Mr. Greenspan discusses financial reform and the importance of the State
Remarks by the Chairman of the Board of Governors of the US Federal Reserve System,
Charter
Mr. Alan Greenspan, at the annual meeting and Conference of State Bank Supervisors held in San
Diego, California on 3/5/97.
I am pleased once again to address this annual meeting of the Conference of State
Bank Supervisors. Before I begin, I would like to join his colleagues in wishing Bob Richard well.
Over the years, it has been a pleasure to work with him. He will be sorely missed.
Today, I shall concentrate my remarks on the current debate in Congress and
elsewhere on how best to accomplish financial reform. This subject has been a recurring theme in
Federal Reserve comments, speeches, and testimonies during the first part of 1997 and, I suspect, the
subject will continue to engage us for some months ahead. My remarks today will reemphasize some
of the points made at other venues this year, although I will attempt to place these arguments in the
context of the impact of financial reform on the state-chartered banks and on the roles such banks,
and their regulators, play in maintaining the overall well-being of our banking system and our
economy.
To begin, there does appear to be general agreement on the need for financial reform.
Permitting various financial businesses to be conducted jointly should provide the benefits of
increased services and/or lower prices to financial customers, improved risk reduction, and cost
savings for financial firms. More broadly, it should improve the efficiency and stability of the
financial system that underlies our economy. These benefits are expected to flow primarily from
opportunities for diversification, non-interest cost reduction, and cross-marketing for those banks,
investment banks, and insurance companies that find ways to profitably merge their businesses in the
wake of legislation permitting expanded powers for banking organizations.
But the longer financial reform is delayed, the less important and useful it will be. Put
in economist's jargon, the longer the delay the lower the marginal economic benefits produced by
reform legislation, and the more we should be concerned instead with possible unintended negative
effects that might outweigh those marginal benefits. Let me explain.
Financial markets, as we all should know by now, have a way of effectively
circumventing uneconomic barriers or bottlenecks created by inefficient legislation or regulation.
Today, it has become possible, through the judicious use of derivative instruments, for a financial
firm engaged primarily in one kind of financial activity to mimic the risks and returns of any other
financial activity. Banking, investment banking, and insurance can no longer be viewed, from a
risk-return perspective, as separate and distinct lines of business. To cite just one example, banks are
prohibited from underwriting insurance, yet the writing of a put option -- a form of derivative activity
engaged in widely by large banks -- is, in economic substance, a form of insurance underwriting.
Other derivative markets, including the emerging credit derivative instruments, now permit banks to
diversify their credit and market risks as if they had been permitted to merge with investment banks
or insurance companies. Thus, some of the long-sought-after economic benefits resulting from the
repeal of legislative barriers between and among different "types" of financial firm already have been
achieved through the creativity of the marketplace. Nevertheless, by not being able to engage directly
in the impermissible activity, a banking company cannot achieve the production or marketing
synergies, and therefore the cost reductions, that may flow from joint operations and that may benefit
a bank's shareholders as well as its customers.
In addition to the actions of the marketplace, banking regulators have acted, within the
constraints of statute, to facilitate economic combinations of banking and nonbanking financial
activities. Specifically, the Federal Reserve has adopted both liberalization of Section 20 activities
and expedited procedures for processing applications under Regulation Y. The OCC, meanwhile, has
generated some controversy by liberalizing banks' insurance agency powers as well as procedures
generally for establishing operating subsidiaries of national banks that may engage in activities not
permitted to the bank.
This is not to say that financial reform legislation will have no marginal benefit.
Clearly, in addition to the benefit of lowered costs, much remains to be accomplished in the form of
improved management efficiency. These benefits, which will accrue both to the banks and the general
public, probably can be maximized only within the context of clear legislative authority for
combining financial firms of various types. We must be careful, however, in our efforts to achieve the
benefits of financial reform, not to violate the tenets of good public policy. In this regard, the Federal
Reserve believes that any financial reform should be consistent with four basic objectives:
(1) continuing the safety and soundness of the banking system; (2) limiting systemic risk;
(3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and
the subsidy implicit in the federal safety net. I have spent a good deal of time of late on the fourth
objective. Therefore, today I will concentrate on the first three and how, in particular, financial
reform must be careful to preserve the role of the state-chartered bank in meeting our economy's
macroeconomic objectives and our concerns regarding systemic risk.
