Regional President Speech

April 1987 Second Draft Silas Keehn Remarks Vanderbilt Univeristy Bank Charters: They Ain't What They Used to Be In 1934, the largest and most prestigious investment banking firm, J.P. Morgan & Company, caught Wall Street by surprise when it decided to choose the commercial banking business over investment banking. As I am sure you are all aware, the Banking Act of 1933, more commonly known as the Glass-Steagall Act, forced banking firms to choose between the securities underwriting business and commercial banking. Two-thirds chose to relinquish their bank charters in order to remain in the securities business, but one notable exception was J.P. Morgan. Morgan believed that strong investment banking and investment advisory backgrounds would provide Morgan with a comparative advantage as a commercial bank that primarily served major businesses, foreign governments, and wealthy individuals. In addition, in the early 1930s, the underwriting business was relatively inactive, and an early return to greater activity did not seem imminent. Now, some 50 years later, banking organizations are being faced with the same choice, although not because of a major new banking bill in Washington, but instead because of market forces. Ironically, or perhaps fittingly, one of the first banks to have considered giving up its bank charter was Morgan Guaranty. Among the major U.S. banking firms, J.P. Morgan & Co. has one of the highest returns on assets. However, most of its profits do not come from its main line of business, lending to blue-chip companies. from Morgan's investment banking activities. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis They come 2 Why has this come to pass? One reason is that blue chip companies are much more sophisticated now than they were when Morgan chose commercial over investment banking. Now they can borrow more cheaply by directly accessing the capital markets than by going to ...... their commercial bankers. It's important to realize that this phenomena is only affecting a specific segment of the banking industry. The industry's share of the market for credit to all nonfarm nonfinancial corporations has grown more or less steadily. about 24 percent of i I~'- Set¾aml 1960 these firms obtained their credit from commercial banks. By 1985, businesses were obtaining over 42 percent of their credit from commercial banks. Nonf arm nonfinancial business loans- at -banks as percent of credit market instruments ~ ~-· _ ~ tf0 ipfo~ 20 10 so 62 64 66 68 10 72 74 76 1e 80 82 84 86 1 oefined as the ratio of outstanding loans, commercial mortgages, and multifamily mortages made by banks to nonfarm nonfinancial corprations, divided by total credit market debt of nonfarm nonfinancial corporations. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 3 If we narrow our focus to nonfinancial corporations we find that banks' current market share is well above the 1960 level of 27 percent, and roughly equal to all time high of 36.8 percent, which was reached in 1974. These statistics suggest banks are not generally becoming less competitive as suppliers of credit to business. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Nonfinancial corporate business loans at banks as percent of credit market instruments 20 10 60 62 54 66 6l! 70 72 74 76 78 80 82 84 86 4 However, investment grade borrowers have been steadily shifting away from banks to the commercial paper market. Since 1975, commercial paper has grown over sevenfold while business lending by large banks grew less than threefold. Commercial paper vs. C&I loans at large banks Billion S 2751 250 I 225 200 175 150 125 100 75 Commericot paper 15 ~ ~ •GIi,__ . ~ Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 76 n 78 19 80 a, 82 -r ~ -.... /V~ ~ ~ , , r ~ ~-J as a, es ~r 6 LcJJ ~ 5 It seems that the largest banks have been particularly hard hit: In 1975, they held about 67 percent of all bank commercial and industrial loans, but in 1985, they held less than 51 percent. Consequently, the outlook for traditional lending to investment grade borrowers is bleak and Morgan, along with a few other large banking firms, are toying with the idea of giving up their bank charters to become investment banks. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis C&I loans at large banks as a percent of total bank C&I loans 60 55 50~~~~-~-~ 75 76 77 78 79 80 81 82 83 84 85 5 I 1o 6 Regulation prior to 1970 Over the last 50 years, regulation has served to create an artificial boundary between banking, other parts of the financial services industry, and the economy at large. not always been so sharp. The delineation has Prior to 1927 trust companies and state chartered banks were active in the securities business. In 1927 commercial banks, trust companies and their affiliates underwrote 37 percent of all new bond issues. In 1927 underwriting became a permissable activity for National banks. By 1930 comercial banks and their affiliates were underwriting 60 percent of all new bond issues. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Early commercial banks and trust companies • 1 927 - underwrote 37% of all new bond issues • 1930 - underwrote 60% of all new bond issues 7 The role of commercial banks in the underwriting business only came to an end in 1933 with the passage of the Glass Steagall Act. Glass Steagall prohibited Federal Reserve members and their affiliates from engaging in underwiting activities. Most states followed suit. The separation of banking from other financial and nonfinancial activities is a more recent event. passed the Bank Holding Company Act. In 1956 Congress Among other things the Act prohibited multibank holding companies from engaging in any nonfinancial activities and gave the Federal Reserve the power to determine which financial activities are permissable for multibank holding companies to pursue. An early casualty of this law was the Transamerica Corporation, then owner of numerous banks located across the western third of the United States as well as a major insurance firm. While the Bank Holding Company Act applied to multibank holding companies, one bank holding companies were still free to engage in any other activities except investment banking. -- In the late 60s many banks began to take advantage of this legal oversight, but it was not closed until 1970. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Commercial banking legislation • 1933 - Glass-Steagall Act • 1956 - Bank Holding Company Act • 1970 - Amendments to the Bank Holding Company Act 8 The effects of this regulatory structure on the organization of the financial services industry can best be judged by examining three important financial services firms -- Morgan, Merrill Lynch, and Sears. retailer, a retailer. But each of these types of firms was beginning to position itself to compete with each other in the "financial services" industry. In 1969, J.P. Morgan & Co., recognizing competition from the commercial paper market for domestic loan customers, formed a bank holding company in order to broaden the r-finance-related services that it was able to offer and made substantial additions to its international faciltities. In the early 1970s, Merrill Lynch was also concerned with plans to reorganize in order to be ready for entry into other finance-related fields. Unlike the other two firms, Sears did have a major presence in several segments of the financial services industry--retail installment credit, insurance and deposit taking--but it too was preparing to expand further into financial services. