Mark W Olson: Observations on the Evolution of the Financial Services
Industry and Public Policy
Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System,
at the Center for the Study of Mergers and Acquisitions, University of Miami School of Law, Sixth
Annual Institute on Mergers and Acquisitions, Miami Beach, 7 February 2002.
* * *
It is a pleasure to visit the University of Miami School of Law, and I thank you for inviting me. In line
with the theme of your Institute, today I would like to discuss the ongoing consolidation of American
banking, and to some extent the conglomeration of the American financial system. This trend is one of
the most notable features of the contemporary financial landscape. Because the health of the financial
sector is central to the health of the entire economy, understanding the evolution of the financial
services industry is important to us all. As a third generation banker and having spent much of my
adult life on financial services public policy issues, the implications of this evolution are of particular
interest to me.
I will first briefly trace the evolving structure of the financial services industry, including some of the
more interesting developments since the passage in November 1999 of the Gramm-Leach-Bliley Act. I
will suggest that the U.S. financial services industry will likely remain a highly diverse and competitive
industry with room for many successful business models. I will then outline what I believe are the key
supervisory and regulatory issues facing bank supervisors in two critical areas: bank safety and
soundness and antitrust enforcement. I will argue, among other things, that the regulatory system set
up by Gramm-Leach-Bliley provides a sound and workable model for maintaining a secure and
competitive financial system.
The Evolving Structure of the Financial Services Industry
Commercial banking, the largest single component of the financial services industry, has experienced
massive consolidation since 1980. The number of banking organizations in the United States declined
from around 12,300 in 1980 to slightly more than 6,600 by the middle of 2001. But in comparison with
virtually any other developed economy of the world, the 6,600 existing banking organizations is an
extraordinarily large number. It reflects the origin of banking in this country. Until President Lincoln
signed the National Banking Act, all bank charters were state charters. Thus, for our first one hundred
years, we had a tradition of a large number of relatively small community-based banks. The rapid
consolidation was initiated here in the Southeastern states in the 1980s with the relaxation or removal
of previously existing legal restrictions on intrastate and interstate banking and branching. Following a
decade and a half of significant consolidation, the percentage of banking assets held by the top ten
banking organizations more than doubled, from about 22 percent in 1980 to about 45 percent in 2001,
while the share held by the top twenty-five organizations increased from about 33 percent to
61 percent.
Despite the scale of consolidation and the substantial increase in banking concentration at the national
level, banking concentration within local market areas has, on average, declined a bit over the past
two decades. This apparent anomaly largely reflects the fact that many of the mergers and
acquisitions have been between banking organizations in different geographic markets. In those
instances when the merging parties did serve the same local markets, the dynamic nature of
competition and antitrust enforcement by the Federal Reserve and the Department of Justice has
helped to limit increases in local-market concentration. The stability of average local-market
concentration over time is noteworthy because research suggests that competition for retail customers
takes place substantially at the local-market level and concentration is an important determinant of
competition. A second factor impacting the declining concentration in local markets was the expanded
number of bank branches during that period. Though the number of banks has declined, the number
of bank branches has increased.
Besides commercial banking, other components of the financial service industry have experienced
some consolidation in recent years. However, consolidation involving nonbank financial institutions
such as insurance and securities firms has been much more modest than that in commercial banking,
most likely because of the absence of preexisting restrictions on geographic expansion for these types
of firms. Like banks, insurance underwriting firms vary widely in size, ranging from several large
national insurers to numerous small local or technically specialized firms. Investment banking has
been more heavily concentrated for some time, no doubt in part reflecting the greater geographic
expanse of the markets for their services.
In the past two decades, some degree of consolidation has also occurred across different segments of
the financial services industry. During the 1980s and 1990s, as the Federal Reserve modified its
regulations, many bank holding companies established so-called section 20 subsidiaries to carry out
securities activities that had not been permitted within banking organizations since passage of the
Banking Act of 1933, or Glass-Steagall. In 1998, Travelers and Citicorp combined to form Citigroup in
anticipation of the repeal of Glass-Steagall and the enactment of more liberal legislation. In November
1999, the Congress passed the Gramm-Leach-Bliley Act, which in fact allowed firms to combine
banking, insurance, and securities activities within a financial holding company, or FHC.
