The Future of Banking in America - Farmer School …FDIC BANKING REVIEW 1 2004, VOLUME 16, NO. 1 The...

FDIC BANKING REVIEW 1 2004, VOLUME 16, NO. 1

The Future of Banking in AmericaSummary and ConclusionsGeorge Hanc*

Purpose and Approach of the Future-of-Banking Study

The purpose of the FDIC’s study of the future ofU.S. banking is to project likely trends in thestructure and performance of the banking industryover the next five to ten years and to anticipatethe policy issues that will confront the industryand the regulatory community.1

This study comes 17 years after the FDIC’s lastcomprehensive consideration of the future ofbanking.2 That earlier study, Mandate for Change,was undertaken against a background of increasedcompetition for banks, weak profitability, and areduced market share in commercial lending. Thestudy recommended product and geographicderegulation, with appropriate safety-and-sound-ness safeguards, to ensure the viability of thebanking industry.

Since then, the environment for banking haschanged radically. Legislation was enacted to per-mit both interstate branching and combinationsof banks, securities firms, and insurance compa-nies. A generally strong economy, as well asderegulation, led to marked improvements inbank profitability and capital positions. At the

same time, however, the deregulation of productsand markets intensified competition among banksand between banks and nonbank financial com-panies. In addition, together with improved infor-mation technology, deregulation accelerated theconsolidation of the banking industry throughmergers and acquisitions and set the stage for theestablishment of huge banking organizations ofunprecedented size and complexity.

Although the condition of the industry has great-ly improved over the past decade or so, banks andthe regulatory community will face significantchallenges in the years ahead. Competition willcontinue to be intense, and few banks, if any, willbe insulated from its effects. In the view of someobservers, rapid consolidation of the bankingindustry will continue and may adversely affectthe availability of credit for small businesses andlocal economies. Large, complex banking organi-zations may pose difficult supervisory issues, while

* Former Associate Director, Division of Insurance and Research, FederalDeposit Insurance Corporation.1 Throughout the paper, “this study” refers to the FDIC’s collective project onthe future of banking (FOB), consisting of the 16 papers listed in the firstsection of the references.2 FDIC (1987).

2004, VOLUME 16, NO. 1 2 FDIC BANKING REVIEW

The Future of Banking

the burden of reporting and other regulatoryrequirements will fall heavily and disproportion-ately on small banks unless remedial action istaken. Further advances in information technolo-gy will permit the development of new products,services, and risk-management techniques butmay also pose important competitive and supervi-sory issues. Nonbank entities will continue tooffer bank-like products in competition withbanks, raising anew the question of whetherbanks are still “special” and, more fundamentally,whether banks are sufficiently different from non-bank firms to justify the maintenance of a safetynet for banks.

It is useful, therefore, to try to chart the course ofthe banking industry in the next five to ten yearsand to consider what policy issues the industryand regulators will face. The authors of this studydo not pretend to be clairvoyant. They are mind-ful of the many financial predictions that wereonce offered with confidence but turned out to bewrong or premature. This study is perhaps bestdescribed as an exercise in strategic thinking. Itsapproach is to analyze what has happened in therecent past, consider in detail reasons for expect-ing recent trends to continue or to change, anddraw the consequences for bank and regulatorypolicies. As always, uncertainties abound, andevents that may now appear fairly improbablemay in fact shape the future. This paper closeswith a discussion of a number of such possibleevents.

The future-of-banking study addresses three broadquestions:

1. What changes in the environment facingbanking can be expected in the next five to tenyears?

2. What are the prospects for different sectors ofthe banking industry in this anticipated environ-ment? Because the banking industry is not mono-lithic and different segments of the industry have,to some degree, different opportunities and vul-nerabilities, the study considers separately theprospects for large, complex banking organiza-

tions; regional and other midsize banks; commu-nity banks; and limited-purpose banks.

3. What policy issues are the industry and regu-lators likely to face in the years ahead? Separateconsideration is given to

� Consolidation of the banking industry: Whatare the prospects for, and implications of,further consolidation of the bankingindustry, particularly relating to safety andsoundness, market concentration, andsmall business credit?

� Combinations of banking and commerce:What are the pros and cons of permittingcommon ownership or control of banksand commercial enterprises? What are theoptions for regulating such combinationsso as to protect the bank safety net andavoid conflicts of interest?

� Large-bank supervisory issues: What are theimplications for bank supervision of thegrowing complexity of large bankingorganizations?

� Governance issues: Recent corporate scan-dals have led to efforts to hold corporatedirectors and managements to a higherstandard. What are the likely effects onbanking and what should banks do toavoid governance problems?

� Financial services regulatory issues: Whatshould be done, either under existing lawor through new legislation, to enhancethe effectiveness of the federal financialregulatory system?

� Bank liability structure: What are theimplications for supervision and depositinsurance of changes in the structure ofbank liabilities?

� Economic role of banks: How does theincreased role of nonbank financial insti-tutions and markets affect the rationalefor a safety net for banks?

Summary and Conclusions


The Environment for Banking

The future of banking will be shaped, in largepart, by the environment—economic, demo-graphic, regulatory, technological, payment-system, and competitive—in which it operates.

Economic Environment

In the decade ahead, a climate of moderate eco-nomic growth without severe or long-lastingrecessions would be conducive to the stronggrowth and profitability of the banking industry.In such a climate, bank failures would be few innumber and idiosyncratic in nature—typicallycaused by managerial and internal control weak-nesses, excessive risk taking, or fraud, rather thanby broader economic forces. Such, at least, hasbeen the pattern of bank failures in most of theyears since the inception of the FDIC, with theprincipal and very large exception of the 1980sand early 1990s. However, the economy is notimmune to speculative bubbles like those occur-ring in the energy, commercial real estate, andagriculture sectors in the 1980s, which wereamong the important causes of the wave of bankfailures during that period, or the more recentbubble in communications technology in the1990s. Boom-and-bust conditions in markets inwhich banks participate could once again producea significant number of failures caused by eco-nomic conditions, although the banking industryis stronger than it was on the eve of the 1980s,geographic diversification has reduced the vulner-ability of many banks to local economic distur-bances, and bank supervision has beenstrengthened.

Demographic Environment

Among the main demographic trends likely toaffect banking in the years ahead are the aging ofthe population and the continued entry of immi-grants.3 In the next decade or more, the babyboomers (people born during the post–World WarII bulge in the birth rate) will retire or approachretirement. There are more than 80 million baby

boomers, and they account for 30 percent of thetotal U.S. population. Life-cycle theory and theavailable data suggest that they will be engaged inliquidating assets to a greater degree—and willmake less use of credit—than younger age groups.Also compared with younger age groups, they willhold a greater proportion of their wealth in liquidassets, including bank deposits. At the same time,baby boomers may be less averse to risk than simi-lar age groups that had experience with the GreatDepression. Therefore, the composition of thebaby boomers’ wealth is likely to be affected notonly by their stage in the life cycle but also bytheir overall motives for saving and their invest-ment experience with equities and other marketinstruments. Baby boomers will live longer thanthe preceding generation and may find that theirpost-retirement incomes will be inadequate tosupport costs such as health care. Many, though,will inherit wealth from their parents and willneed financial services for their retirement plan-ning. Banks will therefore be able to profit bybroadening their services to meet baby boomers’financial preferences.

