies have bank supervisory responsibilities? And, I hesitate to even ask, why
there are separate federal and state supervisors for thrift institutions and credit unions? Just in
case even the questions confused you, let me step back and outline the structure of the bank
supervisory system in the United States.
If you want to open a bank in the United States, you must get permission - that is,
a charter - from a government agency. There are two ways to do this: state governments charter
"state banks," and the federal government, through the Office of the Comptroller of the
Currency, charters "national banks." Thus, each state has a state bank supervisor. At the federal
level, things get a bit more complicated. The Comptroller of the Currency supervises national
banks. But since the FDIC insures certain deposits of both state and national banks, the FDIC
also has supervisory authority over the state and national banks that it insures. Moreover,
national banks must be, and state banks may be, members of the Federal Reserve System. In
addition, most banks are organized in bank holding companies, and the Federal Reserve is the
exclusive supervisor of bank holding companies. Savings and loans and credit unions get
separate charters, and each has its own state or federal supervisor.
In reality, the supervisory system is not quite as complex as it sounds, because,
believe it or not, both statutes and agreements among supervisors divide up supervisory authority
so that regulatory overlap is, to a significant degree, minimized. This division of labor involves
the allocation of primary federal regulator to the Federal Reserve for state member banks, to the
OCC for national banks, and to the FDIC for insured state non-member banks. In addition, the
coordination among the federal regulators in the interest of consistent treatment of banks is
facilitated by the Federal Financial Institutions Examination Council (FFEIC). Still, despite the
division of labor and the coordination through the FFEIC, the U.S. system is rather complicated.
Why do we have such a "Balkanized" structure of bank chartering and supervision
and regulation? In large part, it is not so much by design as it is the result of reacting to many
individual problems. But I believe that there is at least one systematic factor - the long-standing
desire of many Americans for a decentralized banking system. An important theme in American
political philosophy has been distrust of concentrations of power, especially concentrations of
financial power. Thus, from the start of our republic individual states insisted on being able to
charter their own banks, and were suspicious of the federal government's efforts to do so. It was
not until the trauma of the Civil War that Congress passed a National Bank Act that allowed for
extensive federal chartering and supervision of banks.
Even after passage of the National Bank Act, virtually all banks were severely
restricted in their ability to operate across state lines. Indeed, until passage of the McFadden Act
in 1927 national banks could only have one office. While this restriction was relaxed in 1933,
national banks and state banks that were members of the Fed were prohibited from branching
outside of their home state. Restrictions on interstate banking were viewed as important for
maintaining a "dual" banking system in which both federal and state governments could charter
banks, and in which no one bank, or group of banks, could gain too much power. Restrictions on
interstate banking only began to be dismantled within the last two decades, and were pretty much
entirely gone by the end of 1997. However, concerns about preserving a viable dual banking
system are still very much alive.
Today, bank supervision and regulation focus on three primary areas of public
policy concern. Safety and soundness supervision attempts to ensure that banks are managed
prudently and in ways that maintain the stability of the banking system. Enforcement of the
antitrust laws in banking seeks to foster open and competitive markets that provide high quality
banking services at minimum prices. Consumer protection laws and the Community
Reinvestment Act are aimed at making sure consumers are fully informed about the most critical
characteristics of banking products and services, and that banks meet the financial services needs
of their local communities, with particular attention to the needs of low and moderate income
neighborhoods. Congress has required the Federal Reserve to play an active role in all of these
areas.
The fact that the Federal Reserve has responsibilities in all of these areas is
sometimes strongly questioned. There has been more than one proposal over the years to
remove the Fed from bank supervision and regulation. I must confess that sometimes when I am
involved in a complicated supervision issue, I am tempted to feel that someone else should do it.
But in my saner and more reflective moments, I remain convinced that removing the Fed from
bank supervision and regulation would be a serious mistake. Let me try to explain why.
The central bank, in my experience, needs direct, hands-on involvement in the
supervision and regulation of a broad cross-section of banks in order to carry out the Fed's core
responsibilities of conducting monetary policy, ensuring the stability of the financial system,
acting as the lender of last resort, protecting the payments system, and managing a financial
crisis. Meeting all of these responsibilities is not just an academic exercise, it requires practical
knowledge of financial institutions and markets, knowledge that comes with being deeply
involved in supervising individual banking organizations. Without such involvement, the
Federal Reserve would be much less able to maintain both its practical knowledge of banking
and other financial markets, and the influence and authority necessary for macroeconomic policy
and crisis management. Ivory towers are great for universities, but they are not desirable for
central banks.
