Regional President Speech

Remarks of Silas Keehn, President Federal Reserve Bank of Chicago Before The Bankers Club of Chicago Chicago, Illinois May 12, 1982 The Changing Regulatory Environment Having spent over twenty years in commercial banking and having developed some definite views and opinions about the proper role and position of the regulator during that phase of my career, I find it more than a little surprising to be here tonight as President of the Federal Reserve Bank of Chicago--in the role of regulator. Most of you have heard the old adage, "Where you stand on an issue depends upon where you sit." If you accept that adage as true, you might reasonable expect that there have been some changes in my views about regula- tion. Participating in the formulation and implementation of regulations does provide a different perspective. But much of what I learned as a commercial banker about the ineffectiveness and inequities of many regulations and the app!:"apriateness of a more limited regulatory environment still rings true. The major difference in the shift from a regulateeto a regulator is that I now must consider regulation from the standpoint of the total banking and financial system rather than from the viewpoint of an individual bank or bank holding company. I have become more keenly aware of how different the effects are for banks depending on their location, their markets and their size. Being on the other side of the desk I also know how sharply these differences are felt and how forcefully they are expressed. This is not an insignificant hurdle and one that must be overcome in developing a better regulatory climate. But, these differences among banks need not be such a barrier. There are Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 2 - plenty of opportunities that do exist and will continue to exist in the financial environment of tomorrow--and that holds true for all banks, large and small alike. Tonight, I'd like to talk with you about my current views and attitudes about regulation in a changing financial environment. I'll start with the structural area where de facto deregulation has exceeded actual legislative change, then shift to some interest rate and balance sheet comments where early moves toward deregulation have had a not altogether happy result and, finally, briefly highlight the capital adequacy issue where there is a new element of regulation. Let me begin with the structural issue; that is, the geographic and the service or activity lines of banks. These are areas of banking that are undergoing significant and rapid change. In the very popular book, Future Shock, Alvin Toffler argued that change is occurring at such a rapid and accelerating pace that it has become difficult, perhaps almost impossible, for individuals, governments and businesses to adapt to the altered environment they face. But it seems to me that for the banking industry, changes are occurring at two very different speeds--the changes evol ving from the very dynamic marketplace are moving with lightning speed, while those dependent on the regulatory climate seem to be moving at a snail's pace. The McFadden Act and Douglas Amendment to the Bank Holding Company Act have gotten to be rather tiresome words for most of you--I've been predicting their demise within the next five years for at least the last fifteen years. From a strictly legal viewpoint, these laws are still very much with us. My hunch is that the CEOs of many major banks came to the correct conclusion quite some years ago that these restrictive laws would not be changed and that be cause the markets all around them were changing so rapidly, they had better Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 3 - devise ways around these barriers or risk losing market position. Edge Act Banks, initially located in New York to participate in international transac tions, were an early vehicle; then Edge Act Banks began to appear around the country and the line between international and domestic activities began to weaken. Then loan production offices began to emerge with broad geographic dispersion and some large banks have all but fully decentralized their whole sale banking activities. Though this geographic expansion still lacks the important deposit-taking capabilities, I think even this has become a less important feature. Thus the laws which were originally devised to inhibit overly aggressive competition by imposing geographic constraints have been transformed into minor competitive annoyances by many banks. To the extent that these regulations have been circumvented, they are no longer producing their intended benefits, however nebulous, but are only raising the private and social costs of doing the same business. Meanwhile, the range of services, or product lines in the new parlance, has dramatically expanded. Through the holding company structure, a great many institutions have acquired consumer finance companies, leasing companies, ,,10.cl.ga':Je banking activities, and on and on. These activities, of course, also provide broad geographic coverage. As just an example, and carefully choosing institutions not headquartered in the Seventh Federal Reserve District, though it is true for our banks as well, Citicorp operates over 440 offices in 39 states and Manufacturers Hanover Corporation has 471 offices in 30 states. n.rnerica has about 3,000 employees in New York and Citicorp has slightly ):l,,~ir r.