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Positioning of firms in the 1970s • J.P. Morgan • Merrill Lynch • Sears 9 New Developments 1970 to 1980 The 1970s witnessed several major developments. The first was the increasing international orientation of the large money center s ep in this process, the creation of the Eurodollar market, actually began in the 1960s, but this market grew most I rapidly in the 1970s. Major developments in the 1970s • International orientation • Overseas investment banking • Competition for deposit services • Deregulation of securities industry Several factors were responsible for this growth including the imposition of Regulation Q ceilings on large certificates of deposit, the attempt to limit capital outflows from U.S. banks, and the more favorable treatment of foreign deposits when calculating reserve requirements. In 1970. /, overseas deposits of U.S. banks accounted for about 8 percent of total deposits at U.S. banks. By 1980. deposits at overseas branches of U.S. banks accounted for about one quarter of all deposits at U.S. banks, while for the nine largest U.S. banks they accounted for a little more than half of deposits. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Eurodollar market • Regulation Q ceilings • Limitations on capital outflows • Favorable treatment of foreign deposits 10 At the same time American banks began to lay the groundwork to enter the field of investment banking overseas. only applied Since Glass Steagall to the underwriting of securities within the United States, the large money center banks began to set up merchant banking subsidiaries in London, where the underwriting activities of banks were less tightly restricted. By 1980 most money center banks had a significant merchant banking presence in the London markets and were competing head to head with the major investment banking firms. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Major developments in the 1970s • International orientation • Overseas investment banking • Competition for deposit services • Deregulation of securities industry 11 In the U.S., commercial banks found themselves competing with brokerage firms and investment banks in the market for deposit services. The combination of high rates and regulations restricting the payment of interest on demand deposits created a demand for an alternative to bank deposits. money market mutual funds. In response~ securities firms created The money market funds gave securities firms a way to obtain many of the services provided by bank deposits while avoiding a regulatory structure that created substantial costs for bank customers. By the beginning of 1980, MMMFs acj ounted for a little over 5.5 percent of transactions balances. 2 · ~ ~ ~ ~ ':t ()&.-4/}((if~ ,; l<fv •J' ~,f- ~-(4,1_,Z£_ Major developments in the 1970s • International orientation • Overseas investment banking • Compeutton for deposit services • Deregu lation of securities industry 2 This includes currency held by the public, demand deposits, other checkable deposits, savings deposits, overnight repurchase agreements, and MMMF balances. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 12 Another important development of the 1970s was the deregulation of the investment banking industry. Prior to 1975_ stock exchanges .I were permitted to set the fees brokers could charge for executing trades. This sheltered inefficient brokers and reduced competition. With the end of rate fixing, less efficient brokers were forced into merger or bankruptcy while highly efficient brokers experienced rapid growth. This shakeout created a securities industry that was better suited for competing with commercial banks. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Major deveJopments in the 1970s • International orientation • Overseas investment banking • Competition for deposit services • Deregulation of securities industry Deregulation of securities industry • Eliminated inefficient brokers • Increased competition • Created a more competitive securities industry 13 By 1980, a number of firms were attempting to build a presence across a wide array of financial services. On the heels of deregulation of the brokerage industry came the entry of a major insurance company, a travel services firm, a retailer, and a money center bank into the brokerage business. In 1981, Prudential acquired Bache; American Express acquired Shearson; Sears acquired Dean Witter; and BankAmerica announced plans to acquire Charles Schwab. At the same time, Merrill Lynch was making headway into the banking industry; its cash management account boasted of over half a million accounts. The lines of commerce that separated the various types of financial services providers were fading fast. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ~ ~. Acquisitions in the early 1980s • Prudential acquires Bache • American Express acquires Shearson • Sears acquires Dean Witter • BankAmerica acquires Schwab Developments in the 80s The system of bank regulation in place at the beginning of 1980 differed only slightly from the system that was created in 1933. ----- However, the last seven years have witnessed some dramatic changes. Some of these changes have been the result of legislation. Other changes have arisen as a result of reinterpretations of existing laws. Legislative changes included the six-year phase out of Regulation Q beginning in 1980, the reduction in reserve requirements for commercial banks, the granting of bank powers to the nation's thrift industry, and the elimination of regulations prohibiting thrift institutions from engaging in securities, insurance and real estate brokerage activities. Several important changes in the interpretation of existing regulations also occurred. As a result of actions by the Federal Reserve, bank holding companies gained many new powers. Among them, the right to act as discount brokers, investment advisors, futures commissions merchants, and Bankers Trust decision. However, banks also found themselves facing increasingly stringent capital requirements. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Deregulation of the 1980s • Phase-out of Regulation Q • Reduction in reserve requirements • Expanded powers of thrifts • Bank holding compan ies gain new powers ------------- 15 Investment banks also benefitted from the reinterpretation of existing banking legislation. As a result of litigation it became possible for firms outside of banking to enter the industry by acquiring a bank which did not accept demand deposits and make commercial loans ~ Many investment banking firms, including Merrill Lynch, availed themselves of this opportunity. The MMMFs managed by investment banks also made important inroads into banking. Despite the lifting of regulation Q, MMMFs share of total transactions balances doubled between 1980 and 1987 percent. _____... ercent to over 10 Investment banks also found themselves competing head on with commercial banks in the provision of customized products for managing interest rate and exchange rate risk. The most important of these are interest rate swaps. In 1987, an insurance company is no longer just an insurance company; a securities firm is no longer just a securities firm; and a retailer is no longer just a retailer. Prudential, for example, is now fully entrenched in the securities business and is planning to expand into real estate brokerage. Merrill Lynch, as well as other securities firms, competes with banks in deposit taking through mutual funds and some securities firms even own banks due to the "nonbank bank" loophole. Sears is very close to providing one-stop shopping; it offers securities and real estate brokerage services as well as insurance, deposit services, and retail credit at its many retail outlets throughout the country. These firms and many others--General Motors Ford, Westinghouse, General Electric, Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 16 etc.--compete with commercial banks in banks' traditional areas of lending and deposit taking. The lines that separate commercial banks from other lines of commerce have faded, and commercial banks are beginning to look elsewhere for profits. three areas: off-balance-sheet guarantees, investment banking, and hedging products. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Banks have concentrated on ►Also Banks see Financial services Investment firms Stock brokers Insurance companies Credit unions Savings & loans Retailers 17 The decline of traditional banking Despite serious restrictions, nontraditional activities are already a major source of profits for banks. A large part of noninterest income at banks is a result of their investment banking activities. Fee income (excluding capital gains from trading accounts) as a percent of total operating income for bank holding companies with assets over $1 billion increased steadily from 1981 to 1984. For these organizations, noninterest income's share of total income has increased by over 30 percent. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Noninterest income as a percent of total income at large banks Pere~) ,J '0.1 I i 19 8J 19 84 18 Commercial banks already play an important, though sharply restricted, role in the the domestic market for investment banking services. They underwrite state and municipal securities, manage investment funds through trust accounts, act as advisers in mergers and acquisitions, and privately place securities. The top ten commercial banks that acted as advisers in mergers and acquisitions in 1985 were involved in over 100 deals valued at $6 billion. The top 10 banks in public financing underwrote over 2,000 issues of tax-exempt securities in 1985, valued at $22.5 billion. In private placements, the top 10 banks managed over 700 issues valued at $11 billion, an@rcent market share. Investment banking activities of 10 largest U.S. banks Value Number of Deals ($ billions) 5.94 115 Tax-exempt bonds 22.50 2.471 Private placements 13.16 713 Mergers & Acquisitions Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 19 outside the United States, commercial banks compete directly with investment banks in several types of activities, including underwriting Eurobonds, Eurocommercial paper and equity issues. Nine of the top ten bank holding companies underwrite Eurobonds; they managed over 140 issues valued at $15 billion (an 11 percent market share). Each of the top ten bank holding companies underwrite Eurocommercial paper, and seven of the top ten underwrite international equity issues. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Investment banking activities of U.S. banks overseas Eurocommercial Eurobonds II ~ Citicorp X X BankAmerica Chase Manhattan X X X X Manufacturers Hanover X J . P. Morgan & Co. International Equities X X X X X X Chemical NY Corp. X X Security Pacific Corp. X X Bankers Trust Co. X X X X X X 9 10 7 First Interstate Bancorp. First Chicago X X X 20 Commercial banks are also becoming more like investment bankers by increasing their sale of loans. Rather than booking loans, they are essentially underwriting them by extending credit and temporarily warehousing loans before selling them to third-party investors. Loan sales represent an unbundling of traditional bank lending services. The selling bank originates and services the loan, but an investor funds the loan and assumes the credit, liquidity and interest-rate risk in exchange for a portion of the principle and interest paid to the bank under the loan agreement. Loan sales, therefore, allow a bank to operate more like an investment bank than a traditional commercial bank. Selling loans is not a new activity for commercial banks. Commercial loan participations and overlines are quite common, but there is some evidence that commercial and industrial loan sales are increasing in volume and importance. From 1983 to 1985, the amount of C&I loans sold, excluding overlines and syndications, jumped nearly sevenfold to roughly $35 billion. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Loan sales • Unbundling • Originating ;c, servicing loans • Funding loans 21 Sales of securitized loans are also picking up. Securitization is the pooling and repackaging of loans into securities, which are then sold to investors. While securitization contracts can become quite detailed, the basic idea is simple. originates a number of loans. coled together. A financial intermediary The cash flow of these loans are then Claims to these cash flows are then sold to a thir~ party, either by actually selling the loans or by issuing a liabilit with payments that are tied to the pool's cash flow. Like whole loan sales and participations, securitization provides an additional funding source and eliminates assets from a bank's balance sheet. Unlike whole loan sales and participations, securitization is often used to market small loans that would be difficult to sell on a stand-alone basis. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Turning mortgages into securities -··- - □ □ no □ □ 1 Financial institutions make mart a e loans Mortgages are bundled and sold as securities -~ ill J J r 22 There are three basic types of loan-backed securities, each of which developed out of the secondary mortgage market. is the pass-through security. The first type It represents direct ownership in a portfolio of loans that are similar in term to maturity, interest rate, and quality. The portfolio is placed in trust, and certificates of ownership are sold to investors. The loan originator services the portfolio and collects interest and principal, passing them on, less a servicing fee, to investors. Ownership of the loans in the portfolio lies with the investors; thus, pass-throughs are not debt obligations of the originator and do not appear on the originator's financial statement. Major types of loan-backed securities • Pass-throughs • Mo, tgage backed • Pay-throughs The second type of loan-backed security, the collateralized security, related to mortgage-backed bonds. Like pass-throughs, collateralized securities are backed by a portfolio of loans, but unlike pass-throughs, collateralized securities are debt obligations of the issuer, so the portfolio of loans used as collateral remain on Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 23 the issuer's books as assets and the collateralized securities are reported as liabilities of the issuer. The cash flows from the collateral are not dedicated to the payment of principal and interest on the securities. The third type of loan-backed security is the pay-through security. This security combines some of the features of the pass-through with some from the collateralized bond. The pay-through is collateralized by a portfolio of loans and appears on the issuer's financial statements as debt. The cash flows from the portfolio, however, are dedicated to servicing the bonds in a way similar to that of pass-throughs. These instruments were first used w i y i ~ e s . The market in shroomed from ~ l i o n industry in 1981 into • dustry in 1985, based on trading volume. currently, about 31 percent of all residential mortgages outstanding are held in the form of securities. securitized. In 1980, only 13 percent were While S&Ls and the federal mortgage agencies are the biggest players, banking firms are also active in mortgage banking. And some of the nation's largest banks are trying to move into the business of underwriting mortgage securities. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Federal agency pass-throughs as a percent of residential mortgages Percent J5 JO 25 10 eo e, 82 64 24 In the last year or so, the market for other "securitized" consumer loans has also been expanding. Packages of auto loans and credit card receivables are increasingly being sold to third-party investors. In 1985, only $1 billion in auto loans were securitized. In 1986 $10 billion were sold under this method. Salomon Brothers estimates that $15 billion in auto loan-backed securities will be issued this year. Last year, an estimated $50 million in credit card receivables were securitized; this figure is expected to double by the end of this year. Several banking firms have set up separate subsidiaries to securitize such assets. privately place securitized assets. Morgan Guaranty has begun to And the top U.S. banks are vying for the job of adviser in selling government loans. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Securitized consumer credit t ,s-f~ . ~,• Auto loans 15 10 Crltdit cord loa ns ~ 198 5 0 1986 198 7 . projK le>d 25 Off-balance sheet activities Commercial banks are also supporting their customers in the capital markets through off-balance-sheet activities. Most off-balance-sheet items can be classified into three categories: Trade-related, credit-related, and hedging-related. Trade-related OBS activities Commercial letters of credit (CLC) are the most common trade-related off-balance-sheet item. Used mostly to facilitate foreign trade, CLCs are essentially payment guarantees. A CLC guarantees the seller payment by the issuing bank when certain documents specified in the letter of credit are presented to the bank in accordance with the terms of the CLC. CLCs, in effect, substitute the creditworthiness of the issuer, usually a bank, for that of the buyer or importer. Since the creditworthiness of the bank is, generally, better known than that of the importer, trade is facilitated. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Commercial letter of credit 1a . lrnoort er orders qooda i---2-_ !::x_oon _.,,_,n,_o•g _OOd _ s ,_o ,m _ oort_.,. __ .l. E:xoorter sends dratt and cocuments 4. Bonlic occ eols drof tI and pays iucporter face valu e ,... diK:ount lnlportar 5. Bonlt forwonla docum.,, t1 6. Importer pays bOnlt 26 CLCs are issued at the request of the buyer (importer) by his bank. The beneficiary of the CLC is the seller (exporter). An importer orders goods and then has his bank issue a CLC naming the exporter as beneficiary. The exporter ships the goods to the importer and sends draft and documents to the issuing bank. A bankers acceptance is created when a time draft is presented to the bank by the exporter and the bank stamps it "accepted." Usually, the accepting bank discounts the draft and pays the exporter in cash. The bank then either holds the acceptance in its portfolio as it would a loan or sells it in the secondary market. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 27 Credit-related OBS activities Credit-related off-balance-sheet items include loan commitments, standby letters of credit, note issuance faciltities, and asset sales with recourse. Each of these serve as a substitute for traditional bank lending. Loan commitments are perhaps the most common off-balance-sheet items. A loan commitment is a lender's promise to make a loan up to some maximum amount for a certain period of time at agreed-upon terms. In exchange for this promise, the lender receives a fee or compensating balances. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Credit-related OBS activities • Loan commitments • Standby letters of credit • Note issuance facilities • Asset sales with recourse 28 Standby letters of credit {SLCs) are similar to commercial letters of credit, although there are a few key differences. The most important difference is that standbys often expire unused. guarantee either financing or performance. SLCs For example, they have traditionally guaranteed municipal bonds and commercial paper, and they often guarantee performance on construction contracts. As long as the party who obtains a SLC fullfills his financial or contractual obligation specified in the SLC, the SLC expires unused. Like commercial letters of credit, standby letters of credit involve three parties--the account party, the issuer, and the beneficiary. The account party, such as an issuer of commercial paper or municipal bonds, obtains a SLC from a bank, the issuer, naming the third party, such as a creditor, beneficiary. The SLC is payable upon presentation of evidence of default or nonperformance by the account party. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The bank is legally bound to pay the beneficiary Credit-related OBS activities • Loan commitments • Standby leners of credit • Note issuance facilities • Asset sales with recourse Standby letter of credit l!lanll: {Issues SLOC J 29 if the account party defaults or does not perform according to some contract whether or not the bank knows that the account party is unable to repay the bank. In other words, a SLC is irrevocable. Note issuance facilities. While there are many variations on note issuance facilities, a NIF, in general, is a medium-term arrangement between a borrower and an underwriter or a group of underwriters. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Credit-related OBS activities • Loan commitments • Standby letters of credit • Note issuance facilities • Asset sales with recourse 30 Under this arrangement the borrower can issue short-term paper, known as Euronotes, usually with maturities of three or six months, over a period of usually five to seven years. These notes are usually in denominations of $500,000 or more. For a fee, the underwriter commits to either purchase the notes or provide standby credit. Often the underwriter then places the notes with investors at a price higher than he paid for them. For example, according to one scenario, a group of managing banks fully underwrite the issue, purchasing it at a discount. The notes then are either held by the managing banks or sold to investors. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Note issuance facilities • Medium-term arrangement between borrower and underwriter • Borrower issues short-term paper • Underwriter commits to purchase notes or provide standby credit • Underwriter keeps notes or places them with investors 31 Asset sales with recourse involve the sale of assets, usually loans, from a firm's balance sheet with some type of guarantee or put option. While commercial loans are typically sold without any explicit guarantees, banks sometimes guarantee portfolios of consumer loans sold to investors, since it is difficult for individual investors to evaluate the quality of these loans. This practice has become less common in recent years since bank regulators began requiring banks to treat these guarantees as loans when calculating the bank's capital requirement. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Credit-related OBS activities • Loan commitments • Standby letters of credit • Note issuance facilities • Asset sales with recourse 32 Hedging-related OBS activities Investment-related off-balance sheet items include options, futures and forward contracts, and swaps. An option is the right, but not the obligation, to buy or sell securities or commodities at a specified price on or before a certain date in the future. A "put" option is the right to sell; a "call" option is the right to bl;!Y. Futures and forward contracts are agreements to buy or sell securities or commodities at an agreed-upon price on a specified date in the future. The primary differences between forward contracts and futures are that futures are traded on organized exchanges, have standard terms, and generally require margin. A swap is a transaction in which two parties, known as counterparties, agree to exchange cash flows over a period of time. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Hedging-related OBS activities • Options • Futures and forward contracts • Swaps 33 There are two basic types of swaps: rate swaps. currency swaps and interest In a currency swap, two counterparties agree to exchange specific amounts of two different currencies at the outset and repay the amounts over time according to a predetermined rule which reflects interest payments and amortization. Sometimes, however, no exchange of currency takes place initially or at maturity. In an interest rate swap, no principal is ever exchanged, but interest payments of differing character (e.g., floating rate and fixed rate) are exchanged according to a predetermined rule and based on an underlying notional amount. Intermediaries are often involved in swaps. Originally, intermediaries merely brought the two counterparties together. But as the number and types of end-users increased, they became reluctant to assume the credit risks associated with purely brokered swaps. Consequently, large commercial banks and investment banks intermediated by entering into two offsetting swaps. high credit ratings often bypass such intermediation. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Example of interest rate swap End-users with 34 Trends in OBS activities Off-balance-sheet banking appears to be widespread, and becoming more so, yet banks with more than $25 billion in assets commanded 70 percent of the OBS market over the 1983-85 period. The average ratio of all off-balance-sheet items to assets for the dozen largest banks was 147 percent. In 1985, the ratio of commercial loans to assets for these banks remained about the same as the ratio for 1978; while, during this period, the ratio of standby letters of credit to assets and the ratio of loan commitments to assets increased 11 and 13 percentage points, respectively. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis C&I loans, standby letters of credit and loan commitments at money center banks ? erc enl ol os~•~i :1 !01 I 251 20 10 ::~ 1,,'lns :.!ti loon -:o .,,m,rments SLOCs 35 Although the lion's share of off-balance-sheet banking belongs to the largest institutions, the number of banks that engage in off-balance-sheet activities has been increasing, so that in 1985, 75 percent of all banks participated in off-balance-sheet activities. Banks with $5 to 25 billion in assets, the so-called "Super Regionals", increased their share of the overall market by more than 4 percentage points between 1983 and 1985, largely at the expense of the money centers. The Super Regionals' increased share of the OBS pie is due to an increased share in a broad range of activities. Participation in off-balance-sheet banking among smaller banks has grown steadily. The number of banks with assets under $500 million that engage in off-balance-sheet banking grew by more than 600 banks from 1983 to 1985, with over 10,000 banks in this size class participating in at least one OBS activity. Nevertheless, overall OBS activity has grown much faster than activity at small banks. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Share of the OBS market by bank size, 1985 36 Trade-related off-balance-sheet activities have become less important for banks in every size category. Except at the money centers, hedging activities have become more important and financial guarantees have become more important. Financial guarantees include loan commitments, standby letters of credit (SLCs), and participations in SLCs. The increase in financial guarantees is due to increases in loan commitments as a percent of OBS items, whereas SLCs as a percent of OBS items have declined. The reverse trend for investment-related and finance-related activities occurs for the money centers, which are more heavily concentrated in off-balance-sheet investment-related or hedging items. Much of the increase in hedging activities for the money centers is due to the rise in commitments to purchase foreign currency and U.S. dollar exchange, which make up more than 85 percent of their hedging activites. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Types of OBS activity by bank size, 1985 Pen:ent shore :001 5 - 5$B 901 I eo 1 , S!B 70 60 40 JO 20 L--- Trade -----1 _ :-;"onc e ----' 37 Why are traditional banking activities becoming less important? Why are some commercial banks moving away from traditional banking activities? Some fingers have been pointing to regulation. Those doing the pointing argue that banks have a comparative advantage in originating loans, but a disadvanatage in warehousing them--keeping them on their books. This disadvantage stems from the "regulatory taxes" that banks must pay in the form of federal deposit insurance premiums, foregone interest from holding required reserves, and mandatory capital requirements that exceed those that would be maintained in the absence of regulation. By underwriting securities or issuing off-balance-sheet guarantees, banks can still offer financing services to their customers, and they can also avoid "regulatory taxes." Avoidance of regulatory taxes is not new. In the 1970s, the Fereral Reserve System found its membership shrinking as banks sought to escape the competitive disadvantages created by the combination of burdensome reserve requirements and high interest rates. By 1980 the cost of funding a riskless domestic loan through a commercial bank was 61 basis points higher than funding it through the commercial paper market. 3 More and more banks were finding Fed membership unattractive. Congress' response to the membership problem was to pass the Depository Institutions Deregulation and Monetary Control Act of 1980 which drastically lowered reserve requirements and required all financial institutions to hold reserves with the Fed. Banks should 3 see the attached table for a summary of changes in the regulatory taxes over time. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 38 have found themselves in a stronger position vis a vis nondepository-based financial intermediaries. As a result, having a banking charter should have become more attractive. But if this is the case why are several large institutions publicly discussing the merits of giving up their bank charters? One possible reason is that total regulatory taxes have increased even though the reserve requirement tax has decreased. Aside from reserve requirements, there are two other components to the regulatory tax, requirements to hold equity capital and requirements to pay a deposit insurance premium that does not vary with bank risk. Against these costs, banks must balance the benefits from a bank charter--federal deposit insurance and access to the discount --..--------:----:-window. These two advantages, especially deposit insurance, allow a bank to attract deposits at a lower rate than would otherwise be possible given the risks that it is taking. However, for low-risk assets, this lower rate may not be sufficiently low to compensate the bank for the regulatory taxes. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 39 Reserve requirements generate a tax by forcing banks to hold noninterest-bearing balances with the Federal Reserve. At one money center bank, required reserves as a percent of total domestic assets fell by approximately 50 percent between 1980 and 1986. Holding interest rates constant at their 1980 level the reserve requirement tax would have fallen from 44 basis points to 22 basis points. However, during the same period the average rate on Fed funds fell from 12 percent to less than 6 percent. This reduced the funding disadvantage created by reserve requirements to 11 basis points today. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Composition of regulatory taxes on domestic loans 1980-1985 Burden of reserve requirements ~- Burden of depas1t insurance premiums Burden of capital requirements - - - - - - - - • b•sispoints • ~ • • • To111I •0 1980 44 13 61 1985 holding tax structure and interest rates consunt at the 1980 level■ 22 21 51 1985 holding i n t - rate■ constant at the 1980 level■ 22 1s· 45 1985 actual 11 1985 assuming 1987 tax structure 11 .. 28 20 39 40 When funding a riskless asset, deposit insurance premiums While the FDIC had always levied a fee of a basis represent a tax. points per dollar of domestic deposits, it traditionally rebated up to half the charge at the end of the year. Under financial pressure due to a mounting number of failing banks, this practice was terminated in 1985. The net result, a 4 basis point increase in the regulatory tax. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Composition of regulatory taxes on domestic loans 1980-1985 rewrve Burden of dePOsrt insurance Suroen of capnal ~ Suroen of premiums ~ ( • • • • - - • - - - • - ••• • • bHl6 1980 ~ pamts • • • • • • • • • • - • • - • ) 44 13 61 1985 holding tax Structure and interest rates constant 22 21 51 1985 hola,ng 1nt-1 ratN consuint at the 1980 1...,.1, 22 15• 45 1985 actual 11 at tne 1980 1.-1 26 1 985 assuming 1987 tilll 5U\Jcture 11 20 39 41 The burden created by capital requirements arises because payments to debt holders are not treated as corporate income for tax purposes. If banks are forced to raise their equity-to-debt ratios, then their cost of funds will rise by the amount of the additional taxes paid. Between 1980 and 1986 bank equity capital ratios have risen from 3.6 percent of assets to 4.8 percent of assets. If banks' ability to shelter income had remained unchanged, the funding disadvantage generated by the reliance on equity capital would have risen from 13 basis points per dollar of assets to 21 basis points. However, taking changes in market rates, rates on tax exempt securities, and changes in the taxation of banks into account, the burden of bank capital requirements in 1985 was about 7 basis points in 1985. Unfortunately, the 1986 tax act dramatically alters the ability of banks to shelter income, making it likely that the burden of capital requirements will take a sharp jump -- to perhaps 20 basis points. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Composition of regulatory taxes on domestic loans 1980-1985 Buroen of f90u w- n f · .. . ...... . 1980 1985 holdin<J taa structu,e at tfle 1980 ,_ c _ , at the 1 tl0 1985 actual 13 81 22 • 21 51 22 8 15• 45 r.CN - Su,den of apnal premiums ~ Toial .... . . ~poinu . . . . . . . . . . . . . . ·) • " and interest rat• conaant 1985 hol01ng i n t - 8un1en of / 11 26 1 985 assuming 1987 tax lill'Ueture 11 0 39 42 Taking all these factors into account, one concludes that between 1980 and 1985 regulatory taxes for funding a riskless asset have fallen from 61 basis points to 26 basis points. Composition of regulatory taxes on domestic loans 1980-1985 Burden of reou1rements Buroen of Burden of deoo111 insurance capital premiums rec,u11ement1 ~ . - •••• - • • • buupomu • ~ • • • 1980 Total ·0 u 13 81 1985 holding 1u structure ancs interest rares constant 22 21 51 1985 holding 1n1entSt rat" consc.ant II u,e 1980 ,.,,.., 22 15• 45 1985 .ctual 11 at UM I 980 level• 1985 assuming 1987 t aa scn.icture Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 11 28 20 39 43 However, this may not have significantly improved the competitive position of banks. Over half the decline in the regulatory tax has been the result of changes in the level of rates, not changes in regulation. If interest rates had remained at their 1980 levels, regulatory taxes would have only fallen by 10 basis points. would still have been at a 51 basis point disadvantage. Banking Second, there have been dramatic changes in the composition of the regulatory tax. In 1980 reseve requirements generated over 70 per cent of the tax. Reserve requirements could be avoided, in part, by reducing reliance on reservable funds--either by shifting lending activity into overseas branches of the bank or by shifting from deposits to nondeposit sources of funds. In 1985 reserve requirements only account for about 40 percent of the tax. After the new tax bill is phased in, equity capital requirements could be responsiable for as much as 50 percent of the regulatory burden. The burden created by equity capital requirements cannot be reduced by changing the composition of liabilities. It can only be neutralized by reducing warehousing activities. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The changing composition of regulatory taxes Burden of reserve deposit insurance ~ premiums Burden of Burden of capnal ~ ( • • • • • • • · • · • • • · •• pMC8nt•• · • • · · · · · • · ) 1980 72 19B5 holding tax structure and interest rat• constant at the 1980 lewis 21 43 HI 41 1985 holding interest rates constant at the 1980 levels 49 17 33 1985 actual 42 31 27 1985 assuming 1987 tax structure 28 20 51 44 While regulatory taxes have decline, most of the rates, not changes in remains large relative to bank prof ing banks have of even 26 basis points. Thus the - .,......,--~~-·- - -ial services without using the banking system. away from traditional activities Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 45 Not just regulation There is considerable variation in bank's reliance on off-balance-sheet activities. If the regulatory tax argument is correct then the higher a bank's regulatory taxes, the more it should rely on off-balance-sheet activities. Our study of guarantee products--loan commitments, standby letters of credit, and commercial letters of credit indicates that banks with higher regulatory taxes are more likely to issue these guarantees. However, bank soundness is an even more important factor. The reason is simple, these guarantees are more valuable the greater the probability that the issuer will remain solvent. Factors in issuance of guarantees Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis • High regulatory taxes • Bank soundness 46 We have also tried to identify why banks engage in loan sales. We found that banks with greater regulatory taxes sold more loans. However, regulatory taxes are not the sole force driving loan sales, nor are they the strongest. A bank's comparative advantage in originating and servicing loans, as measured by the ratio of noninterest expense to loans, has a large impact on a bank's probability of selling loans, and it has the largest impact in determining the amount of loans that a bank will sell. We also found that banks with poorly diversified asset portfolios were more likely to find loan sales to be an attractive alternative. Among the regulatory taxes, the most important determinants of loan sales seem to be capital requirements and deposit insurance premiums. Reserve requirements have a smaller impact. In the case of off-balance-sheet guarantees, capital requirements and deposit insurance premiums have the strongest impact on a bank's decision to offer standby letters of credit, but reserve requirements are the only significant regulatory tax for commercial letters of credit and loan commitments. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Factors in loan sales/' • Originatin~and servicing loans • Diversification • Regulatory taxes 47 The desire to avoid regulatory taxes, to reduce risk and to benefit from unique cost advantages are all important factors in explaining why some commercial banks' desire to function as investment banks. role However, other factors must also be playing a since nonbank financial firms are also increasing their reliance on off balance sheet activities. General Motors Acceptance Corporation, the largest auto lender in the United States, has been the largest issuer of CARs (Collateralized Automobile Receivables). Ford's and Chrysler's captive finance companies have also sold issues of CARs. And several computer companies have sold debt collateralized by computer leases. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Nonbank financial firms and OBS activities • GM , Ford, and Chrysler • Computer companies • Property and casualty insurers 48 Property and casualty insurers guarantee such things as commercial paper, municipal bond issues and lease contracts as well as securitized loan sales. Since 1980, property and casualty insurers have increased premiums written on financial guarantees nearly threefold to $2.3 billion. That is 1.6 percent of net property and casualty premiums written, compared to just under 1 percent in 1980. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Financial guarantees by property / casualty insurers l,l; lhona $ 3000 o~ - - - - - -- - - - - - - - - - - Ratio Ratio 1• 15 76 77 78 79 80 81 82 83 8• 85 49 Several factors account for this rush to adopt new ways of doing business. Macroeconomic forces, such as increased interest rate volatility and inflation, have encouraged the development of many financial innovations that allow investors to hedge existing financial positions. Trading of financial futures contracts has increased twendivefold since 1977, and financial futures now accoun " for about 40 percent of all futures contracts traded, compared to 2 ercent in 1977. been dramatic. Growth in options on financial instruments has also In 1979, 3.6 million contracts were traded on the CBOT, and in 1984, nearly 41 million were traded. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Futures and options contracts on financial instruments ~1illions ,;o j I 50 JO 20 10 77 78 79 l!O 81 82 IIJ 50 Technology has also played a very important role in financial innovation. Many financial innovations, including financial futures, -----------.. swaps and NIFs, technology. were made possible because of advances in computer By making the same information available simultaneously to many market participants, technology has reduced the need for many of the traditional services provided by financial intermediaries, such as credit evaluation and monitoring. This has put pressure on banks and other financial services providers to innovate, to stay ahead of the competition, and to pay attention to the demands of the marketplace. Increased competition among financial services providers has also played a role in fostering the rapid innovation of financial products. Many types of suppliers now offer the same products at competitive prices over a much broader geographic area. Retailers, manufacturers, and insurers compete with banks in the traditional areas of lending and deposit-taking, but they also compete in some of the newer nontraditional areas as well. Catalysts for financial innovation Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis • Technology • Competition 51 Conclusions Over the last ten years commercial banks have attempted to find ways to compensate for their limited abilities to engage in underwriting, have developed important new products for managing interest and exchange rate uncertainty, and changed the role they play in the lending process, shifting from funding loans to simply originating and/or guaranteeing them. In my opinion, the first two