While our supervisory responsibilities make us a better macroeconomic
policymaker, I believe that our macroeconomic policy responsibilities make us a better bank
supervisor. In the course of designing and implementing our supervisory policies, we must
weigh safety and soundness concerns against the potentially adverse effects on the economy of
excessively rigid regulations. As Chairman Greenspan has observed, the optimal rate of bank
failure is not zero. Banks must be allowed to perform their economic functions of measuring,
accepting, and managing risk. Taking and managing risk mean that sometimes risk will have
costs, including failure. In my judgement, the central bank is in a unique position to balance the
complex and sometimes conflicting objectives of financial stability and a growing economy.
The Fed is less likely to engage in an unnecessarily restrictive or, for that matter, excessively
loose, supervisory policy than is an agency focused either solely on bank safety and soundness or
solely on growth. Finally, the U.S. central bank, because of its extensive and well-established
relationships with foreign central banks is ideally positioned to engage in coordinated action in
managing international financial crises and in supervising institutions that have a substantial
international presence. The on-going crisis in Asian financial markets is our most recent
example of the need for such coordination of supervision.
The Federal Reserve is the primary bank regulator of only 5 of the largest
25 banks, the large, complex and internationally active banks that are the major sources of
systemic risk. The Federal Reserve is able, nevertheless, to maintain a flow of information about
the risk profiles and risk management practices of all large banking organizations through its
responsibilities as exclusive supervisor of all bank holding companies. It is for this reason that
the Federal Reserve places such a great emphasis on maintaining its role as supervisor of bank
holding companies.
Key Trends Challenging Bank Supervisors
Let me turn now to a discussion of the key trends in banking and financial
markets that are challenging bank supervisors. Surely the most profound force that has been
transforming the financial, and other sectors of our economy, is the rapid growth of computer
and telecommunications technology. In finance, a critical and complementary force has been the
development of intellectual "technologies" that enable financial engineers to separate risk into its
various components, and price each component in an economically rational way. Indeed, Nobel
Prizes have been awarded for some of these discoveries.
Implementation of financial engineering strategies typically requires massive
amounts of cheap data processing; and the cheap data processing would not be useful without the
formulas required to compute prices. The combination of the two has led to a virtual explosion
in the number and types of financial instruments. Key examples include virtually all types of
financial derivatives, such as interest rate and currency swaps and, more recently, credit
derivatives. Asset-backed securities, from mortgage-backed securities to credit card receivables
to collateralized loan obligations, provide additional examples of what can result from the
mixing of technological and intellectual innovation. Such products have lowered the cost and
broadened the scope of financial services, making it possible for borrowers and lenders to
transact directly with each other, for a wide range of financial products to be tailored for very
specific purposes, and for financial risk to be managed in ever more sophisticated ways.
Financial innovation has been the driving force behind a second major trend in
banking - the blurring of distinctions among what were, traditionally, very distinct forms of
financial firms. One of the first such innovations, with which we are all now very familiar, was
money market mutual funds. Money market mutual funds took off in the late 1970s as market
interest rates rose above rates that banks were allowed to pay on deposits. Eventually the entire
system of interest rate controls, known as Federal Reserve Regulation Q, was dismantled by
market realities and then, as a result, by the law. In the 1980s, banks began to challenge whether
the Glass-Steagall Act prohibited combinations of commercial and investment banking. Today,
both the regulators and the courts agree that Glass-Steagall does not imply a total prohibition,
and bank supervisors have allowed a substantial blending of commercial and investment banking
in the form of so-called Section 20 subsidiaries of bank holding companies. More recently,
traditional separations of banking and insurance sales have also begun to fall, with support from
the supervisors and the courts.
A major result of the continued blurring of distinctions among commercial
banking, investment banking, and insurance is a tremendous increase in competition in markets
for many financial services. Greatly intensified competition has also led to increasing pressure
for revisions to many of the banking laws and regulations, such as the Glass-Steagall Act, that,
despite some successful efforts at relaxing them, continue to exert outdated and costly restraints
on the banking and financial system. However, the issues involved are often complex and highly
political, and so far efforts to achieve "financial modernization" have been more piecemeal than
I would desire.