Since 1990, the United States has attracted 9million immigrants. Of the total U.S. population,33 million, or 11 percent, are immigrants.Though the number of new immigrants is expect-ed to increase, immigrants as a whole may notsupply a proportional amount of funds for bankdeposits because of low incomes and lack of legaldocumentation. In addition, immigrants oftensend large remittances back to their home coun-tries. Low rates of home ownership and relianceon borrowing from informal sources such as familyand friends are other factors likely to keepdemand for bank credit low. Immigrants demandfewer mortgage loans because of their lower rateof home ownership and tend to make larger downpayments than native-born Americans. Banksnow earn service fees for transferring remittancesand, in connection with this activity, may be ableto provide incentives for immigrants to open

3 This section is based on the FOB paper by Jiangli. Long-term reductions inpopulation in some rural areas also have implications for banks and are dis-cussed in the section on community banks.



banking accounts. Banks are tailoring their prod-ucts to meet immigrants’ unique characteristics—for example, by offering low-fee transactionaccounts and flexible mortgage packages. Asimmigrants reside longer in the United States,their incomes will rise, more of them will buyhomes, and they will generally merge into thefinancial mainstream.

Both baby boomers and immigrants will increasetheir supply of deposits to banks, but for differentreasons. Baby boomers will desire to hold safe andliquid assets when they get older, whereas immi-grants will likely become wealthier as they staylonger in the United States. As for the effects ofaging baby boomers and immigrants on thedemand for bank loans, the two groups tend tooffset each other. Immigrants now demand fewerbank loans because of low incomes and a relianceon informal banking, but when they live longenough in the United States, they tend tobecome home buyers. In the next 10 to 20 years,however, increased loan demand from immigrantsmay not fully compensate for retiring babyboomers’ decreased loan demand.

Regulatory Environment

As in the recent past, future deregulation of bankpowers is more likely to start from developmentsin the marketplace or actions by individual statesthan from initiatives by Congress or the executivebranch. However, Congress and the executivebranch may be more receptive to proposals forlegislation designed to protect consumers, preventserious misconduct by bank personnel, or advancenational security objectives. The provision of abank safety net and the existence of regulatoryagencies to enforce compliance make banking apolitically attractive vehicle for furthering suchobjectives. The results have been substantialreporting and other regulatory burdens on banks.These requirements frequently involve fixed coststhat tend to be proportionally heavier on smallbanks. Although, as noted below, we regard com-munity banks as a viable business model, the dis-proportionate impact of regulatory burden onsmaller banks places them at a competitive disad-

vantage. Excessive regulatory burdens may notonly hurt existing banks but may also discouragenew entrants, thereby depriving bank customersof the benefits of increased competition fromnewly established banks. This prospect highlightsthe importance of reducing reporting burdenswherever possible.

The FDIC established a special task force toreevaluate its examination and supervisory prac-tices in an effort to improve operations andreduce regulatory burden without compromisingsafety and soundness or undermining importantconsumer protections. Over the last several yearsthe FDIC has streamlined examinations and pro-cedures with an eye toward better allocatingFDIC resources to areas that could ultimatelypose greater risks to the insurance funds—areassuch as problem banks, large financial institu-tions, high-risk lending, internal controls, andfraud.4

The FDIC is also leading an interagency effort toidentify and eliminate restrictions that are outdat-ed, unnecessary, or unduly burdensome. Thiseffort is pursuant to the Economic Growth andRegulatory Paperwork Reduction Act of 1996.Comments are sought from the banking industryabout which regulations are the most burdensomeand which regulations place the industry at acompetitive disadvantage. The agencies havejointly published the first two of a series ofnotices soliciting comment on regulations in anumber of areas and have been conducting out-reach sessions with bankers, consumer groups, andcommunity groups. Armed with input from theseefforts, the agencies will conduct a comprehensivereview of banking regulations and will report toCongress on their findings and on the actionsthey have taken, or plan to take, about the levelof burden. The agencies also expect to send Con-gress a list of legislative areas for consideration.

4 Actions taken by the FDIC, as well as interagency efforts to reduce regulato-ry burden, were outlined in congressional testimony by the Vice Chairman ofthe FDIC (Reich [2004]).


Technological Environment

The banking industry is now more dependent ontechnology than ever before, with annual industryexpenditures for technology topping an estimated$30 billion.5 In recent decades, the focus of large-bank technology developments has shifted.These decades began with a large number ofmergers and acquisitions after restrictions oninterstate banking and branching were lifted, andthe technology component of merging two enti-ties proved to be a challenging task for acquirers.Lessons were learned over time by institutionsthat experienced numerous rounds of acquisitions.By the late 1990s, Y2K concerns dominated tech-nology planning and, to an extent, restrained thelevel of mergers and acquisitions. Y2K work alsohad the effect of benefiting banks by requiringplanning for business continuity and disasterrecovery. Meanwhile, the world of technologycontinued to change, with rapid adoption of theInternet and increases in the market capitaliza-tion of Internet-related companies. Bankersinvested heavily in Internet products and services.More recently, the technology focus of banks hasmoved to cost cutting, consolidation, and ration-alization. Large banks will continue to developnew technologies and adapt to legislative and reg-ulatory changes, such as Basel II and Check 21.Imaging, increased bandwidth, wireless network-ing, and Web services are innovations likely tohave an impressive effect on the use of bank tech-nology. For large banks, security and operationalresiliency remain major concerns.

Community banks also depend on technology, butmore as users of proven technology than as cre-ators or innovators. By using proven technologiesas they become available, community banks nowoffer a wide variety of products and services, oftenmatching large banks in the scope of their offer-ings to retail customers. As a result of competitivepressures, even small banks now find it mandatoryto have sophisticated, well-functioning technolo-gy to support customer service, administration,and financial reporting. But managing technologyis a challenge for community banks, and amongFDIC-supervised banks, only slightly more thanhalf perform core processing in-house; the

remainder outsource this function. Thus, third-party service providers play a critical role in theefficiency and security of technology operations atcommunity banks.

Objective assessments of community bank infor-mation technology (IT) operations are availablethrough the examination process and from a sur-vey of FDIC IT examiners. The vast majority ofFDIC-supervised banks receive sound compositeIT examination ratings. Examiners report thatcommunity banks are using technology to providecustomers with more and better-quality productsand services. Examiners also note vulnerabilitiesat FDIC-supervised banks in the areas of riskassessment and audit, strategic planning, manage-ment of outsourcing, security, and personnel.

Technology will continue to be a major expense,and security will remain a crucial issue for banksof all sizes. Responding to an ever more complextechnology environment will be challenging.Nonetheless, proper technology management iswithin the grasp of every bank and can lead tobetter customer service, lower operating costs,and a more efficient banking system.

Payment-System Changes

Although the much-heralded checkless societyhas yet to arrive, major changes are underway inretail noncash payment systems, as the use ofchecks as a means of payment has declined andelectronic forms of payment have increased.6After rising for many years, the number of checksused in retail transactions declined from 49.5 bil-lion in 1995 to 42.5 billion in 2000—the latestyear for which comparable data are available.Over the same period, the number of retail elec-tronic payments increased from 14.6 billion to28.9 billion.


5 This section is based on interviews with large-bank supervisory personnel atthe Office of the Comptroller of the Currency and the Federal Reserve Boardand on information received from FDIC examiners who have experience per-forming or reviewing information technology examinations. The results are dis-cussed in detail in the FOB paper by Golter and Solt.6 This section is based on the FOB paper by Murphy.



