Prior to the passage of the Interstate Banking Efficiency Act, Congress largely had ceded to the states the power to determine how bank holding companies could branch within states or expand across state lines. Generally, states could permit a bank holding company to expand by (1) interstate banking—acquiring bank subsidiaries outside its home state; (2) interstate branching—establishing branches outside its home state; and (3) in-state branching—acquiring branches throughout all or part of its home state. Section 3(d) of the Bank Holding Company Act of 1956, commonly known as the Douglas Amendment, prohibited bank holding companies from acquiring a bank subsidiary in another state unless the state where the acquired bank was located specifically permitted such acquisitions. The Douglas Amendment had two central purposes: (1) to help alleviate concerns that economic power could be concentrated among a relatively small number of nationwide banking institutions and (2) to keep national and state-chartered banks on an even footing by giving states, not the federal government, authority over interstate banking. The McFadden Act of 1927 generally barred interstate branching for all national banks and all state-chartered banks that were members of the Federal Reserve System.A national bank was allowed to branch within its headquarters state to the extent that state law authorized branching by state banks. Over time, most states relaxed their interstate banking laws by enacting laws authorizing out-of-state bank holding companies to acquire in-state banks and bank holding companies. Many of these state laws had nationwide triggers, which allowed holding companies from anywhere in the country to acquire banks in those states. By year-end 1993, all but one state—Hawaii—permitted some form of interstate banking. Most states had laws permitting in-state branching. However, only eight states permitted interstate branching, and only for state-chartered Federal Reserve nonmember banks. Although most states had relaxed their interstate banking laws, some bankers urged Congress to enact a nationwide banking and branching law to facilitate the banking industry’s ability to compete. They argued that without a nationwide law, banking companies must deal with each state separately, and that this was an expensive and inefficient process. Proponents of a nationwide interstate banking and branching law believed that removing restrictions would strengthen the banking industry and benefit customers by (1) increasing competition and geographic diversification, (2) reducing the need for customers to maintain separate accounts in different states, and (3) offering a wider range of products and services that are generally associated with larger banking companies.Opponents feared such actions would lead to adverse effects such as excessively concentrating assets and deposits under large banks’ control, impairing smaller banks’ survival, and reducing small businesses’ access to credit. Congress passed a nationwide interstate banking and branching law, the Interstate Banking Efficiency Act, during the second session of the 103rd Congress. This act authorizes the Federal Reserve Board, effective 1 year from the date of enactment, to permit adequately capitalized and adequately managed bank holding companies to acquire banks located anywhere in the United States outside of the acquirer’s home state without regard to state laws. In addition, the act provides for interstate mergers and branching by FDIC insured banks in states where such activity is permitted. First, beginning June 1, 1997, banks may merge across state lines so long as the states involved have not enacted laws which expressly prohibit interstate mergers before that date. Interstate mergers earlier than June 1, 1997, are allowed in states having laws that expressly allow them. Second, out-of-state banks may acquire branches, without acquiring the bank itself, but only if the state where the branch is located permits such transactions. Finally, the act permits national and state nonmember banks to enter states for the first time through the establishment of a new branch, if the state has a law expressly permitting such branching. The three states we focused on—California, Washington, and Arizona—allowed us to examine interstate banking and in-state branching provisions in a variety of banking and economic environments. According to many observers, California’s large size, diversified economy, and relatively consolidated banking industry provides one example of how the nation might fare under nationwide banking and branching. California law has permitted in-state branching since the early 1900s and interstate banking since 1987. Several large California banks have branched throughout the state, but out-of-state banks have no significant presence. In contrast, once Washington and Arizona introduced interstate banking, out-of-state bank holding companies acquired the majority of the banking assets in each state. Washington had some restrictions on in-state branching until 1985 and passed interstate banking in two phases. First, in 1983, out-of-state banks were allowed to purchase failing in-state banks in Washington. Second, in 1987, out-of-state bank holding companies were permitted to purchase healthy Washington banks as long as the state where the acquirer was headquartered permitted reciprocal arrangements for