Nevertheless, deregulation has been a major force for change in the banking and
financial services industries. Two decades ago we still had Regulation Q, the Glass-Steagall Act
was widely viewed as requiring a virtual prohibition of combinations of commercial and
investment banking, and interstate banking and branching were barely fantasies even at the state
level, let alone applications for combinations of insurance and banking. Just a few days ago, the
House of Representatives almost voted on a massive re-write of the laws on permissible bank
holding company activities and is now scheduled to consider the issue early next month. It is
difficult to predict the outcome of that bill, and I will not. But I will note that the pressures of
market developments for changes in the rules set up during the Great Depression are immense.
If Congress does not act, loopholes and regulatory changes will continue to be exploited - with
or without bank participation. The forces of technology and globalization will deregulate in one
way or another. I and my colleagues would prefer that the Congress would guide those changes
in the public interest, but legislative deadlock will not do the job because the status quo will not
hold.
The fourth major force transforming the banking landscape is the globalization of
banking and financial markets. Indeed, globalization has been reshaping not only the financial,
but also the real economy for at least the last three decades. The interactions of developments in
both the financial and real economies have expanded cross-border asset holdings, trading, and
credit flows. In response, financial intermediaries, including banks and securities firms, have
increased their cross-border operations. Once again, a critical result of this rapid evolution has
been a substantial increase in competition both at home and abroad. Today, for example, almost
40 percent of the U.S. domestic commercial and industrial bank loan market is accounted for by
foreign-owned banks.
The final significant trend I will highlight is the on-going consolidation of the
U.S. banking industry. I think that it is fair to say that the American banking system is currently
in the midst of the most significant consolidation in its history. As I mentioned earlier, in the last
two decades nearly all of the traditional barriers to geographic expansion of U.S. banks have
crumbled. While the states took the lead in eliminating these barriers beginning in the late
1970s, the final step was taken by the federal government with passage of the Riegle-Neal Act in
1994. Under this Act, virtually full interstate branch banking became possible in June 1997.
A few facts will perhaps give you a feel for the profound changes occurring in the
structure of the U.S. banking system. In 1980 there were about 14,400 banks in the U.S.
organized into about 12,300 banking organizations. By the end of 1997, the number of banks
had fallen to just under 9,100, and the number of banking organizations to not quite 7,200. This
42 percent decline in the number of banking organizations was due in part, but only in part, to
the large number of bank failures in the late 1980s and early 1990s. A more important factor
was mergers among healthy banks. Since the early 1980s, it has not been unusual to see 400 or
more mergers among healthy banks each year.
While mergers have occurred, and continue to occur, among banks of all sizes, I
would emphasize three aspects of the current bank merger movement. First is the high incidence
of "mega mergers," or mergers among very large banking organizations. Several mergers of the
last few years have been either the largest at the time, or among the largest bank mergers in U.S.
history. Examples include the combining of Chase Manhattan and Chemical Bank, Wells Fargo
and First Interstate, NationsBank and Barnett, and, most recently, First Union and CoreStates.
Second, despite all of the merger activity, a large number of medium to small banks remain in
the United States. Moreover, by most measures of performance these small banks are more than
a match for their larger brethren for many bank products and services. Indeed, when a mega
merger is announced it is not uncommon to read in the press how small banks in the affected
markets are licking their chops at the business opportunities created thereby. Research seems to
support their optimism. Lastly, while the overall number of banking organizations has fallen
since 1980, this does not mean that new, or de novo, entry has not occurred. From 1980 through
1997 some 3,600 new banks were formed in the United States. My bottom line? The
U.S. banking structure is highly dynamic, is adjusting to a variety of forces, and defies easy
generalizations.
The current wave of bank mergers has led to a substantial increase in bank
concentration at the national level. For example, the percentage of banking assets controlled by
the top 10 banking organizations rose from about 22 percent in 1980 to 34 percent in 1997. The
percentage held by the top 25 increased from 33 to 53 percent.