Although fewer checks are being written, thenumber is still very large in absolute terms and incomparison with the number being written inseveral other countries, some of which have virtu-ally eliminated the use of checks. Therefore,efforts are being made to “electronify” checksearly in the process of clearing and settlement bysending the information forward electronically;that process is expected to be faster and lessexpensive than current methods, which requirethe physical transportation of large amounts ofpaper.

Banks will have to adapt their product offeringsand pricing as well as their back-office processingto reflect these payment-system changes. Sincemore electronic transactions are cheaper toprocess, as is the conversion or truncation (orboth) of checks, banks that do not explicitlycharge for transaction services on a per-item basiswill see a reduction in costs. For banks that haveexplicit fees for each service (mainly banks thatsupply cash-management services), it will be nec-essary to ensure that the profit margins on theelectronic transaction services are commensuratewith those on the paper transaction services.Banks of all sizes should be able to continue toserve their customers with a mix of capabilities,including ATMs, on- and off-line debit cards,credit cards, and other services.

Bank regulators must be aware of the risk implica-tions of the changes in payment systems and mustadapt their approaches accordingly. Operationalrisk is obviously an important issue. In this regard,the ownership of fund transfer networks haschanged dramatically: the number and proportionof networks owned and operated by nonbankentities has increased, whereas those owned byjoint ventures of banks have declined. Becausethe operation of these networks directly affectsthe risk exposure of banks, the risk-managementpractices of the network providers may haveimportant implications for the banking industryand the bank regulatory community.

Banks and bank regulators also need to be con-cerned about the market structure of the networkproviders, especially those for ATMs, debit cards,

and credit cards. Significant consolidation amongnetwork providers has already occurred, and anyfurther concentration raises concerns about pric-ing, quality of service, and product innovation inthis segment of the market—one for which bankregulators have no direct responsibility.

Competitive Environment

The shares of debt held by commercial banks andsavings institutions as a percentage of the totalvolume of debt have declined compared with theshares held in earlier decades of the twentiethcentury.7 Some observers have interpreted thisdecline as a sign of competitive weakness or evenobsolescence. However, this decline is partly dueto the proliferation of channels of financial inter-mediation, which often involve the issuance offinancial instruments to fund other financialinstruments rather than the channeling of fundsto nonfinancial sectors of the economy—house-holds, businesses, and governments.

In this regard, the overall volume of borrowing incredit markets has apparently increased perma-nently. During the 1980s the volume of borrowingby nonfinancial sectors of the economy rose from1.3 times annual GDP to nearly 1.9 times annualGDP, an increase reflecting the rising indebted-ness of households and nonfinancial businesses, intandem with deficit spending by the federal gov-ernment.

The growth of debt in our economy during the1980s was associated with a decline in the shareof domestic nonfinancial borrowing that is direct-ly funded by commercial banks (the sharedeclined from 30 percent in 1974 to a low of 20percent in 1993). But when debt growth leveledoff in the early 1990s, commercial banks’ share ofthis credit-market pie also leveled off, and sincethe early 1990s it has remained generally stable.The continued need for bank financing on thepart of many borrowers reflects their inability—owing to their small size and idiosyncratic risk—

7 Trends in the importance of banks in U.S. credit markets are discussed inthe FOB paper by Samolyk.


to access financial markets directly and cost effec-tively.

The reduction in banks’ share of the credit-mar-ket pie reflects a dramatic shift in the way loansare being financed. Specifically, asset securitiza-tion (the pooling of loans and their funding bythe issuing of securities) has allowed loans thatused to be funded by traditional intermediaries,including banks, to be funded in securities mar-kets. The securitization of home mortgages andconsumer credit has reduced the extent to whichthese types of loans are directly funded by com-mercial banks and has had an even more adverseeffect on savings institutions.

Nonetheless, commercial banks continue to playa significant role in funding business borrowers.The average share of nonfinancial business bor-rowing that commercial banks hold on their bal-ance sheets has remained relatively stable for fivedecades. At the same time, there has been a clearshift in how banks lend—a shift from shorter-term lending to loans secured by business realestate. This shift may reflect banks’ continuingcomparative advantage in real estate lending, aform of lending less well suited to the standardiza-tion necessary for asset securitization.

The savings institution share of total household,business, and government debt has also stabilizedin recent years, but at levels much lower thanthose of earlier post–World War II decades. Thereasons for the decline are the liquidation of asubstantial portion of the savings and loan indus-try during the 1980s and early 1990s, the absorp-tion of numerous savings institutions bycommercial banks, and the rapid growth of mort-gage-backed securities.

Banks’ importance relative to capital markets islower in the United States than in many othercountries. However, some countries are movingcloser to the U.S. model as a result of forces thathave increased the efficiency of “arms-length”financial markets, including improvements in theprocessing of information, increases in interna-tional trade and capital flows, and political inte-gration.8 Thus, the lower market share of banks

in the United States may be seen as a sign of theadvanced development of capital markets and ITin the United States rather than as a sign of ter-minal weakness in the banking industry.

Of course, market-share data based on balance-sheet totals underestimate the continuing impor-tance of banks in financial markets preciselybecause they do not include off-balance-sheetactivity. Through backup lines of credit, loanorigination, securitization, and other means,banks support lending by other entities and earnfee income. An alternative measure of the impor-tance of banks in the financial system is providedby the bank share of total net income of financialsector firms, which reflects income and expensefrom both on- and off-balance-sheet activities.During 1992–2002 net income of publicly tradedcommercial banks and savings institutionsaccounted for an average of 44 percent of totalprofits of all publicly traded financial compa-nies—about the same proportion as in 1985,before the banking crisis of the late 1980s andearly 1990s.9 Moreover, the net income of thelargest individual banks was far greater than thatof the largest nonbank financial companies.10

The ability of the banking industry and thelargest individual banks to earn high net incomerelative to other financial firms is hardly a sign ofcompetitive weakness.

The Environment for Banking: Summary

In general, the environment for banking in thenext five to ten years is likely to remain favorable.The economic environment appears conducive togood banking industry performance, assumingthat recessions are mild and that we avoid thespeculative bubbles similar to those that con-


18 Rajan and Zingales (2003).19 Tabulations by the FDIC, based on data from Standard and Poor’s Compu-stat. For other measures of banks’ market share, see the FOB paper bySamolyk, and Boyd and Gertler (1994).10 In 2002 Citicorp earned net income of $10.7 billion from banking opera-tions, and Bank of America Corp. earned $9.2 billion, whereas the four largestnonbank financial companies earned net income ranging from $4.6 billion to$5.8 billion (tabulations by the FDIC, based on data from Standard and Poor’sCompustat).



tributed to widespread failures during the 1980s.The banking industry’s market share has stabi-lized, according to a number of measures.Reduced use of checks and increased use of elec-tronic payments are likely to exert downwardpressure on costs of the banking system as awhole. Over time, banks will have increasedopportunities to serve two growing segments ofthe population—retired baby boomers and immi-grants.

Potential problems in the environment are likelyto be associated with inadequate safeguards in theuse of technology. Consolidation and increasednonbank ownership of fund transfer networks—especially networks for ATMs, debt cards, andcredit cards—may expose banks to new opera-tional risks. Outsourcing certain functions,including moving work offshore, involves politi-cal, business-continuity, and security risks. Inade-quate IT staffing may make some banksvulnerable to attacks on the software they use,with customers exposed to inconvenience andbanks to weakened reputations and weakenedcompetitive positions.

For community banks, in particular, the burden ofreporting and other regulatory requirements posesa significant threat to future prosperity. Efforts toaddress this problem are described above.