bank holding companies headquartered in Washington. Arizona has had in-state branching since the 1870s and interstate banking since 1986. California, the most populous state in the nation, was considered economically sound until the early 1990s. Washington is a middle-sized state that since the mid-1980s has, for the most part, exhibited steady but more moderate economic growth than California. Arizona, also a middle-sized state, has in recent years experienced rapid economic growth followed by an abrupt downturn. All three states had relatively high rates of economic growth from 1984 through 1990. California’s and Washington’s gross state products grew 60 percent and 58 percent, respectively, while the national gross domestic product grew 46 percent during this 6-year period. Despite its economic problems, Arizona—whose gross state product grew by 52 percent—also grew at a faster rate than the nation as a whole. Although its real estate market suffered greatly, the remainder of Arizona’s economy continued to grow. The three states fared differently in the national recession that began in 1990. California began to suffer from the effects of the recession in 1990; as of year-end 1993, economists saw its recovery lagging behind the nation’s. Washington, in contrast, did not begin to suffer the effects of the recession until mid-1991, and economists did not expect the recession to be as prolonged or as deep as it was in California. Finally, Arizona had experienced economic problems well before the national recession began in 1990. In the late 1980s, Arizona’s economy was severely hit by a variety of factors, the most frequently cited being the collapse of the real estate market. However, according to economists in the state, Arizona, like the nation, has started its economic recovery. In examining the experiences of the three states, we focused on a broader period—December 1984 through June 1993—than the period when interstate banking laws became effective in those states. We did this because the three states phased in the relaxation of interstate banking laws over time. For example, California began lifting interstate banking restrictions in 1987; Washington in 1983; and Arizona in 1986. Further, two of the states—California and Arizona—have permitted in-state branching for many decades. In addition, many geographic restrictions on banking were removed by states permitting out-of-state banks to expand into the states we examined; many mergers among financial institutions occurred (some involving the largest banks in the western states); and a nationwide recession took place. In each of the three states, to evaluate the degree of market share among large and smaller banks, we (1) analyzed call report data maintained by FDIC on banks’ profitability and market share, along with data on mergers, failures, and new charters maintained by both federal and state regulators; (2) reviewed economic research; and (3) met with regulators, bankers, and other interested parties. To assess the availability of credit for small businesses, we examined banks’ asset portfolio data, interviewed bankers, and met with focus groups in 11 markets. Our focus groups were composed of individuals who helped businesses apply for bank financing, SBA officials, officials of city and county departments of economic development, and former bankers. Although the focus group results could not be statistically generalized as representative of small businesses, they offered us a practical means of obtaining a small business perspective on credit availability. Further, since the scope of our work was limited to California, Arizona, and Washington, we could not extrapolate our observations to other states. FDIC provided written comments on a draft of this report. These comments are presented and evaluated on page 17 and 18 and are reprinted in appendix V. We also requested comments from the Office of the Comptroller of the Currency (OCC) and the Federal Reserve. OCC said it had no substantive comments and the Federal Reserve did not provide comments, which is its policy when we do not make recommendations. We conducted our work from June 1992 through June 1994 in accordance with generally accepted government auditing standards. We present a more detailed discussion of our scope and methodology in appendix I. Studies have shown a link between the removal of branching restrictions and banking industry consolidation within a state. On the basis of such studies, many observers predicted that nationwide interstate banking and branching would also lead to consolidation. Such consolidation had not occurred in the three states covered by this report, in part perhaps, because the bank concentration levels for these three states were already high. For example, of the states with a large banking presence, California had the second highest concentration level—with the three largest banks accounting for 62.3 percent of banks’ assets. Of the states with a medium banking presence, Arizona and Washington had the highest and second highest concentration levels, with the three largest banks accounting for 82.6 percent and 62.4 percent of total bank assets, respectively. Figure 1 shows that the market share the largest banks controlled within each of these states fluctuated over the period we reviewed. However, by mid-1993, these market shares either approximated 1984 levels or fell below those levels.