Mr. Greenspan looks at the need for financial reform and the importance of
a decentralized banking structure in the United States Remarks by the Chairman of the
Board of Governors of the US Federal Reserve System, Mr. Greenspan, at the Annual
Convention of the Independent Bankers Association of America in Phoenix, Arizona, on
22/3/97.
As always, it is a pleasure to address this convention of the Independent Bankers
Association of America. This is the sixth year I have addressed this convention, and during that
time four separate Congresses have debated how best to reform the financial system. I last spoke
to you about financial reform in 1994, in Orlando, and it is clear that the real world occurrences
of the past three years have not diminished the relevance of those words. Therefore, I shall
reemphasize some of those thoughts today in the context of legislative proposals that are now
before the current Congress.
Let me begin by reiterating the essential thrust of the Federal Reserve's position
regarding financial reform. We believe that any changes, either in regulation or legislation,
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 safety net. My
remarks today will focus primarily on the macroeconomic and risk implications of financial
reform and how, in particular, such reform must enable community banks to maintain their
critical role in the macroeconomy.
The importance of the community bank
Our banking system is the most innovative, responsive, and flexible in the world.
At its core is a banking structure that is characterized by very large numbers of relatively small
banks -- more than 7000 separate banking organizations. This banking structure is very different
from that of other industrialized nations -- for example, there are less than 500 banks
incorporated in England, Germany, and Canada combined. To be sure, the very largest U.S.
banking organizations account for the lion's share of banking assets. Still, no one institution
controls more than 6 percent of total domestic banking assets in the United States.
This highly decentralized, highly diverse banking structure is almost certainly the
direct result of our market economy itself. Indeed, it is revealing that the first edition of Adam
Smith's Wealth of Nations was published in 1776, the year of the birth of our nation. Our
market-driven economy, founded on Smith's principle of "natural liberty" in economic choice,
and the banking structure that evolved within that economy, have proved to be remarkably
resilient. During the banking crisis of the late 1980s -- a crisis which was felt in banking systems
throughout the world -- more than one thousand U.S. banks failed. But less than a decade later,
loan loss reserves and bank capital at U.S. institutions stand at their highest levels in almost a
half century. Moreover, the reestablishment of equilibrium regarding safety and soundness in
our banking system was accomplished without costing the taxpayers a penny.
To be sure, the effects of the banking crisis, as well as the ongoing pace of
consolidation within the industry, have reduced the total number of banking organizations by
more than a third since 1980. Nevertheless, we remain a nation characterized by a large number
of smaller community banks -- just as we are a nation characterized by a diversity and small
average size of our nonfinancial businesses. Moreover, one cannot easily imagine nor desire that
the decentralized, diverse nature of our banking system will fundamentally change any time
soon. There is, of course, a strong connection between our banking structure and the nature of
our small-business-oriented economy. Smaller banks traditionally have been the source of
capital for small businesses that do not generally have access to securities markets. In turn,
small, new businesses, often employing new technology, account for much of the growth in
employment in our economy. The new firms come into existence often to replace old firms that
were not willing or able to take on the risks associated with high-growth strategies. This
replacement of stagnating firms with dynamic new firms -- what the economist Joseph
Schumpeter called the "perennial gale of creative destruction" -- is at the heart of our robust,
growth-oriented economy.
It is this freedom to take on risk that characterizes our economy and, by
extension, our banking system. Legislation and regulation of banks, in turn, generally should not
aim to curtail the predilection of businesses and their banks to take on risk -- so long as the
general safety and soundness of our banking system is maintained. As I have said many times,
regulators and legislators should not act as if the optimal degree of bank failure were zero.
Rather, policymakers must continually assess the tradeoff between, on the one hand, protecting
the financial system and the taxpayers, and on the other hand, allowing banks to perform their
essential risk-taking activities, including the extension of risky credit. Optimal risk-taking on the
part of our banks means that some mistakes will be made and some institutions will fail. Indeed,
even if a bank is well-managed, optimal risk-taking means that such a bank can simply get
unlucky. Either through mistakes of management or through the vagaries of economic luck,
bank failure will occur, and such failure should be viewed as part of a natural process within our
competitive system.
Just as regulators and legislators must accept failure, they also must not, in their
zealousness to maintain a safe and sound financial system, artificially restrict competition among
banks or between banks and their nonbank counterparts. For example, we should not repeat the
experiment with "micromanagement" of bank activities that was embodied in the 1991 FDICIA
legislation, much of which was repealed in the 1994 banking legislation. In this regard, so long
as we do not place artificial regulatory roadblocks in their way, I am not overly concerned with
the ability of our smaller banks to compete with their large, regional or national counterparts.
Our research shows that, when a large bank enters a new market through acquisition of an
existing smaller institution, typically lending to small businesses initially declines. But then
existing community banks take up the slack by lending to the borrowers spurned by the larger
organization. Indeed, several community bankers have commented that they welcome the entry
of large institutions into their markets via the acquisition route, seeing it as an opportunity to
acquire some of the customer base that often is lost by the newly acquired bank.