Prospects for Banking Sectors

As is well known, the U.S. banking system ischaracterized by large differences in the size ofinstitutions; the system includes some of theworld’s largest banking organizations as well asthousands of relatively small banks. Institutionsalso differ in the extent to which they are affectedby local rather than national economic forces andin the business strategies they have adopted tocope with their environments. Individual banksor groups of banks have, to some extent, differentbusiness opportunities, risk exposures, and futureprospects, and many of these differences are asso-ciated with size. In this study, banks are dividedinto the following groups:

Large, complex banking organizations—defined as the top 25 organizations interms of assets

Community banks—defined as institu-tions with less than $1 billion in assets

Regional and other midsize banks—defined as banks that fall between com-munity banks and the top 25 (in otherwords, banks with assets greater than $1billion but less than the assets of thesmallest of the top 25 organizations—cur-rently about $42 billion)

Special-purpose banks—includes creditcard banks, subprime lenders, and Inter-net banks.

Except when specifically noted, “banks” and“banking organizations” refer to independentcommercial banks and savings institutions and tothe holding companies of such institutions.“Assets” when used to denote the size of differentgroups of institutions means the assets of commer-cial banks and savings institutions combined.Asset limits of size groups are adjusted for infla-tion as measured by the GDP price deflator.

Large, Complex Banking Organizations

Over the past 20 years the structure of the U.S.banking system has changed enormously inresponse to changes in the legal, regulatory, andfinancial landscape.11 At the end of 2003, the 25largest insured banks and savings institutions held56 percent of total industry assets, with the 10largest holding almost 44 percent, up from 19 per-cent in 1984. For the next 15 banks, the growthhas been much less dramatic: the combined assetsof the banks ranked 11 through 25 have risenonly 2 percentage points, from about 10 percentin 1984 to 12 percent at the end of 2003.

11 This section is based on the FOB paper by Reidhill, Lamm, and McGinnis.Information on individual institutions is based on publicly available data.


Why did these institutions grow to be so large?Has the elimination of restrictions on branchingand ownership been the main driving force? Dolarger banking organizations enjoy economies ofscale? Does management simply want to controlever-larger organizations? Do investors exert pres-sure to increase asset size, revenues, or netincome? To some extent, all of these appear to betrue.

The passage of the Riegle-Neal Interstate Bank-ing and Branching Efficiency Act of 1994undoubtedly helped spur large banks to spreadacross state lines and to grow. This developmenthelped create large, geographically diversifiedbranch networks that stretch across large regionsand even coast-to-coast. The Gramm-Leach-Bliley Financial Services and Modernization Actof 1999 (GLB) allowed the largest banking organ-izations to engage in a wide variety of financialservices, acquiring new sources of noninterestincome and further diversifying their earnings.Contributing to these developments wereadvances in IT that facilitated control of far-dis-tant operations and fostered new products, servic-es, and risk-management techniques.

As these banks have grown, have they gained effi-ciencies from their growth? The conclusionsreached in the economic literature on bankeconomies of scale are mixed; some studies havefound economies of scale and scope, and somehave not.12 With respect to market power, stud-ies of mergers that resulted in high concentrationsin local markets did not find significant gains tothe acquiring firm. On the other hand, consolida-tion that leads to geographic diversification seemsto be associated with increased profits andreduced risk. Some studies have also concludedthat banks may seek growth in an attempt to beregarded by the market as too big to fail.13

According to this view, the funding costs of abank would be lower if holders of uninsureddeposits, bonds, and other credits assumed theywould be protected if the bank failed.

Although the academic literature does not pro-vide conclusive evidence that greater size leads tocost and other advantages, there appears to be

continual pressure on bank management fromshareholders and market analysts to show growthin both revenue and earnings. Bigness is appar-ently regarded as advantageous. Nevertheless, thewave of mergers and acquisitions that occurredafter enactment of the Riegle-Neal Act and GLBhas probably passed. The large number of dealswithin the recent past partly reflects the backlogcreated by a restrictive legal environment; in aless-restrictive legal environment, many of therecent mergers and acquisitions would haveoccurred earlier and over a longer period.Although Riegle-Neal prohibits mergers when themerged bank’s domestic deposits would exceed 10percent of total domestic deposits (or 30 percentof the deposits in any state), only the Bank ofAmerica is close to the 10 percent limit (as aresult of the recent merger with FleetBoston);other members of the top 25 group are much fur-ther from the limit and are not prevented fromundertaking mergers by this legal provision. Fur-ther mergers among large banks may be expectedin the immediate future, although not in the vol-ume experienced after geographic and productderegulation.

Large banking organizations have widely differentbusiness strategies. Among the eight largest com-panies, some have extensive foreign operations,while others are essentially domestic commercialbanks.14 Some have major credit card operations,and others do not. Some have large trading oper-ations and are active in securities markets, whileothers do not and are not. Some focus on loans tobusinesses, while others have major consumeroperations. Some concentrate on commercial andindustrial loans, while a few are very active (oreven specialize) in mortgage finance. They also


12 These studies consider the cost structures of the bank as a whole. This isnot to deny that there may be scale efficiencies in specific business lines,such as credit card operations. See the section on limited-purpose banks.13 “Too big to fail” is a misnomer. The question for investors is whether unse-cured and uninsured creditors of such a bank would be protected if the bankwere to fail.14 The eight largest banking organizations, in descending order of asset size asof January 2004, are Citigroup, J. P. Morgan Chase, Bank of America, WellsFargo, Wachovia, Bank One, Washington Mutual, and FleetBoston. In theaggregate, these institutions account for 41 percent of total banking industryassets.



differ in geographic reach within the UnitedStates.

With some exceptions, the larger the institution,the more likely it is to engage in a wide range ofactivities. The smaller institutions are more likelyto concentrate on growing their retail and con-sumer banking franchises, either internally orthrough mergers, and entering the investmentbanking business by purchasing smaller brokeragefirms or building on a proprietary mutual fundbusiness. At least in the near term, widespreadentry into the property and casualty insuranceunderwriting business is unlikely. Life insuranceunderwriting and insurance brokerage show morepromise, with less risk.

Despite the variety of business models, some ofthe ways in which large banks have changed aresimilar across all or many of them. They haveincreased their fee income as a percentage of totalincome, possibly to reduce their vulnerability tocyclical interest-rate changes. Most of them haveincreased income from deposit charges, and somehave taken advantage of the new powers underGLB to increase trading revenues, investmentbanking income, and insurance commissions andfees. Much of the noninterest income from newpowers is concentrated in the top two or threebanks. These banks have also shifted fromdeposits to collateralized borrowings. Large banksalso appear to have been successful in limitingtheir exposure to credit losses by improving theirrisk-management practices.

The experience of the eight largest banks duringthe recent economic recession has been mixed.Four of these banks had fairly consistent returnson book equity over the period, while the otherfour had large declines in earnings, with one bankexperiencing an actual loss in 2000. In no casewas the solvency of an organization threatened.

This mixed record may illustrate the advantagesand disadvantages of large, complex organizations.In some cases, geographic diversification, interna-tional diversification, product diversification, andrisk-management practices seem to have paid offwell. Although some of the success was undoubt-

edly due to a very favorable interest-rate environ-ment, loan losses during the period were low. Inother cases, there were evident problems in man-aging large, complex organizations and in manag-ing the process of acquiring and mergingorganizations. It appears, therefore, that the vari-ous strategies for capitalizing on size, geographicdiversification, and product diversification can besuccessful—but that size itself does not guaranteeconsistent success.