developments are of concern only because they challenge regulators to develop a supervisory system that is suited for these activities. The push to obtain underwriting and brokerage powers is simply an attempt by u.s banks to resume a role that they lost as a result of the passage of Glass-Steagall in 1933. The major challenge here is for regulators to develop ways of regulating these activities that do not increase the risk to the FDIC. This can be done in two ways. First, we can permit large bank holding companies to go bankrupt and make sure that the underwriting subsidiary is segregated from the banking subsidiary. Alternatively, we can permit underwriting to go on within the bank and make sure that banks are closed as soon as they become insolvent. The movement into risk management products -- swaps, caps, futures, and options -- is again mostly of concern because these new products require regulators to develop new areas of expertise. The risks that need to be taken into account are somewhat different than those that need to be taken into account when valuing floating rate loans. However, it is clear to me that these products are a natural outgrowth of developments in the nation's futures and options Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis l 1, .. I I 11 !' if Tir ,! '. !; !; :'. ~ Jt-, A/2p,-n' • ··-v-·~o Digitized for FRASER https://fraser.stlouisfed.org p Federal Reserve Bank of St. Louis • .. ~_j' • A.~~ . l. ~~~~ o.. . ~ C-#lU ~ -4- b-.Jc:-.c;. A ~ - ' ~-~ I I i! ~ ~ i ~ A ~~. A- ~ { u,A,U ~ ~~ _$ ~ .. / C - .3 - ~ ~~ / ~~. t!.-/ ~ O , 13~~ ~ ~ L IL II[ I Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ~~~ p ~ s , 11 P o £ , ~ . 52 markets. on the other hand, I do find the growth in credit guarantee activity and asset sales to be of possible concern. Yet even here, there is evidence that suggests that these products should be viewed in a positive light. It is a fact that the marketplace's willingness to accept a bank's off-balance-sheet guarantees is positively correlated with bank safety. It is also true that banks have a strong incentive to issue these guarantees to their most creditworthy customers. Loan sales also seem to have positive implications for bank soundness. They allow banks to do what they do best--originate and service loans--rather than warehouse them. Also, loan sales allow banks to diversify their portfolios, which will improve the safety and soundness of individual banks. And since a substantial portion of loans that are being sold are reportedly going to foreign and nonbank investors, loan sales should improve the safety of the whole banking system. 4 These factors all suggest that the movement of banks away from the funding of loans does not seem as detrimental to the banking system as some might believe. In fact, there is evidence that indicates that such a move may be an improvement. However, bankers and regulators are going to have to develop better methods for understanding and evaluating the risks of banks' off-balance-sheet 4 A recent Senior Loan Officer Opinion survey indicated that only 25 percent of loans sold by large banks were sold to other American banks. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ~~~ ~ /1:,~ ~ - 53 activities. This need is particularly acute since there is evidence that these new banking products would not disappear if regulatory taxes were greatly reduced or even eliminated. Also, recent changes in the tax code make it likely that the incentives for banks to shift into investment banking are only going to increase. Despite the obvious merits of credit guarantees and asset sales, regulators cannot afford to ignore the possibility that their rapid growth is largely explained by our existing system of taxes and subsidies. In general, the higher the regulatory taxes on low risk assets relative to the regulatory subsidies for holding risky assets, the more likely banks are to move toward riskier assets and riskier activities. In general, it is better to eliminate bad regulation than to simply permit banks to evade it. This suggests that we should take steps to reduce the taxes imposed on low-risk assets and the subsidies for holding high risk assets. Regulatory taxes could be reduced by reducing reserve requirements, paying interest on reserves, and permitting banks to substitute long term debt for equity capital. Such steps have been presented in a recent proposal by the New York Fed and I hope that they are adopted. One way to reduce the subsidy for risk taking would be to take our newly proposed risk-based capital requirement a step further and begin to distinguish between low- and high-risk loans. This would reduce the regulatory tax on low-risk assets as well as reducing incentives for banks to take risk. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 54 I also believe that if reform is going to be made, we should take the opportunity to simplify the existing regulatory structure. With the advent of interstate banking, it is conceivable that a single bank holding company will have to deal with the Comptroller, the FDIC, The Federal Reserve Board, twelve Federal Reserve Banks, and 50 state regulators. to administer. This system is aggravating to bankers and costly I believe we have to do something to decrease the number of regulators in the picture. Just as J.P. Morgan's decision to concentrate on commercial banking was based on gaining a competitive advantage and on the future prospects of underwriting, so too are the decisions by some commercial bankers today to move away from traditional banking activities. While regulatory taxes have played a key role in today's decisions, other factors such as risk management, efficiency, technology, and a natural desire to resume their pre 1933 role in the securities markets are also important. Because many of these activities can be conducted without a bank charter, charters have become less valuable. This new environment should lead regulators to step back and re-evaluate the costs and the benefits of current regulation. At this point the ball is really in our court. Regulators have a responsibility to the banks they regulate to determine the feasibility of investment banking activities regulating banking firms that engage in and to reexamine regulations which penalize banks for holdlong low risk assets. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ! 4 ji h itI! ., l• ·1' 1, ~-.., C-# ·.,.t~ ~ l, 'j ,j C, lJ 'I tit. 11 il I t+e--v-.1 C(.,o ~~ . ~~ ~ ~ ~ - o'1... ~ ~ ~ ~~ ~ ,. ~,-..e.-6- • . . ti· ~. 'et-.J~ !, p I I l. I . !1 .2, F, ,,Al ~ ;J 4 °'. a.Jb I i, •r:, ~~ , I ;:;~s ~ , j ~ (.,-.)~~~ 2.. ~ ; rs I I l !' t I d Digitized for FRASER t j • https://fraser.stlouisfed.org c, Federal Reserve Bank of St. Louis ~ ~~ . 

Silas Keehn (1987, April 7). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19870408_silas_keehn

@misc{wtfs_regional_speeche_19870408_silas_keehn,
  author = {Silas Keehn},
  title = {Regional President Speech},
  year = {1987},
  month = {Apr},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19870408_silas_keehn},
  note = {Retrieved via When the Fed Speaks corpus}
}