The importance of the state-chartered bank
Some erroneously dismiss state-chartered banks as representing only the down-scale
end of the banking market and, therefore, being not particularly worthy of careful policy
consideration. State-chartered banks indeed are smaller on average than national banks, and are
disproportionately represented within the very smallest size class. Nevertheless, state-chartered banks
account for about a third of our superregionals, not to mention a few state banks that are among the
very largest money center institutions. Even the preponderance of small, state-chartered banks,
however, play a critical role within our financial system, for several reasons.
First, having large numbers of community-sized banks, be they state-chartered or
national banks, is a major contribution to the stability of the banking system and the well-being of the
macroeconomy. Just as a more highly diversified loan portfolio reduces risk to the individual bank, a
more highly diversified banking structure reduces risk to the banking system as a whole. Indeed, our
decentralized and diverse banking structure was arguably the key to weathering the financial crisis of
the late 1980s. During those dark days, our system was able to absorb more than a thousand U.S.
bank failures. And yet here we are, less than a decade later, with loan loss reserves and bank capital
at their highest levels in almost a half century, and the insurance fund restored to its maximum
coverage ratio -- all without cost to the taxpayer. Of course, the bank failures of the past decade,
combined with the current wave of mergers and acquisitions, have served to reduce significantly the
total number of banking organizations in the U.S. But the more than 7,000 separate banking
companies that remain are more than sufficient to maintain our highly decentralized and flexible
banking structure.
Large numbers of small banks go hand in hand with a macroeconomy characterized
by large numbers of small, entrepreneurial nonfinancial businesses. Smaller banks traditionally have
been a major source of capital for small businesses that may not have access to securities markets. In
turn, small businesses account for the major portion of new employment and new ideas, thereby
playing a major role in fueling economic growth.
This connection running between small banks, small business, and the macroeconomy
-- indeed the role of banks generally in funding business expansion -- is so important that we must be
sensitive to the tradeoff between risk-taking and bank solvency. Risk-taking -- prudent risk-taking to
be sure -- is the primary economic function of banking. All wealth is measured by its perceived
ability to produce goods and services of value in the future. Since the future is fundamentally
unknown, endeavoring to create wealth implies an uncertain expectation of how the future will
unfold. That is, creating wealth is risky.
Hence banking, to further its primary economic purpose of financing the economy,
cannot and should not avoid prudent risk-taking. Bank supervisors, in turn, need to recognize that the
optimal bank failure rate is not zero. A zero failure rate over time implies either extraordinary insight
by bankers, a notion I readily dismiss, or an undue and unhelpful degree of conservatism in banking
practice. In taking on risk, of course, some mistakes will be made, and some banks will fail. Even if a
bank is well-managed, it can simply become unlucky. Failure should occur, indeed does occur, as
part of the natural process within our competitive economy. It should not be viewed as a flaw in our
financial system, and certainly we should not attempt to eliminate it. Only when the failure rate
threatens to breach a prudent threshold should we become concerned.
Just as large numbers of smaller banks are a key to the robustness of our economy,
the state charter is a key to the robustness of our banking structure. The dual banking system has
fostered a steady stream of banking innovations that have benefited consumers and bank shareholders
alike. For example, the NOW account, as I like to point out, was invented at a state-chartered bank;
and the NOW account was the opening shot in the campaign to remove national deposit interest rate
controls and allow banks to compete on common ground with nonbank institutions such as money
funds. The 1994 interstate branching statute likewise has its origin in the state laws that permitted
cross-border banking, beginning with the rewriting of the Maine banking laws. Adjustable rate
mortgages are another innovation that began at the state level, and of course, the National Banking
Act itself has its origin in the states' "free banking" laws of the nineteenth century.