In the two years since the Gramm-Leach-Bliley Act went into effect, nearly 600 financial holding
companies have been formed. Although the act was initially perceived by some to benefit primarily
large institutions, approximately three-quarters of the current domestic FHCs have assets of less than
$500 million, and about 45 percent of these have assets of less than $150 million. Virtually all of the
new activities undertaken by FHCs have been in insurance sales and merchant banking. In addition,
most of the previous section 20 subsidiaries have converted to traditional securities underwriting and
dealing subsidiaries of FHCs.
When the Gramm-Leach-Bliley Act was passed, many observers predicted that it would dramatically
transform the structure of the financial services industry through the formation of large financial
conglomerates. Such a transformation has not yet occurred. My take is somewhat different. By 1999
significant cross-industry affiliations had occurred without the benefit of evolving legislation.
GrammLeach-Bliley brought the statute more in line with marketplace changes rather than creating
opportunities for entry to new markets. Many view the lack of large mergers across different segments
of the industry as an indication that the act has failed to achieve its objectives. As a result, it is
probably the case that most bank holding companies that wanted to engage in securities dealing were
already doing so before the passage of Gramm-Leach-Bliley. Also, though banks have engaged in
selling insurance for some time, it is not clear that many of them are really interested in underwriting
insurance. Indeed, Citigroup's recent decision to spin off its property and casualty business suggests
that the benefits of combining commercial banking and the full range of insurance activities may be
less than initially anticipated.
Still, the concept of the financial conglomerate has received a great deal of attention in recent years
because of the diminishing distinctions across financial services firms.
It is useful to recall that the retail financial industry went through a phase of conglomeration about
twenty 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 benefits of specialization and the
provision of niche service were recognized instead.
I believe that this past experience with business conglomerates could be tempering some enthusiasm
for affiliations among the larger financial firms. The difficulty of finding synergies, planning
management structures, engaging in post-merger integration, and other management issues may be
influencing the willingness of larger firms to affiliate. These same experiences should temper our views
of the future structure of the financial services industry. Managing much larger, more-diversified firms
clearly offers both challenges and benefits. Although this business strategy may be optimal for some, it
is surely not the best approach for all financial services firms.
So what will the financial services industry look like in the future? Obviously, no one can say for sure,
but I expect that consolidation will continue to occur both within and across segments of the financial
industry. The number of commercial banks is likely to continue to decline, but I expect that we will
always have a large number of banks in the United States and that they will vary considerably in their
size and geographic scope. As one telling piece of evidence, I note that over the 1980s and the 1990s
more than 4,000 new commercial bank charters were granted in the United States. Essentially all of
these new banks were quite small, but were able to achieve profitability in a relatively short period of
time. This having been said, we may well see the formation of a few very large financial
conglomerates, but we will almost certainly continue to see many firms, both in banking and other
financial businesses, that specialize in providing a narrower range of financial products and services.
We will probably see an increase in the number of combinations between U.S.-based and
foreignbased entities, but many strictly domestic financial service providers will remain. In short, I believe that
diversity in size, product offerings, and geographic scope will continue to characterize the American
financial services industry for many years to come.
Some Implications for Supervision and Regulation
What do these trends and projections mean for bank supervision and regulation? A full answer to that
question is too tall an order for today, but I would like to highlight what I consider some of the most
important implications for maintaining a safe, sound, and competitive banking system.
Perhaps the best place to begin is with an understanding of the regulatory framework of
Gramm-Leach-Bliley. This landmark legislation facilitated the development of truly diversified financial
institutions, allowing the market system to decide what arrangements are viable. It also established a
supervisory structure for balancing the difficult tradeoffs that arise when firms that are rightly subject to
different types of regulation are combined into one entity. The basic problem was how to allow banks
and other financial institutions to respond to the evolving marketplace, and, at the same time, preserve
the benefits of the financial safety net provided to banks--all without extending that safety net to other
financial activities and thereby expanding the inevitable incentives to take risk and expose taxpayers
to loss.
The Gramm-Leach-Bliley compromise was to require some separation of financial activities into
different subsidiaries of a common parent, the financial holding company. Under this approach,
socalled functional regulators continue to play their necessary roles for a particular type of legal entity,
but one umbrella supervisor is also assigned a critical function. The umbrella supervisor's
responsibilities are clearly focused on protecting the insured and regulated depository subsidiaries of
financial holding companies.