Are these increases in national concentration a public policy concern? In my
view, the answer to this question is "no," at least at this time, because virtually all the evidence
we have strongly suggests that competition problems almost always arise in banking at the local
level. That is, to the extent that banks are able to exert market power, the exercise of such power
tends to occur in retail markets that are relatively narrow in geographic scope, and for a fairly
well-defined set of customers, usually households and small businesses.
However, a special influence on local market competition may develop as bank
consolidation and interstate branching continue, resulting in the largest banks competing with
each other in an increasing number of local markets. Such widespread competitive contacts may
cause these firms to temper their competitive behavior in individual markets in recognition of the
potential for responses by their rivals in other common markets and in recognition of their
widespread mutual interests.
So, what has happened to banking concentration in local markets since 1980?
The answer is, "not much". For example, the average three-bank deposit concentration ratio in
Metropolitan Statistical Areas, a common measure of local urban markets, hovered between
65 and 68 percent between 1980 and 1997. Concentration measures for rural counties show
similar results, with the average three-bank concentration ratio remaining at about 89 percent
throughout the period. Other measures of local market concentration show similar results for
both urban and rural areas.
The stability of local market concentration in the face of such a large
consolidation of the banking industry is remarkable. While there is no single reason for this
stability, I would point to two factors as being of particular importance. Many mergers,
including some mergers of very large banks, involve institutions that do not compete in the same
local markets. In such cases, local market concentration is obviously not affected. Where the
merging banks do compete in the same local markets, enforcement of the antitrust laws has been
an important factor limiting the growth of local market concentration. Moreover, antitrust
enforcement has no doubt deterred some highly anti-competitive mergers from even being
proposed.
Why have banks been consolidating in number and expanding in size and
geography? Again, no one answer is appropriate, and each merger is somewhat unique and
reflects more than one factor. In recent years many banks have been responding to the removal
of barriers to interstate banking and branching that restricted entry and divided markets. In such
cases, the twin desires to diversify risk geographically and to expand sources of "core" deposits
have surely been important motivating forces. Moreover, geographic barriers had constrained
natural market developments; in an important sense their removal has simply allowed the market
to adjust to a new economic equilibrium from a previously legally mandated equilibrium.
Beyond such adjustments, scale economies are mentioned frequently by bankers
as a causal factor in bank consolidation, although academic research has not tended to find much
evidence of overall economies of scale in banking. Still, economies of scale certainly exist for
some bank operations, such as many back office functions. In addition, some lines of business,
such as securities underwriting and market making, require large levels of activity to be viable.
Increased competitive pressures caused by rapid technological change and the resulting blurring
of distinctions between banks and other types of financial firms, lower barriers to entry due to
deregulation, and increased globalization are also important factors. For example, greater
competition forces inefficient banks to become more efficient, accept lower profits, close up
shop, or - in order to exit a market in which they cannot survive - merge with another bank.
Other possible motives for mergers include the simple desire to achieve market power, or efforts
by management to build empires and enhance compensation. Some mergers probably occur as
an effort to prevent the acquiring bank from itself being acquired, or, alternatively, to enhance a
bank's attractiveness to other buyers.
No matter why banks are merging, the bottom line is that the United States is well
on its way to developing a truly national banking structure for the first time in its history. We
are not quite there yet, but I do not think it will take too many more years. What will this
structure look like? Well, that is obviously a very complex question, the answer to which
involves forecasting years in advance. And I can tell you from many years of experience,
forecasting the economy even one year in advance is a very risky and humbling business. Thus,
any prognostications about future banking structure should be taken with very many grains of
salt.
Still, some economists at the Fed have tried to look through this dark glass to see
the future United States banking structure. For all of the reasons I have discussed, it seems
reasonable to expect a continued high level of merger activity for the foreseeable future. Very
large mergers will not be uncommon. Studies based on historical experience suggest that in
around a decade there will likely be about 3,000 to 4,000 banking organizations, down from
about 7,000 today. Although the top 10 or so banking organizations will almost certainly
account for a larger share of U.S. banking assets than they do today, the overall size distribution
of banks will probably remain about the same. That is, there will likely be a few very large
organizations, and an increasing number of firms as we move down the size scale. Importantly,
a large number of small banks is expected to remain.
Future Directions in Bank Supervision
What do all of these changes mean for how we supervise and regulate banks?