The dual banking system not only fosters and preserves innovation but also
constitutes our main protection against overly zealous and rigid federal regulation and supervision. A
bank must have a choice of more than one federal regulator, must be permitted to change charters, to
protect itself against arbitrary and capricious regulatory behavior. Naturally, some observers are
concerned that two or more federal agencies will engage in a "competition in laxity", and we must
guard against that; but the greater danger, I believe, is that a single federal regulator would become
rigid and insensitive to the needs of the marketplace. Thus, so long as we have a federal guarantee of
deposits, Federal Reserve guarantee of intraday payments over Fedwire, and other elements of the
safety net -- and, therefore, so long as there is a need for federal regulation of banks -- such
regulation should entail a choice of that regulator at the federal level.
As you are well aware, the Federal Reserve has long been a strong supporter of the
dual banking system in the context of efficient supervision. That is why we, along with the FDIC,
have sought examination partnerships with the state banking regulators. Currently, the Fed has
cooperative agreements with about three dozen states, calling for either joint examinations or
alternate year exams. Overall, our experience with these programs has been quite positive, in part
because of the quality of state supervision in the states with the cooperative agreements. Indeed, the
evidence suggests that safety and soundness of state banks compare quite favorably with national
banks, possibly reflecting the benefits of having both state and federal supervision. For example,
during the banking crisis of the late 1980s, when the failure rate by any measure breached the prudent
threshold I mentioned earlier, the national bank failure rate was considerably greater than for state
banks. While bank failure is determined by more than just the supervision process, these data
nevertheless speak well of the quality of the state supervisory process and the ability of the state and
federal regulators to function together efficiently.
The dual banking system, however, despite its advantages and achievements, is under
attack. This attack is neither particularly intentional nor particularly coordinated, but rather consists
of the unintended consequences of statutory and regulatory changes aimed at achieving broader
policy objectives. I am referring primarily to the consequences of the 1994 interstate branching
legislation, coupled with the OCC's recent liberalization of regulatory procedures for operating
subsidiaries of national banks. These events may have served to tip the balance in favor of national
banks, so to speak, in a manner that weakens banks' ability to switch federal regulators without
incurring prohibitive real economic costs. In particular, while most state-chartered banks will
continue to operate on an intrastate basis in local markets, regional and nationwide banks may find
that state charters are burdensome to the extent that the banks are forced to operate under varying
regulatory rules and procedures across multiple states. If that burden were to become excessive,
banks with interstate operations -- especially interstate retail operations -- would likely turn to the
national charter on grounds of simple expediency. For example, I am struck by the fact that the very
largest state-chartered banks among the money center institutions are without significant retail
operations or without announced intentions to expand retail banking beyond their home states. The
rest of the large state-chartered banks, those with assets over $10 billion, consist mainly of lead banks
in multi-bank, multi-state holding companies. It seems likely that some of these institutions will seek
to consolidate their interstate retail operations under a national bank charter after interstate branching
becomes fully operational, unless countervailing forces emerge.
The evident superiority of the national charter is not a foregone conclusion, however.
For example, the Federal Reserve this past month approved an application by a superregional banking
company to consolidate its retail branches in four states under a single state-chartered bank
headquartered in Alabama. The consolidation would become effective on or after June 1, 1997, when
the Riegle-Neal Interstate Banking Act becomes operational. Another positive indication of the
resiliency of the state charter has been the establishment of the State-Federal Working Group. This
cooperative effort involving the states, the CSBS, the Federal Reserve, and the FDIC is contributing
importantly to the strengthening of the supervision of state-chartered institutions through a number of
initiatives, including the adoption of the State/Federal Protocol. The Protocol and the Nationwide
Supervisory Agreement of 1996 spell out the principles and specific actions that would lead to a
seamless supervision and examination of interstate, state-chartered banks. Other initiatives of the
State-Federal Working Group include greater examination emphasis on bank risk management
processes, a more formalized, risk-focused approach to examination, and expanded and more
effective use of information technology. It would also be extremely helpful, especially if enacted
prior to interstate branching becoming fully operational, if the Congress were to pass the so-called
home state rule, which would place state-chartered banks on an equal footing with national banks
with regard to permissible activities of branches in a host state.