Under this overall framework, the umbrella supervisor is to rely on the functional regulator as much as
possible and is allowed to examine functionally regulated affiliates if, and only if, it believes that their
activities are creating undue risk for the insured depository affiliate. Put differently, the umbrella
supervisor is charged with evaluating risks in the organization that could affect any bank or other
insured depository affiliate. The Congress chose the Federal Reserve to be the umbrella supervisor
based on our many years of experience with supervising bank holding companies and the Fed's
central role in managing financial crises.
The supervisory and regulatory framework established by Gramm-Leach-Bliley is a logical extension
of the development of bank supervision in this country. The Board has moved assertively and flexibly
to implement the full intent of the law, and we are focused on controlling risk exposures at insured
depository subsidiaries of an FHC. For example, our approach to umbrella supervision differs
depending on the mix of banking, securities, and insurance activities and the degree of their
integration within the financial holding company. Holding companies that include large and complex
banks receive considerably more attention than do organizations that have only minimal and relatively
straightforward banking operations. We have established formal procedures for sharing information
with a number of functional regulators and have informal sharing arrangements with many others. We
meet periodically with a wide range of agencies to discuss issues and to coordinate supervision. To
further this effort, we continue to develop programs for establishing the practical processes of meeting
joint responsibilities, especially with the Office of the Comptroller of the Currency and the Securities
and Exchange Commission. Indeed, it is widely understood that all our activities need to evolve with
changing market and technological realities.
With the Gramm-Leach-Bliley structure as background, let me turn to what I believe should, as we
move forward, be our major supervisory and regulatory priorities in the areas of safety and soundness
and competition policy. In my judgment, both the safety and soundness of individual banks and the
stability of the overall banking system begin with strong equity capital positions at individual depository
institutions. Strong equity capital provides a cushion against unexpected losses that can be used
without triggering a bank's default. More generally, strong equity capital lowers the probability that a
bank will fail. Strong equity capital also provides owners with a substantial stake in the future value of
the firm and thus helps to control the safety net's moral hazard incentives to take excessive risk. From
the perspective of day-to-day supervision, regulatory capital standards, the core of which are
standards for equity capital, provide the foundation for nearly all supervisory and regulatory policies.
The current set of regulatory capital standards, established in 1988 by an international agreement
among the industrialized nations known as the Basel Accord, is in need of reform. The central role of
such standards requires us to give reform a high priority. As you may know, such efforts are well under
way. Our efforts are focused on reforming the Basel Accord for those banks for which the current
standards are most in need of repair. Specifically, reform efforts are concentrated on developing
standards that are more risk sensitive and that build upon the internal risk-rating and
riskmeasurement systems that have been developed by the relatively small group of the world's most
financially sophisticated and complex banks. These banks are engaged in a wide range of traditional
and not-so-traditional banking activities, and their risk exposures and risk-management systems are
often extraordinarily complicated. I expect that concrete proposals for reform will be forthcoming within
a year or so. We must take the time to get these revisions right. I hope that the process, rather than
being driven by the calendar, is being driven by a desire both to achieve more risk sensitivity and to
acquire a meaningful understanding of the new Accord's implications. Both can occur only if the
industry and the regulators work together to develop and assess the likely effects of the new Accord.
A second priority for bank supervisors is to continue to develop policies and procedures that ensure
that no bank is too big to fail. By "not too big to fail" I mean that stockholders can lose all of their
investment, that existing managers can lose their jobs, that uninsured creditors can suffer losses, and
that the institution can either be reorganized or be wound down and possibly sold, in whole or in part,
in an orderly way. Given the size, complexity, and international scope of some of our banking
institutions, this task is not easy. But at the Federal Reserve, developing such procedures has been a
priority for some time.