It seems clear that for the immediate future, thelarge banks will continue to try to grow throughinternal growth and acquisitions. As these institu-tions grow and expand the breadth of their prod-ucts, potential problems of managerialdiseconomies and corporate governance mayarise. The sheer size and complexity of today’slarge institutions place a heavy burden on theirfinancial and operational risk-management sys-tems. Undoubtedly many of these problems arebeing addressed. Permitted single-company expo-sures are reportedly being reduced at almost alllarge banks, and exposures are being trackedacross business units. Financial risk models arebeing implemented in response to both the busi-ness need for better risk management and a pre-sumption that Basel II will eventually beimplemented.

What can be learned from the recent experienceof the top 25 banks? The success of the best-per-forming organizations might argue that largeorganizations can be efficient and effective. Thelarge losses sustained by the worst performers sug-gest that the risk of failure in these banks,although very small, is greater than zero. Howev-er, the size and diversification of these organiza-tions help them absorb losses.

If larger and larger banks become a reality, howwill the FDIC’s risk profile be affected? First, ifmore institutions come up against the 10 percentdeposit concentration limit, efforts to raise thatlimit may be expected over time and may raiseconcerns about the concentration of economicresources and power. Second, the possible failureof large banks, however unlikely, represents a risknot only to the insurance funds but also to the


banking system itself because of the large increas-es in deposit insurance premiums that might berequired. Over the past 19 years the size of thelargest banks has grown dramatically comparedwith the relevant deposit insurance fund. At year-end 1984 the Bank Insurance Fund (BIF) balancewas $16.3 billion, and the largest BIF memberbank was about 7 times larger than the BIF. Atyear-end 1996 the largest single bank was about 9times greater than the BIF. By the end of 2003the largest single bank was almost 19 times largerthan the BIF ($33.8 billion).

Basel II will effectively create a different capitalstandard for the largest banks. Should the depositinsurance system be changed to isolate smallbanks from the effects of the failure of largeinsured institutions? If so, how? How will theFDIC and the regulatory agencies meet the chal-lenges of mitigating the concentration of risk cre-ated by these very large and still-growingorganizations? Capital adequacy standards andvigilant supervision present the greatest promise.Optimally pricing deposit insurance, creating sep-arate safety-net arrangements for large and smallinstitutions are ideas that deserve discussion andresearch.

Regional and Other Midsize Banks

For purposes of this study, banks that have assetsof more than $1 billion but less than the assets ofthe smallest of the 25 largest banking organiza-tions (currently about $42 billion) are designated“regional and other midsize” banks.15 As a groupthey are heterogeneous, not only in asset size butalso in geographic reach. A quarter of them aretruly regional in the sense that they have a signif-icant presence in a number of markets, while theremaining three-quarters are sizable banks con-centrated in one market—either located in onlyone state or having more than 60 percent of theirdeposits in only one market (as measured by met-ropolitan statistical areas [MSAs]), or both. Thisstudy has divided banks in this in-between sizegroup into two subgroups depending on the geo-graphic concentration of their deposits: one sub-group consists of the truly regional banks, and the

other consists of the other midsize banks (i.e.,those considered to be large local banks ratherthan regional institutions).16

In the past seven years, both subgroups have con-sistently outperformed community banks in termsof average return on assets (ROA) and have oftenoutperformed the top 25 banks. During the sameperiod the number of regional and other midsizebanks increased by 13 percent. In terms of assets,however, the midsize sector lost market sharebetween 1996 and 2003, largely because of thetop 25 banks’ dramatic growth through mergersand acquisitions.

The regional and other midsize banks may besmall enough to avoid any diseconomies that maybe associated with managing distant facilities andheterogeneous product lines but large enough toattract qualified employees, diversify their portfo-lios, and take advantage of IT to offer a wide vari-ety of services and to manage risk. Within thisgroup, banks that are concentrated locally havehad somewhat better earnings than those whoseoffices are dispersed. Whether locally concentrat-ed banks will continue to outperform regionallydispersed banks is uncertain. If economic condi-tions should significantly worsen in some localmarkets, banks concentrated in these marketsmight be hit hard.

Despite the whole group’s strong performance,some commentators have predicted the decline oreven the disappearance of these banks. This viewreflects a judgment that, in order to thrive, abank needs either the close community ties of asmall bank or the geographic scope, marketingpower, and product lines of a megabank.

However, it is hard to imagine that one of thebest-performing banking sectors is slated for out-right disappearance. Like other good performers,regional and other midsize banks have a numberof practical options. They may acquire communi-


15 This section is based on the FOB paper by Gratton.16 According to this definition, a bank would be considered a “true” regionalbank if it operated in more than one state and had less than 60 percent ofits deposits in one MSA.


ty banks, merge among themselves, or seek to beacquired by larger banks that remain below the 10percent deposit concentration limit. And rapidgrowth and mergers among some communitybanks may augment the number of in-betweenbanks. We expect the number of banks in theregional and other midsize group to remain signif-icant.

Community Banks

Community banks (defined here as institutionswith less than $1 billion in aggregate bank andthrift assets) were not swept away by larger banksfollowing product and geographic deregulation, assome observers had expected.17 Communitybanks represent about 94 percent of all banks inthe United States—nearly the same as their 95percent share in 1985, when the recent wave ofconsolidation began.18 The persistently largenumber of relatively small banks is characteristicof the U.S. banking system and reflects long-standing public policies based on concern aboutthe concentration of economic power, the desireto maintain local ownership and control, andefforts to protect local banks from competition. Insome cases, these considerations had led to a pro-hibition of branching; for example, in 1985 42percent of all community banks were located in12 states that previously had unit banking.

The picture has changed greatly as a result of thebanking crisis of the 1980s and geographic dereg-ulation. The number of community banks hasdeclined by 47 percent since 1985, as a resultboth of failures (in the earlier part of this period)and (more recently and more significantly) of vol-untary mergers. Moreover, the community bankshares of total banking industry assets, deposits,and offices have also declined.

Perhaps the most notable feature of the decline inthe number of community banks has been its per-vasiveness: the number has declined across geo-graphic areas, across both growing and decliningmarkets, and among community bank size groups.The number declined in rural areas, small metro-politan areas, and large metropolitan areas, and,

within the latter, in suburban as well as urbanareas,19 with the pace of the declines during theperiod since 1985 falling within a fairly narrowrange. Moreover, in areas that suffered net reduc-tions in population (mostly rural counties), thedecline in the number of community banks wascomparable to the decline among communitybanks as a whole.20

The number of community banks declined some-what faster in formerly unit-banking states thanin states that had permitted branching.21 Thisfinding suggests that restrictive branching lawscontributed to the establishment of some smallbanks that could not (or preferred not to) contin-ue as independent entities once branching restric-tions were lifted and competition increased.However, the difference in rates of decline wasnot very large. Among community banks of differ-ent sizes, the largest decline was among bankswith less than $100 million in assets (where dis-economies of small scale are believed to exist);however, this decline resulted not so much frommore mergers or failures as from the fact thatnumerous small banks grew faster than the rate ofinflation and “graduated” to a higher size group.