Analysis of competition
Clearly, as the banking industry consolidates we need to maintain competitive
markets. Competitive markets are our best assurance that consumers receive the highest quality
products at the lowest possible prices. As I discussed earlier, there are many reasons to believe
that in recent years competition has increased greatly in markets for a large number of financial
products and services. This is true for many products purchased in local, regional and national
markets. However, in some cases we still observe potential competitive problems with a
proposed bank merger. Fortunately, the antitrust laws, as written into the banking statutes, give
us the means to maintain competition in such situations. These laws require that the Board
approve only those mergers that are not expected to substantially harm competition. When
implementing this policy, the Board may require changes to a merger proposal, and may even
deny an application, if the merger or acquisition would result in a highly concentrated market, or
an excessively large increase in concentration. As I indicated a few minutes ago, the focus of
our analysis is normally on local retail markets for banking products and services.
Over the past year or so, quite a few applicants have pushed very hard at the
Board's frontier for approving merger applications. Some applicants appear to have held the
view that almost any merger could be approved, even if it violated the screening guidelines that
both the Federal Reserve and the Department of Justice use to decide which mergers require
close examination.
In response, the Board has occasionally felt compelled to remind applicants,
especially those proposing a merger that would affect a large number of local markets, that
substantial changes in market concentrations will receive careful review. Moreover, when
mergers would exceed the screening guidelines, "mitigating" factors must be present. By
mitigating factors I mean conditions that tend to create a more competitive market than is
suggested by market concentration alone. These would include characteristics that make a
market highly attractive for new entry, or situations where nonbank providers of financial
services are unusually strong. The greater the deviation from the screening guidelines, the more
powerful and convincing the mitigating factors must be.
I have been particularly concerned with cases where a large number of local
markets are affected. In such cases, even if the adverse effect is fairly small in each of several
local markets, it seems to me that the cumulative, or total, adverse effect might be significant.
Thus, when a large number of markets are affected adversely, I believe that we should be
especially careful to assure ourselves that there are substantial mitigating factors.
In addition, when a merger would cause a large change in concentration in a
market that is, or becomes, highly concentrated, I think we need to give special attention to the
impact on competition. The reason for this is that I think when the change in concentration is
large, the effect on interfirm relationships, market dynamics and thus competition is likely to be
more pronounced, other things equal.
Assessing safety and soundness
Technological change, financial innovation, the acquisition of new powers by
banking organizations, the increasing geographic scope of banks, and the globalization of
financial markets all challenge our ability to examine and assess the safety and soundness of
individual banking firms. One way that examiners are adapting to this changed world is to focus
much of their attention on the information and risk management systems of banks. The key
question they ask is: How effectively are these systems measuring and controlling an
institution's rapidly changing risk profile? The emphasis on risk management is most critical at
our largest, most sophisticated, and most internationally active banks. Many of these banks use
advanced economic and statistical models to evaluate their market and credit risks. These
models are used for a variety of purposes, including allocating capital on a risk adjusted basis
and pricing loans and credit guarantees.
The development by some banks of increasingly accurate models for measuring,
managing, and pricing risk has called into question the continuing usefulness of one of the
foundations of bank supervision - the so-called risk-based capital standards, or the Basle Accord.
The Basle Accord capital standards were adopted in 1988 by most of the world's industrialized
nations in an effort to encourage stronger capital at riskier banks, to include off-balance sheet
exposures in the assessment of capital adequacy, and to establish more consistent capital
standards across nations. The Accord was a major advance in 1988, and has proved to be very
useful since then. But in recent years calls for reform have begun to grow. I will outline briefly
one of the key problems we are currently facing with the Basle Accord.
The Basle Accord capital standards divide bank on- and off-balance sheet assets
into four risk buckets, and then apply a different capital weight to each bucket. These weights
increase roughly with the riskiness of the assets in a given bucket. The basic idea is that more
capital should be required to be held against riskier assets. However, the relationship is rough.
Perhaps most troublesome, the same risk weight is applied to all loans. Thus, for example, a
loan to a very risky "junk bond" company gets the same weight as a loan to a "triple A" rated
firm.
While the Accord has the virtue of being relatively easy to administer and enforce,
it also clearly gives banks an incentive to find ways to avoid the regulatory capi