-F more tnan 2,000 in California--and, not incidentally, Citicorp has about 400 c~ployees here in Chicago. These diversifications seem to move in waves and the current expansion is taking the institutions into investment related activities. BankAmerica Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 4 - Corporation has an application pending to acquire Charles Schwab, a discount brokerage firm. Security Pacific, with the advantage of a statewide branching structure, is already offering a full line of securities services through an agreement with Fidelity Brokerage Services. And Citibank has indicated its intention to develop plans to offer a cash management service in conjunction with Quick and Reilly, also a discount brokerage firm. Glass-Steagall, at least on the surface, has a nice symmetry to it: banks can't underwrite securities, except for Treasuries, agencies and general obligation municipals, and investment underwriters can't accept deposits, but the evolution of deposit substitutes has blurred these distinctions. Thus Glass-Steagall has become asymmetric in its practical impact. Money market mutual funds aren't technically deposits--a participant buys shares. But, somehow, they look like a deposit, smell like a deposit and taste like a deposit--and the almost $200 billion in money market mutual funds has to some very large extent come out of your deposits. Many of you heard Mr. Edward Telling, Chairman of the Board of Sears Roebuck, address The Economic Club of Chicago a few weeks ago. In his comments he laid out Sears' strategic planning in clear detail; much of the infra structure for their expansion into consumer financial services is already in place--their money market fund has been activated and apparently with early success, and they have completed the acquisition of Coldwell Banker and Dean, Witter, Reynolds. And there is that magnificant customer file of some 25 million active accounts--Glass-Steagall and McFadden do not seem to be bother ing them very much. And you are all too familiar with the other examples of the reverse stampede across Glass-Steagall--American Express/Shearson, Prudential/Bache and Merrill Lynch with its burgeoning array of financial services. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 5 - Meanwhile, significant technological developments have accelerated the pace of change--particularly in the communications and information processing areas. As a result, costs have dramatically declined. Indeed, hardware with the same capabilities as computers costing over a million in the 1950s now cost a small fraction of that amount. Funds can be transferred quickly and cheaply among institutions, while up-to-the-minute, on-line records are main tained which provide easy access at great distances. Transfer instructions can be given on-line, pre-authorized or keyed by a plastic card. This has greatly increased the mobility of deposit accounts. As a consequence, the traditional distinctions between types of institutions have become blurred and the advent of 800 telephone number communications has eroded geographic boundaries for the retail customer. Broad scale credit card mailings by many banks are examples of this and money funds that rely on phone lines like arterial veins probably don't have a clue as to what McFadden is all about. It is a little perplexing that with all of these changes, legislation and regulation have been extremely slow to respond with appropriate modernization. As a regulator, I think the Federal Reserve has a responsibility to main tain a healthy operating environment in which our financial institutions can compete, reasonably freely, and grow on a basis consistent with the marketplace. The significant decline in the vitality of the railroads over the past few decades is certainly the result of a great many factors; but I would suggest that the r.c.c. played a major role. The public utilities in their re:ation ships with the various Public Utility Commissions are undergoing the same transformation. I think that bank regulators need to be mindful of these examples. Without in any way trying to shift the burden of the Federal Reserve's responsibility to lead in suggesting the appropriate legislative changes in Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 6 - Congress, the banking industry itself has a critically important role to play in this process. Given the appropriate political timing, and those moments seem to be few and far between, I have a sense (and this is certainly a personal point of view) that Congress would be favorably disposed to appro priate legislative changes. But don't look for big help from the electorate. Whereas unemployment and other politically explosive matters are the kinds of issues that bring people into the streets, banking legislation is not one of these issues. The bulk of our population is unaware of the restrictions which burden you, and as long as they are being reasonably served, they really don't care. For example, witness the relaxed attitude of the public with regard to the problems the thrift industry is experiencing. Clearly, we need help from the banking system; as long as various seg ments of the financial services industry maintain myopic and parochial views, resisting almost any changes that will have a negative impact on their activi ties, Congress will continue to cast a blind eye on financial regulatory reform. They just aren't going to be willing to act as a referee in a continuing intra and inter industry dog fight. It will be exceedingly im portant for the various participants to reach a reasonable entente prior to seeking congressional involvement on financial reform legislation. I well recognize that this is a statement that is easy to make but exceedingly difficult to bring about--vested interests can be very deep-seated. But