Systemic Risk and the Role of the Federal Reserve
By now, we are all acutely aware that the process of "financial reform" is a complex
one, with intended and unintended consequences flowing from almost every act of the legislator or
regulator. I have focused today on only two aspects of the debate over financial reform, albeit two
very important aspects -- the need to maintain our uniquely decentralized banking system, with its
reliance on large numbers of relatively small institutions, and the desirability of retaining the dual
banking system, with its implicit choice of regulator. Let me conclude by turning to another important
facet of the debate over financial reform -- the role of the Federal Reserve in containing systemic risk.
It is critical that we guard against diminution of this role as yet another unintended consequence of
financial reform.
The risk of systemwide disruptions, for better or for worse, is importantly determined
by the actions or inactions of our largest, most complex banking organizations. The architects of
financial reform, therefore, must necessarily consider how best to supervise risk-taking at these large
organizations and, in particular, whether there should be significant umbrella or consolidated
supervision of the banking company.
In the past, holding company supervision was concentrated at the bank level, not only
because the bank tended to constitute the bulk of risk-taking activities but also because the holding
company tended to manage the bank separately from the various nonbank activities of the
organization. More recently, however, the focus of supervision of holding companies by the Federal
Reserve has been modified to reflect changes in management procedures -- holding companies now
tend to manage risk on a consolidated basis across all their bank and nonbank subsidiaries. Risk and
profitability measurements, including, for example, risk-adjusted return on capital calculations, most
often are made by business line rather than on a subsidiary basis. As banks engage in new or
expanded nonbanking activity in the wake of financial reform, it is likely that these activities too
would be managed on a consolidated basis. For this reason, and because supervisors recognize that
scarce examination resources are often most effectively employed by focusing on risk management
processes, our determination of an institution's safety and soundness increasingly will be based on an
analysis of the decisionmaking and internal control processes for the total organization.
Such umbrella supervision need not be in any significant way "intrusive", nor should
financial firms be burdened by the extension of bank-like regulation and supervision to their nonbank
activities. For some time, the focus of the Fed's inspections of nonbanking activities of bank holding
companies has been to assess the strengths of the individual units and their interrelations with one
another and with the bank. Emphasis is placed on the adequacy of risk measurement and
managements systems, as well as internal control systems, and only if there is a major deficiency in
these areas should the inspection of the nonbank activities become at all intrusive. We intend that this
philosophy of holding company supervision will not change as banks are granted extended powers.
Finally, I should note that some have questioned not only the need for umbrella
supervision but also the need for the Fed's involvement in such supervision. It is primarily the
responsibility of the Federal Reserve to maintain the stability of our overall financial system,
including the interconnections between the domestic financial system and world financial markets.
This obligation to protect against systemic disruptions cannot be met solely via open market
operations and use of the discount window, as powerful as these tools may be.
If the past is any guide, financial crises of the future will be unpredictable and unique
in nature. The globalization of financial and real markets means that a foreign crisis can impact on the
domestic financial system, and vice versa. Our ability to respond quickly and decisively to any
systemic threat depends critically on the experience and expertise of the central bank with regard to
the institutional detail of the U.S. and foreign financial systems, including our familiarity with
payments and settlement systems. Thus, in order to carry out our systemic obligation, the Federal
Reserve must be directly involved in the supervision of banks of all sizes and must, in particular, be
able to address the problems of large banking companies if one or more of their activities constitute a
threat to the stability of the financial system.
Conclusions
The concerns I have outlined today demonstrate the necessity that the central bank
maintain appropriate supervisory authority and, as I hope I have made clear, this authority is best
exercised within the current context of the dual banking system, a system that has served us so well
over the generations. Financial reform clearly is needed, but financial reform should not be
interpreted to mean regulatory reform for its own sake. I am hopeful that reasoned financial reform,
based on sound tenets of public policy, can be achieved in a manner that preserves the best
components of the current system while introducing the improvements that are long overdue.