The dual banking system and the importance of choice of federal regulators
Just as our decentralized banking structure is a key to the robustness of our
macroeconomy, a key to the effectiveness of our banking structure is what we term the dual
banking system. Our system of both federal and state regulation of banks has fostered a steady
stream of innovations that likely would not have proceeded as rapidly or as effectively if our
regulatory structure were characterized by a monolithic federal regulator. For example, the
NOW account was invented by a state-chartered bank. Also, the liberalization of prohibitions
against interstate banking has its origin in the so-called "regional compacts" that permitted
interstate affiliations for banking companies in consenting states. Adjustable rate mortgages are
yet another example of innovation at the state level that has benefitted financial institutions and
their customers.
Just as important as the fostering of innovation is the protection the dual banking
system affords against overly rigid federal regulation and supervision. The key to protecting
against overzealousness in regulation is for banks to have a choice of more than one federal
regulator. With two or more federal regulators, a bank can choose to change its charter thereby
choosing to be supervised by another federal regulator. That possibility has served as a
constraint on arbitrary and capricious policies at the federal level. True, it is possible that two or
more federal agencies can engage in a "competition in laxity" -- but I worry considerably more
about the possibility that a single federal regulator would become inevitably rigid and insensitive
to the needs of the marketplace. So long as the existence of a federal guarantee of deposits and
other elements of the safety net call for federal regulation of banks, such regulation should entail
a choice of federal regulator in order to ensure the critical competitiveness of our banks.
The job of a banking regulator, difficult under any circumstances and for a variety
of reasons, is especially critical as it regards the connection running between banking risk and
the impact of such risk-taking on the macroeconomy. As I have been pointing out, the historic
purpose of banks is to take risk through the extension of credit to businesses and households
-credit that is so vital to the growth and stability of the economy. But this fact creates a
significant conflict for banking regulators. On the one hand, regulators are concerned with the
cost of bank failure to the taxpayer and the impact of such failures on the general safety and
soundness of the financial system. On the other hand, banks must take risks in order to finance
economic expansion. Decisions about tradeoffs must be made. In the early 1990s, we saw how,
in response to FDICIA, new regulations, weakened capital, and large loan losses, banks reduced
their willingness to take risks, thereby contributing to a credit crunch and slower economic
growth. This recent episode demonstrates clearly how tricky are these tradeoffs between
necessary risk taking and protecting the banking system; a swing too far in either direction can
create both short-term and long-term difficulties.
A regulator without responsibility for macroeconomic growth and stability tends
to have a bias against risk-taking. Such a regulator receives no praise if the economy is
functioning well, but is criticized if there are too many bank failures. For such a regulator, the
tradeoffs are one-sided and, if the decisions of such a regulator were left unchecked, the result
might be a stagnant economy at whose core was a stagnant banking system. In contrast, the
Federal Reserve's economic responsibilities are an important reason why we have striven to
maintain a consistent bank regulatory policy, one that entails neither excessive tightness nor ease
in supervisory posture. The former would lead to credit crunches, the latter, with a lag, would
lead to excessive bank failures.
Just as the probability of bank failure should not be the only concern of the
effective regulator, bank regulation is not the only, or even the most important, factor that
affects the banking business. The condition of the macroeconomy also has something to say
about your success as a banker. In that regard, the generally favorable macroeconomic
conditions we have been facing for the past few years suggest that bankers should now take
pause and reassess the appropriateness of their lending decisions. Mistakes in lending, after all,
are not generally made during recessions but when the economic outlook appears benevolent.
Recent evidence of thin margins and increased nonbank competition in portions of the
syndicated loan market, as well as other indicators, suggest some modest underwriting laxity has
a tendency to emerge during good times. This suggests the need for a mild caution that bankers
maintain sound underwriting standards and pricing practices in their lending activities.
Toward financial reform without losing the strengths of our current system
Let me now turn from general concerns over our regulatory structure to more
specific concerns regarding the supervisory and regulatory treatment of our largest, most
complex banking organizations -- a subject in which I suspect community banks have some
considerable interest. As the 105th Congress contemplates financial reform legislation, it is
critical to focus on the issue of how best to supervise risk-taking in these large entities and, in
particular, whether there should be significant umbrella supervision for the entire banking
organization.
Historically, bank holding companies have been largely confined to financial
activities that are similar to, often the same as, those permissible to commercial banks. Also
historically, supervision of banking organizations, both large and small, has tended to focus
mainly on the need to protect the bank. To some extent, this emphasis on the bank rather than
the nonbank activities of the banking organization was prompted by, or permitted by,
management techniques that tended not to treat risk-taking in integrated fashion across the entire
holding company. The regulators' main concern was the bank, and bank safety could be
analyzed more or less remotely and distinctly from the nonbank activities of the banking
organization.