A striking difference between urban and ruralareas is in the various cross-cutting forces thatended up reducing the number of communitybanks. Urban areas had proportionally moremergers and failures than rural areas but also morenew institutions, with the result that total net


17 This section is based on the FOB paper by Critchfield, Davis, Davison, Gratton, Hanc, and Samolyk.18 Bank size groups are adjusted for inflation so that, for community bankingorganizations, the number of organizations with less than $1 billion inbank/thrift assets in 2002 is compared with the number that had less thanabout $650 million in 1985.19 The location of community banks is determined by the location of the hold-ing company headquarters or, when there is no holding company, the locationof the institution’s headquarters. Division into rural, small metro, suburban,and urban areas depends on whether the bank is located in a metropolitanstatistical area (MSA) and on population density. 20 Although banks in counties suffering depopulation showed no greater pro-portional decline in number than banks in other areas, the performance ofbanks in counties suffering depopulation differed from that of banks in grow-ing areas, as discussed in the FOB paper by Anderlik and Walser, and inMyers and Spong (2003).21 The 12 states where unit banking existed as of the end of 1977 were Col-orado, Illinois, Kansas, Minnesota, Missouri, Montana, Nebraska, North Dakota,Oklahoma, Texas, West Virginia, and Wyoming (Conference of State BankSupervisors [1978], 95).


reductions were roughly the same in rural andurban areas. Urban areas are clearly where theaction is; urban areas are central in terms of bothmerger activity and the establishment of de novobanks. The two types of activity are, to someextent, related; dissatisfied customers of a mergedbank may be attracted to a new institution, andareas of high population density may be moreattractive markets for the establishment of newbanks while also containing more attractive merg-er targets.

The pervasiveness of consolidation among com-munity banks casts doubt on, or provides onlyweak support for, some familiar explanations ofthe reduction in the number of community banks.The lifting of branching restrictions in states thatpreviously prohibited branching, diseconomies ofsmall-scale operations, and depopulation andweak local economies all have undoubtedlyaffected the fortunes of community banks. How-ever, none of these factors seems to have been themain cause of the consolidation among theseinstitutions. In time, these factors may producefurther consolidation, although it is difficult toestimate the length of the lags in bank response.These lags may reflect, in part, a lack of intereston the part of potential acquirers in banks locatedin weak local economies as well as the ability ofbanks in such areas to perform at a level satisfac-tory to their owners. In the recent past, at least,the main impetus for consolidation seems to havebeen individual decisions by shareholders andmanagers in response to intensified competition.

As noted above, the effect of mergers and failureswas dampened somewhat by the establishment ofnew banks, mostly in areas of high populationdensity. About 1,250 new community banks wereestablished between 1992 and 2003, of whichabout 100 have been merged and about 1,100remain as independent organizations. Like othernew and young businesses, they exhibit significantrisk factors in some cases, but only 4 have failed.If real estate and other markets served by thesebanks do not experience serious downturns, theseinstitutions will have an opportunity to matureand prosper.22

As a result of both a slowdown in mergers and thecontinued establishment of de novos, the pace ofconsolidation has slowed considerably in the pastfew years. In the near term, some further consoli-dation may be expected. Low returns on equity(resulting partly from higher capital ratios) maylead to consolidation among some institutions, asstockholders seek higher returns throughincreased leverage at merged institutions.23

Attracting and retaining qualified employees andmanagement succession will pose challenges forsome of these institutions. Dependence on inter-est income will periodically squeeze marginsunless fee income is increased. Regulatory burdensmay also contribute to consolidation.

With respect to earnings performance, in recentyears the before-tax ROAs have been lower forcommunity banks than for larger banks. However,this gap between community banks and largerbanks is narrowed after corporate taxes are takeninto account. Community banks hold a larger per-centage of their assets in lower-yield, nontaxablemunicipal bonds. Moreover, about 2,100 commu-nity banks were organized as Sub-chapter S cor-porations as of March 2004 and therefore paid nofederal corporate income tax if they met certainconditions. After taxes, community bank ROAshave averaged from 1.0 percent to 1.2 percent inrecent years, lower than those of larger banks buta level of profitability that would have beenregarded as exceptional in earlier years. As mightbe expected, community banks located in coun-ties experiencing more rapid growth in eitherpopulation or real personal income have experi-enced higher ROAs and net interest margins,


22 During the 1980s, failures were higher among new or “young” banks thanamong existing banks. In the early 1980s a large number of new nationalbanks were chartered following a change in policy by the Office of the Comp-troller of the Currency, a change designed partly to increase competition. Atthe time, banks obtaining a national charter were, by statute, automaticallyinsured by the FDIC. In 1991, as a result of the FDIC Improvement Act, theFDIC obtained separate authority to approve insurance for national banks. SeeFDIC (1997), 106.23 Such reasoning does not apply, or applies with considerably less force, toowner-operated banks that do not rely on uninsured or unprotected sources offunds. Returns of owner-managers may be augmented by compensationreceived as officers of the bank, and there may be no outside shareholders tochallenge the decision to remain independent.


although expense ratios are currently similar.24

These results are hardly surprising; what may besurprising to some is that even in slow-growthareas, the performance of community banks canbe considered “satisfactory.”25

In deposit and loan markets community bankshave faced strong competition, not only fromwithin their own ranks but also from larger banks,credit unions, and nonbank competitors. Thecommunity bank share of deposits has declined inrural, small metro, suburban, and urban areas,with the largest 25 banking organizations showinga large increase in market share.26 (These com-parisons reflect both internal growth and merg-ers.) The share held by regional and other midsizebanks has also declined, while that of creditunions has remained relatively stable, increasingfrom 8 to 9 percent since 1994. Within the creditunion industry, large institutions (assets over $100million) have shown an increased share, whilesmall credit unions have lost ground. Leavingaside the very largest banking organizations, cred-it unions have increased their market share rela-tive to the smaller banks, a development that manywould attribute to credit unions’ tax-exempt sta-tus and the expansion of their permissible areas ofoperation. Not all community banks face creditunion competition of the same intensity; creditunions are concentrated in urban areas in thecentral and eastern states, whereas communitybanks are located in large numbers in rural, subur-ban, and urban areas.27

After adjustments are made for mergers, smallbanks have actually shown more rapid growthsince the early 1990s than the largest banks.28

Small banks have paid higher rates, and chargedlower fees, than large banks in order to attractdeposits. They have also increased their borrow-ings from Federal Home Loan Banks in order tobroaden their sources of funds, as core depositgrowth has lagged behind demands for credit.

On the lending side, there have been declines inthe community bank shares of the increasinglystandardized consumer, home mortgage, and unse-cured business loan markets—markets that large

lenders, using credit-scoring technologies, havepenetrated on a nationwide basis. On the otherhand, community banks appear to be largely hold-ing their own in real estate lending to businessesand in farm lending. Community banks hold adisproportionately large share of small businessand farm loans (real estate and operating loans).

In summary, the number of community banks hasbeen halved since 1985, and these banks’ marketshare has declined relative to the largest banks’market share. On the face of it, the declines innumber and market share would seem to suggestthat community banks have serious problems. Amore detailed examination presents a somewhatmore optimistic view. Community banks still rep-resent 94 percent of the total number of banks,not much different from the percentage beforethe recent wave of consolidation began. More-over, it is impressive that community banks havebeen able to register respectable earnings andgrowth in recent years while facing intensifiedcompetition from nonbank financial companies,as well as from other banks after the removal ofthe branch restrictions that had protected manycommunity banks from competition.