so far, forcing Congress and/or the regulators into the middle hasn't worked and I think a new approach could facilitate positive results. Admittedly, the costs and benefits from any structural reform legislation are going to be perceived to be so different by large banks and small banks, by rural banks and urban banks, and by banks and thrift institutions that a consensus will not Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 7 - be easily forthcoming. There will have to be some give and take here and many of the important decisions regarding what changes are best for the industry and the public may well need to be made by the regulators acting in conjunction with the realities of the marketplace. Let me shift to interest rates and the impact that some deregulation has had on bank balance sheets and earnings. I view the role of regulation as preventing behavior that is detrimental to the public interest while at the same time providing an environment in which the regulated entities have a chance to compete and grow--and importantly to face risks. And the risks that banks face in this regard are changing as well. In fact, one cloud on the horizon that has dampened many banks' enthusiasm. for deregulation is the increased riskiness and fragility of the financial system. Banking is riskier than it used to be if for no other reason than because the economy itself is more volatile. A benign economic environment no longer exists and the interest rate risk of the 1980s has, in many cases, replaced the credit quality risk of the 1970s. In fact, given the current economic situation and its impact on business and industry, I have been impressed by the fact that bank asset quality has remained surprisingly strong. Though loan problems tend to lag the economic cycle a bit, and I suspect that non-performing assets and actual losses will continue to mount, I think bankers have demonstrated an uncanny ability to remember the lessons of the 1974-75 recession. But now there's an additional risk to contend with--namely that caused by the level and volatility of interest rates. we are certainly undergoing a period of significant interest rate volatility which represents a sharp change from the period following World War II up until about 1970. During Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 8 - that period the commercial paper and prime lending rates were amazingly stable. But going back much further in history, the industry has experienced periods of even greater volatility. In fact, our current rate experience is more typical of a longer historical record than that of the 1940s, '50s and '60s. In the 40-year period prior to the Depression, the commercial paper rate typically varied between 4 and 9 percent; variations within each year were generally in the area of 00 and 150 basis points but changes of 400 basis points or more within a year were not unusual. Given the lower average level of interest rates prevailing in those days, a 400 basis point swing during the period is equivalent to an 800 to 1200 basis point movement today. Even more volatile than nominal interest rates were the rates of inflation and deflation. As a result, real interest rates covered a range of as much as plus-or-minus 15 percent and, in fact, real interest rates exceeded plus-or minus 20 percent on eight occasions between 1890-1930, or on average, once every five years. In contrast, from 1952-1972 real interest rates were typically between 3 and 7 percent. During the decade of the 1970s, the real rate ranged between plus 5 percent and a negative 13 percent, being negative for much of the perioj. Wide swings in real rates within a year, or from year to year, did occur in the 1970s due largely to abrupt shifts in the rate of inflation; during the 1950s and 1960s such wide swings were virtually nonexistent. Given that an entire generation grew up during this period without experiencing severe in terest rate volatility, it is no wonder that the abruptness of the change after 1972 and particularly after 1979 has had such wrenching effects on financial markets and institutions that had grown unaccustomed to interest rate volatility. Since the Fed's operating change in 1979, interest rate volatility has increased. This has had an important effect on bank balance sheets. For the Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 9 - ir,dustry as a whole, rate sensitive loans as a percent of total loans has not changed appreciably in the last six years; based on call report data for all insured banks, roughly one-half of all loans are re-priced within a year, some much more frequently. But rate sensitive liabilities as a percent of total liabilities have increased from 20 percent in 1976 to 45 percent in 1981. When we look at the quantity of rate sensitive loans minus rate sensitive lia bilities as a percentage of total assets, we get a rough but at least an indica tive measure of interest rate gap exposure. This ratio has gone from plus 11 percent in 1976 to minus 11 percent in 1981. In 1979 the measure was at zero, or in even balance, ideal positioning for the sharp rise in rates that followed. But rather than immunizing themselves by holding this even balance, bankers did not increase the level of interest rate sensitive assets as their rate sensitive liabilities increased and they thus increased their exposure in the wrong direction and in the face of an increasingly risky environment. The earnings impact has only recently become apparent. For example, returns on assets for all insured banks only declined from .77 to .73 during the period from 1972 through 1981 and return on-equity