More recently, the focus of supervision of holding companies by the Federal
Reserve is being modified to parallel the changes in the management of banking companies.
Most large institutions in recent years have moved toward consolidated risk management across
all their bank and nonbank activities. Should the Congress permit new nonbanking activities by
banking organizations it is likely that these activities too would be managed on a consolidated
basis from the point of view of risk-taking, pricing, and profitability analysis. Our regulatory
posture must adjust accordingly, to focus on the decision-making process for the total
organization. Especially as supervisors focus more on the measurement and management of
market, credit, and operating risks, supervisory review of firm-wide processes increasingly will
become the appropriate principle underlying our assessment of an organization's safety and
soundness.
Some market participants -- especially nonbanks contemplating buying banks in
the wake of any new Congressional legislation, as well as banks contemplating entering newly
permissible nonbank activities -- are naturally concerned over the thought of bank-like
regulation being extended to their nonbank activities. We share this concern, and last month we
asked Congress to modify our mandate to permit the Fed to be more flexible on such issues as
applications for new activities. At the same time, however, we believe there has been some
considerable misunderstanding of our basic philosophy of holding company supervision. The
focus of the Fed's inspections of nonbank activities of bank holding companies is to gain a sense
of the overall strength of the individual units and their interrelations with each other and the
bank. As I indicated above, emphasis is placed on the adequacy of risk management and internal
control systems. Only if there is a major deficiency in these areas would we intend for a bank
holding company inspection to become in any significant way "intrusive," and the number of
such intrusive inspections of nonbanking activities should be quite small if managements are
following prudent business practices.
Some observers have questioned not only the need for umbrella supervision, but
also the need for the Fed's involvement in such supervision. In addition to the reasons I cited
above for central bank involvement in supervision, there is the issue of systemic risk and the fact
that it is primarily the Federal Reserve's obligation to maintain stability in our financial system
and that system's interface with international financial markets. This obligation cannot be met
solely via open market operations and use of the discount window, as powerful as these tools
may be. Financial crises, when they occur, are unpredictable and diverse in nature. Globalization
means that a domestic crisis can become international or that a foreign crisis can become a
domestic concern. The Federal Reserve's ability to respond quickly and effectively to any
particular systemic threat rests primarily on our experience and expertise with the details of the
U.S. and foreign banking and financial systems, including our familiarity with the payments and
settlement system. This expertise, in turn, has been accumulated over the years primarily
through our supervision of large domestic and multinational banking companies, and via our
participation in large payments and settlement systems which are such a critical part of our
financial infrastructure.
In order to carry out our responsibility, the Fed must be directly involved in the
supervision of banks of all sizes -- such as now provided by member banks -- and must also be
able to address the problems of large banking companies if one or more of their activities
endanger the stability of our financial system. This implies that the Federal Reserve have
appropriate supervisory authority. Moreover, the new regulatory structure must retain our
flexibility to respond to changes in the structure of the financial system, especially where such
changes cannot easily be forecast in the wake of significant legislative changes. Systemic crises
occur very rarely by their very definition. But when such crises do occur the consequences of
slow or misdirected action are grave. The central bank, as the lender of last resort, must have the
knowledge, the tools, and the authority necessary to act in a timely and decisive fashion. This is
necessary to protect the whole financial system, not the least of which are the critical players
among our community banks.
Conclusions
Let me conclude by reiterating two of the Federal Reserve's most basic concerns
as the current Congress deliberates the issue of financial reform. First, we should recognize the
increasingly evident fact that financial firms of all sorts now engage routinely in a wide variety
of financial activities that, just a few decades ago, were considered to be nontraditional. Even in
cases where the financial activity is currently not permitted directly, the risks and returns of the
activity can be mimicked through the prudent use of financial derivative instruments such as put
and call options. We should recognize these facts and, in response, structure legislation that
would permit the full economic integration of these various forms of financial activity, in order
to gain the maximum operating efficiencies, the best tradeoffs between risk and return, and the
most flexibility in meeting the needs of the customer. But new legislation should not attempt to
accomplish too much too soon. The Board believes it is prudent to delay, or to implement in
stages, broad authorization of nonfinancial activities for banking companies. We want to be sure
of the smooth functioning of integrated financial activity before we address potential
combinations of banking and commerce.
Second, in permitting broadened financial powers, legislation should strive to
maintain the current roles of both the dual banking system and the central bank. Financial
reform should not be interpreted to mean regulatory reform for its own sake. Banks of all sizes
must have their regulatory choices preserved, just as financial firms of all sizes should be
permitted to engage prudently in a wide range of financial activity. Finally, the central bank
must continue to be able to monitor and address activities of large banking organizations that
might threaten the stability of the system. I am confident that prudent, reasoned financial reform
can be accomplished in a manner that preserves the best of the current system while introducing
the improvements that we all desire.