The conclusion we draw is that the communitybank is a viable business model. Research suggeststhat community banks have certain advantages aslenders to small businesses, small farmers, andother informationally opaque borrowers; theseadvantages are their ability to assess the risks ofborrowers who lack long credit histories, their


24 From 1992 to 2001 community banks located in counties experiencing popu-lation declines recorded ROAs ranging from 1.0 percent to 1.2 percent—notmuch lower than the ROAs of banks located in counties experiencing popula-tion growth. 25 Myers and Spong (2003) reached a similar conclusion.26 Credit union offices and deposits are classified geographically according tothe location of the organization’s headquarters. For the large majority of creditunions this probably is acceptable, although for large credit unions—such asthose serving military personnel—this may distort data on the location of creditunion resources.27 Eighty percent of credit unions are located in MSAs, compared with 54 per-cent of community bank offices.28 Bassett and Brady (2001) reached a similar conclusion. It should be notedthat the more rapid percentage growth rates of small banks may partly reflectthe fact that the internal growth rates of very large banks may be more limit-ed by the size of markets and the marginal cost of increases in funding.


ability to use “soft” data (such as borrower reputa-tions) effectively in risk assessment, and theirability to operate effectively in situations wherethe proximity of decision makers to customers isimportant.29 The proposition that communitybanks have informational advantages in lendingto small business is supported by research suggest-ing that small banks have higher risk-adjustedreturns on business loans than large banks. Thewillingness of private investors to risk their ownmoney to establish new banks is a powerful mar-ket test of the viability of small banks, at least inareas of population density. Moreover, a concen-tration of de novos in areas where large and dis-tant banks have taken over local institutionssuggests, as well, that many customers may be dis-satisfied with the more impersonal approach oflarge banks. Although consumer attitudes maychange and larger banks may seek to emulate thepersonal-service approach of smaller institutions,community banks should continue to be impor-tant in the banking industry for the foreseeablefuture.

Limited-Purpose Banks

Limited-purpose banks are institutions that spe-cialize in a relatively narrow business line. Thelimited-purpose banks examined in this study arecredit card banks, subprime lenders, and Internet-primary banks.30 Numerically these institutionsmake up a small share of the banking industry.Yet their unique production functions and prod-uct mixes warrant attention.

Although the diversification of risks is widelyregarded as desirable, some institutions have cho-sen to specialize. Focusing on a limited set ofactivities allows them to develop expertise quick-ly and become efficient producers. Moreover,technological innovations in the financial servic-es industry, which lead to gains in productivityand economies of scale, may also have promotedspecialization.

The credit card banks provide their customerswith both convenience and liquidity by offering aproduct that can be used as a payment device and

as an open-end revolving credit. Credit cardloans pose unique risks to these lenders, however.In addition to being unsecured, credit card loansdo not have a fixed duration, a lack that compli-cates the measurement and management of inter-est-rate risk. Moreover, the mass marketing ofcredit cards may lead to problems of adverseselection, and small average balances on individ-ual accounts may make collection efforts costineffective. Despite such risks, credit card bankshave managed to offset the effects of potentiallygreater volatility and risk in income: their averageROAs are considerably higher than those of theindustry as a whole. Their high profitabilityresults from high interest rates on credit cardloans, securitization, fee income, successful use oftechnology, and the benefits of scale economies incredit card operations. It is reasonable to expectthat credit card banks will continue to prosper.Credit card banks have been undergoing a processof consolidation, and whether further consolida-tion may be expected depends heavily on whetherthey have exhausted the benefits of scaleeconomies.

In this study, “subprime lenders” refers to insuredinstitutions that extend credit to borrowers whomay have had more limited borrowing opportuni-ties because of their poor or weakened credit his-tories. Not only can these lenders increasebusiness volume by serving a new customer base,but they can also be profitable by pricing theseloans accurately to compensate for greater risk.Although subprime lenders earn interest incomehigher than the industry average, their lendingactivity involves greater risk and losses. Moreover,increased scrutiny from regulators on issues such


29 The extensive literature on the economic role of community banks is dis-cussed in the FOB paper by Critchfield et al.30 This section is based on the FOB paper by Yom. Credit card banks aredefined as institutions that have more than 50 percent of total assets in loansand credit card asset-backed securities (ABS) and have more than 50 percentof total loans and credit card ABS in credit card loans and credit card ABS.Subprime lenders are institutions with more than 25 percent of tier 1 capitalin subprime loans. Internet banks’ primary contact with customers is the Inter-net. Data used in this study are based on 37 credit card banks, 120 subprimebanks, and 17 Internet banks.



as capital adequacy and predatory lending prac-tices may have effectively eliminated the advan-tage the insured institutions once enjoyed relativeto other financial firms operating in the subprimelending field. In response, subprime lending hastailed off recently, and some participants havewithdrawn from the market. On the basis of theevidence to date, it is reasonable to expect bankparticipation in subprime lending to stay atreduced levels, if it does not decline further.

Internet-primary banks are institutions that deliv-er banking services mainly on-line. By takingadvantage of the Internet distribution channel,these institutions offer convenience to their cus-tomers. It was once thought that eliminatingphysical branches and employing fewer employeeswould enable Internet banks to provide bankingservices at lower cost, but in reality, Internetbanks underperform brick-and-mortar banks. Thismay reflect limited consumer demand for Internetbanking services. These institutions are also at acompetitive disadvantage relative to brick-and-mortar banks in lending to small businessesbecause they lack the means of building long-term relationships with borrowers. The evidenceto date indicates that, as a business model, Inter-net banks have apparently only a modest chanceof success, given present customer attitudes andthe present state of technology.

Although limited-purpose banks have compiled amixed record, their activities can be effectivelyundertaken by larger, more diversified institu-tions. A number of credit card banks are sub-sidiaries of large banking companies. On-linebanking is offered by numerous institutions thatalso offer more traditional forms of access. Andwith appropriate underwriting and capital sup-port, subprime lending can be a useful componentof a more diversified portfolio.

Prospects for Banking Sectors: Summary

Individual banks and groups of banks differ great-ly in size, strategy, and operating characteristics.They also share some attributes. Operating in agenerally favorable economic environment, banks

have responded to intensified competition andthe expanded opportunities offered by sweepinglegislative and regulatory change. With someexceptions, they have performed at levels of prof-itability that would have been regarded asextraordinary in earlier years. Assuming effectivemacroeconomic and regulatory policies, each ofthe main banking industry sectors—communitybanks, regional and other midsize banks, andlarge, complex banking organizations—shouldprosper in the years immediately ahead.

Public Policy Issues

Although the banking industry is likely to contin-ue to be healthy, ongoing trends raise a number ofpublic policy issues, mainly related to theincreased size and complexity of banking organi-zations. Chief among the issues that policy makersneed to consider are the safety and soundness ofbanking in an industry dominated by megabanks,and concerns related to bank customers and mar-kets.

The emergence of megabanks has raised the possi-bility, however remote, that failures could depletethe deposit insurance funds, require large premi-um increases that place a heavy burden on theremaining banks, disrupt financial markets, andundermine public confidence. Financial and tech-nological risks arise partly from the problems ofmonitoring and controlling multiple businesslines, geographically dispersed operations, andcomplex corporate structures. Furthermore, thediversification of large banks into new financialareas exposes these institutions to new reputa-tional risks. The involvement of large financialholding companies in recent corporate scandalsillustrates this exposure.

The growing importance of large, complex banksalso raises issues relating to concentration andcompetition in individual markets and the avail-ability of credit for borrowers and local marketsthat were traditionally served by local banks.