Considerable evidence supports the view that market discipline is an important force for controlling
bank risk-taking, especially at the largest institutions. This evidence suggests that reinforcing the
effectiveness of market discipline would have considerable benefit, and thus I believe that such
support should also be a priority. Indeed, in my judgment, market discipline should be an important
complement to supervisory discipline. Efforts over the past couple of years by U.S. banking
supervisors to augment market discipline have focused on better accounting practices and increased
disclosure to improve the transparency of banking organizations. After all, markets function best when
all participants are well informed. Recently, as we all know, the issue of balance sheet transparency
has become a very hot topic. In part for this reason, I will highlight one area of transparency in banking
that I believe is of particular importance.
As recent events have shown, companies can use special-purpose vehicles to obscure their true
financial condition. Such vehicles can serve as useful tools for structuring their legitimate business
transactions. Unfortunately, they can also be used to give the appearance that a company has shed
risk that it has, in substance, retained. Use of special-purpose vehicles to create such an appearance,
coupled with financial-engineering techniques, is not in the spirit of the accounting rules. The
accounting profession's rules require consolidation of certain special-purpose vehicles when an
independent third party has not assumed the substantive risks of ownership of the underlying assets.
Though there does not appear to be a systematic problem with inaccurate treatment by bank holding
companies of sales of loans to off-balance-sheet special-purpose entities, in certain instances
companies have not given appropriate consideration to this accounting requirement.
The banking agencies have long recognized that exposures to risk can include interests in
specialpurpose vehicles and other entities that a banking organization does not consolidate. As a result, as
part of our ongoing examination activities, supervisors have endeavored to take such exposures into
account in assessing the condition of an institution. Furthermore, in appropriate circumstances, when
we find that a banking organization has effectively retained the substantive risks of assets it has
transferred to a special-purpose vehicle, we will require consolidation of those assets in publicly
available regulatory financial statements prepared in accordance with generally accepted accounting
principles. These statements are required at a minimum to meet generally accepted accounting
principles. But the Federal Reserve reserves the right to apply its own sound interpretation of those
accounting principles based on a careful consideration of the underlying facts and circumstances and
the economic substance of the transactions. We have exercised this right and will continue to do so
when necessary to ensure the transparency of an institution's risk profile and financial condition
through the accuracy of its public financial statements.
In related efforts, bank supervisors have in recent years increased their use of market information in
supervisory surveillance of large and complex banking organizations. For example, for some time the
Fed staff has been providing reports to examiners on the interest-rate spreads the market requires on
the subordinated debt of large banking organizations. Examiners are also given estimates of expected
default frequencies derived from the organizations' stock price data. Because such information can be
difficult to interpret, the reports given to examiners provide guidance designed to assist in
understanding whether changes in an institution's debt spread or probability of default are significant.
Looking forward, the Board has instructed its supervisory and research staffs to devote substantial
efforts to improving their ability to use market information in surveillance activities.
The maintenance of open and competitive markets should also be an important goal of public policy.
Such markets are a prerequisite to maximizing both the quality and the quantity and minimizing the
cost of products and services consumed by households, businesses, and government. This is no less
true in banking than in any other line of business. To that end, the Board helps enforce antitrust policy
in the United States. And, just as with bank safety and soundness policy, antitrust policy, to be
successful, must evolve with technological and market realities.
Changes in the way firms deliver financial services to their customers and in the nature of the
relationships among providers of various financial services may require some adjustments in the
implementation of antitrust policy. For example, as the number of large, geographically diverse
banking organizations increases, the nature of competition among banks within a local geographic
market may change. Likewise, if financial institutions continue to expand the scope of products offered
within a single organization, the influence of nonbank competitors on prices of services provided by
banking organizations may increase. In addition, technological change may someday reduce the
importance of local bank branches in the provision of retail banking services. Federal Reserve staff
and other economists continue to monitor and analyze the effects of these and other developments on
the nature of competition within the financial services industry. If changes are needed in the ways that
we evaluate the potential competitive effects of proposed mergers and acquisitions, the Board is
prepared to modify its approach.
Conclusion
In closing, I hope that I have provided you with a useful perspective on the financial services industry
and on the policies of the Federal Reserve. The United States has prospered from and, I believe, will
continue to reap the benefits of a strong and competitive financial services industry. This industry is
evolving at a sometimes breathtaking pace. The resulting changes require all of us to frequently revisit
our assumptions, views, and policies and sometimes to revise those assumptions, views, and policies
in order to continue to achieve the unchanging objectives of a sound and competitive financial system.