actually increased from ::.s ?ercent to 13.7 percent during the same 10 year period. But within this broad category, individual banks with significant gap problems are having a very different experience. And the quality of earnings is also subject to closer inspection. More than a few quarterly earnings reports have been given extra assists by income tax credits, asset or activity sales or other non rP~11rrina events and by modifications in loan loss provisions. In many cases income is being squeezed and is heading south while controllable .. c .... ..1.uLt::.cest operating expenses (which may not be quite so controllable) are heading north. Clearly, these trends are by no means universal--many of the well managed banks that have been carefully monitoring their interest sensitive asset/ liability balance and have controlled their operating expenses, had good reports Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 10 - last year and for the first quarter of this year as well. The pressure on earnings will continue; interest rate volatility seems to be a by-product of the Federal Reserve's operating procedures for monetary policy and as the deregulation of "Q" grinds forward, albeit at a slower pace than some of you would like, the earnings impact will be felt. Though there are some obvious cost aspects of placing increasing percentages of liabilities at flexible and market oriented rates, it should be kept in mind that the de regulation of Q ceilings will provide banks with opportunities to match the maturity and rate sensitivity of assets and liabilities in ways that will reflect individual management styles rather than being narrowly constrained by the policies of regulatory agencies. At a Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago a few weeks ago, Alex Pollock, who is responsible for planning at the Continental Bank, esti mated that there are still some $160 billion in passbook savings balances held by U. S. commercial banks. He further estimated that 31 of the 50 largest U. S. banks could attribute more than half of their 1980 earnings to exploit ing the passbook savings franchise; as you can see, deregulation does have significant cost implications. All of this leads to yet one other critical area--namely, capital. Indeed, the most significant impediment to future growth by some large institu tions could very well be their limited capital positions. As I noted earlier, existing legislation and regulations have not posed insurmountable barriers- many institutions have done an amazing job in terms of expanding their geographic and product coverage. But now the capital positions of banks of all sizes have become the focus of renewed attention. Capital ratios in banking have been declining since the 1930s. As of June 1934, the first call report date following formation of the FDIC, the capital-to-asset ratio for all insured banks was 14.4 percent. That Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 11 - ratio declined unevenly to 8.0 percent by 1965, and since then has further declined, reaching a low point in 1974. The trend at large, money center banks was much the same as that for all banks, though considerably more focus has been put on large bank capital considerations. The equity capital-to asset ratio for the 15 largest banks reached an all-time low level in 1974 when it fell below 4 percent; it rose to just under 5 percent in 1976 and as of the end of last year was close to 4.5 percent. Now, I suppose I could delve into a long and very esoteric argument re garding capital adequacy--with well managed, high earning financial institu tions does capital serve a necessary purpose? Shouldn't capital positions be reflective of differing asset composition from institution to institution? Are varying capital ratios for different sized institutions appropriate? What level of capital is really adequate? And on, and on. But the fact is that over the long term, the rate of asset growth has exceeded the growth in capital and there has been a resultant decline in the capital/asset ratio. Late last year the Federal Reserve and the Comptroller of the Currency issued new capital adequacy guidelines and amended the definitions of bank capital. The main intention of these changes was to stem and, hopefully, reverse the decline in the capital ratios of large banks and to set a more equal standard of capital adequacy on a more uniform basis for all sizes of banks. Primary emphasis has been given to perpetual capital sources. Limited life debt capital now receives uniform treatment and·is given reduced weight as it approaches maturity. The new program will permit somewhat lower capital ratios for smaller banks than many of these institutions currently maintain. Indeed, the wording of the circular provides room for well capitalized, smaller and regional banks to increase their asset levels; for community banks, those institutions with total assets under $1 billion, a capital/asset ratio of 7.0 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 12 - percent is in the acceptable zone, and for the regional banks, those with assets between $1 and $15 billion, a capital/asset ratio of 6.5 percent is in the acceptable zone. Thus, for many institutions these new guidelines represent at least some regulatory relief. For those expansion-minded institutions that have capital positions below the acceptable zone, this may be an awkward time. Banks' stocks are trading at low levels in relationship to earnings and book values. Smaller institutions that do not enjoy ready access to the national or even regional markets may find it even costlier to raise capital from external sources. Thus, there will be some pretty heavy pressure to increase earnings, to reduce or at least restrain dividends, and to improve their asset growth rates or place greater emphasis on transactions that increase earnings but do not increase asset levels. Where the need exists, hopefully the financial markets will continue to respond with new and innovative ways of raising capital externally. Examples of this are the relatively new shelf registration of debt capital based on the recent change in the S.E.C. regulations and another new technique which involves issuing debt with an irrevocable, but marketable, contract attached that re quires the buyer to purchase a specified number of shares at a future date. Long term, zero coupon capital notes which extend the liability duration and reduce the immediate cash payout required for interest are another innovation. Free and creative financial markets will generally develop profitable solutions to perceived requirements and these are but a few examples of market solutions to at least part of the capital adequacy issue. As these innovations come forward, the guidelines themselves will have to be the subject of further review. The capital adequacy circular is still _quite new and it would be far too early to judge just how it will be enforced by the Federal Reserve and the Comptroller. In other words, will it become a club to be used with regard to Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 13 - all applications and related involvements with the regulators, or will it be used judiciously and only in instances where capital adequacy is the issue at hand. Obviously, I would hope that the latter will prevail, but as you can well appreciate, the regulatory machine is very, very large and the judicious application of guidelines, while nice in theory, becomes very difficult in practice. But the fact that the guidelines have been agreed to by the two regulators and that the circular has been issued is indicative that the matter is one that we view with great importance. I think your longer range planning should assume that this is a "no fooling" issue. In conclusion, despite what seems like slow progress on the regulatory and legislative fronts and some of the other problems I've highlighted tonight, it seems to me that the financial services industry is moving and will continue to move through a particularly interesting and exciting phase. My remarks may seem to have placed emphasis on larger institutions but I really don't mean to leave that impression--the opportunities may be relatively greater for the smaller and medium sized banks. For the most part, they are well capitalized- they already have the capital ratios that the larger banks would like to have. By and large, their profit records have been excellent. They certainly won't face the same antitrust restraints that may limit the very large institutions. For small banks, technology is not a serious constraint; information processing costs have fallen sharply and less expensive desk top computers will only accelerate this trend. For larger requirements, either shared systems or support provided by outside vendors will satisfy the requirement. Importantly, smaller institutions are well placed in their local markets, they know their customers well and how to be responsive to the requirements of their market areas and with rapid turnaround times. California is perhaps an excellent example of this. The state has very large institutions with statewide branch Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis - 14 - networks in place, yet aggressive and well managed smaller institutions compete very well in their areas against these bigger banks. A former Superintendent of Banking in California once suggested to me that he felt the positive economic environment in the state is to an important extent due to their banking structure and the level of competition that has resulted from it. Thus, it seems to me that the smaller banks have the most to gain from deregulation. But given the pace of change, time is getting short and it would be counterproductive for banks to try to protect their markets by maintaining the regulatory status quo. The changes are coming much too fast for that, and nice as it may sound, it's not possible to stop the world and get off. There is simply too much to lose by not acting while the revolution in the delivery of financial services is still in a fluid stage. And, I would suggest, the time to act is now. Though large banks have great momentum, since they have successfully dealt with many of the regulatory limitations, they may have lost their zeal for deregulation. Moreover, they may well have changed their strategic planning. Therefore, the smaller banks will have a greater expansion role to play in this process. As I noted at the outset, I have been wrong in my timing predictions. This time I hope I am right and that many of the changes that I've reviewed tonight will come to pass within the next five years. If so, it will be an exciting time to be an active participant in the financial services area and I look forward to it with eager anticipation and great enthusiasm. Thank you very much. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis

Silas Keehn (1982, May 11). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19820512_silas_keehn

@misc{wtfs_regional_speeche_19820512_silas_keehn,
  author = {Silas Keehn},
  title = {Regional President Speech},
  year = {1982},
  month = {May},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19820512_silas_keehn},
  note = {Retrieved via When the Fed Speaks corpus}
}