The FDIC’s approach to analyzing the effects oflarge banks in those two areas and formulating



recommendations for possible action rests onthree principles:

Banking should evolve primarily in responseto the consumer and the marketplace ratherthan in response to regulation. The strongperformance record compiled by thebanking industry in recent years amplyconfirms what banking can achieve whenit is allowed to respond to market forces.There are, of course, situations when gov-ernment action is required to make mar-kets work better. One example is theestablishment of deposit insurance and ofthe bank safety net generally, which hascontributed to the prevention of theextreme instability that characterizedfinancial markets during much of theearly history of the United States. Legisla-tion and regulation to prevent anticom-petitive practices are another example. Inboth cases, government action was takento ensure that markets operate safely, fair-ly, and competitively.

Risks posed by large, complex banks need tobe addressed through effective prudential reg-ulation and supervision. Requiring banks tomaintain adequate capital is central to aneffective regulatory regime. Effectiveexamination, supervision, and enforce-ment are equally important. Furthermore,regulation and supervision should bebacked by market discipline exerted byholders of unprotected bank securities;regulation and supervision should also bebacked by sound governance arrange-ments adopted by the banks themselves.As suggested above, the potential useful-ness of a two-tier, large bank/small banksupervisory system needs to be considered.

To help ensure the effectiveness of prudentialregulation and supervision, the structure ofthe bank regulatory system should be reevalu-ated. In the fragmented bank regulatorysystem of the United States, the FDIC asthe deposit insurance agency has nodirect supervisory responsibility for the

major risks to which it is exposed. At thesame time, state and federal primary regu-latory- agencies that are funded by exami-nation fees are increasingly exposed tofinancial strains arising from the consoli-dation of the industry. Within presentlaw, or with minimum legislative change,it may be possible to coordinate betterthe activities of the various banking agen-cies, reduce the overall cost of regulationand supervision, and help all bank safety-net agencies discharge their responsibili-ties effectively.

The discussion that follows is based on these prin-ciples. It focuses on major public policy issuesarising mainly from the consolidation of thebanking industry and the consequent emergenceof very large and complex banking organizations.The areas covered are the effects of further con-solidation, combinations of banking and com-merce, large-bank supervisory issues, governanceissues, financial service regulatory issues, bank lia-bility structure, and the economic role of banks.

Effects of Consolidation: Safetyand Soundness, Competition,and Small Business Credit

After decades of relative stability, the number ofbanks in the United States has dropped by aboutone-half from the level of the mid-1980s.31 Morerecently, the pace of consolidation has slackened.Although a resumption of the headlong pace thatfollowed geographic deregulation seems unlikely,further mergers and acquisitions can be expectedin the period immediately ahead. As noted above,investors, market analysts, and managers appearto be strongly in favor of mergers as a means ofachieving revenue and earnings growth, eventhough academic studies do not provide conclu-sive evidence that greater efficiency will beachieved. Some of the anticipated advantages ofearlier mergers and acquisitions have failed tomaterialize, although it is difficult to say how the

31 This section is based partly on the FOB paper by Critchfield and Jones.



merger partners would have fared if they had notcombined.

Yet we can also expect the number of banks toremain higher than most recent projections byother analysts.32 In the absence of a new shock tothe industry, it seems likely that the U.S. bankingindustry will retain a structure characterized bythe existence of several thousand small institu-tions, a less-numerous group of regional and othermidsize banks, and a handful of extremely largebanking organizations. It seems reasonable, also,to expect that an eventual balance may developbetween the number of new-bank startups andcharter losses through mergers and acquisitions—with little net change in the number of bankingorganizations nationwide.

The public policy issues raised by consolidationconcern safety and soundness, market concentra-tion and competition, and small business credit.

The effect of consolidation on safety and sound-ness. The failure of one of the largest U.S. banksis generally regarded as a low-probability event.Very large banks have greater opportunities todiversify, although the resulting reduction in riskmay be offset by increased risk taking to enhanceprofits and by problems in monitoring and con-trolling increasingly complex and diverse opera-tions.

The much greater size of today’s megabanks, com-pared with their past counterparts, tends toincrease the prospect that the failure of such abank—although unlikely—would seriously affectthe banking and financial systems. Depending onthe condition of the industry and the generaleconomy, systemic risk could arise from the failureof a bank that is a major player in certain businesslines, including payments processing, internation-al operations, derivatives, and major market-clearing functions. If it is concluded that theleast-cost resolution of such a bank represents anunacceptable risk to the financial system and if,consequently, the bank regulators act to protectunsecured and uninsured liability holders, theadditional cost will be covered by special assess-ments. These will be based essentially on assets

rather than deposits and will be borne more heav-ily by the largest institutions.33

Current law contains certain provisions to dealwith the special issues posed by size. Among theseare the assessment provision of the systemic-riskexception for large-bank failures, the authority forthe FDIC to create different premium systems forlarge and small institutions, and the authority forbank regulators to require more capital based onrisk.

Although various options are available, the mostdirect way to deal with the size of the nation’slargest banking organizations is to ensure thatthey hold sufficient capital to provide a cushionto absorb potential losses. Regulators can accom-plish this by establishing minimum regulatorycapital requirements in addition to requirementsbased on the banks’ internal risk estimates (ascontemplated by Basel II).

Effect of consolidation on market concentration andcompetition. As a result of the concentration ofbanking resources, some large banks may be in aposition to exert their market power to raiseprices of bank services in some markets. Evenwith the consolidation of the past 15 to 20 years,however, the banking industry is less concentrat-ed than either its nearest competitors amongfinancial industries—the securities and the insur-ance industries—or many nonfinancial industries.Banking is also less concentrated in the UnitedStates than in other developed countries. More-over, the 10 percent domestic deposit limitinhibits the creation of a banking monopolythrough nationwide mergers and acquisitions.Although some large banks may have more influ-ence on the prices of banking services in particu-lar markets than they once had, sizable increasesin prices will invite entry by a variety of bank andnonbank firms. Among those entering these mar-kets will be newly established institutions. The

32 See the FOB paper by Critchfield and Jones.33 Current law requires that special assessments in systemic-risk resolutions bebased on assets less tangible equity and subordinated debt, whereas regularassessments are based on domestic deposits. Large banks tend to fund assetswith nondeposit liabilities and foreign deposits to a greater extent than smallbanks.



entry of new banks is encouraged by the existenceof deposit insurance and would be further encour-aged if the reporting and other regulatory require-ments that currently place heavy burdens onsmall banks were reduced.

Taking all these factors into account, we foreseethat competitive forces are likely to continuedominating banking markets for the foreseeablefuture.

Effect of consolidation on small business credit. Con-cern has been expressed about the effect of bank-ing consolidation on the availability of credit forsmall businesses and small farms.34 This concernarises because community banks devote propor-tionally more of their resources to lending tothese borrowers than large banks do. Lending tosmall business has often been “reputational” innature, requiring the local expertise that is bothcharacteristic of community banks and morefavorable to some small business borrowers, suchas new or young firms with limited credit histo-ries. Large banks, on the other hand, are likely tofocus more on large borrowers and use credit-scor-ing and other standardized lending methods inunderwriting loans.

On the basis of the available evidence, the effectof consolidation on small business credit appearsto be complex and dependent on numerous fac-tors. For example, it has been argued that asbanks get larger, they are better able to diversifytheir portfolios and therefore increase their lend-ing to all borrowers, including small businesses.New credit-scoring models used by large banksmay identify borrowers who were previously notable to obtain credit from small banks. Moreover,whether small business lending increases ordecreases may depend on whether the acquiringbank already regards small business lending as animportant business line. The effect of consolida-tion on small business credit availability alsodepends on whether there are other lenders in themarket that can offset a merger-related reductionin lending. These effects seem to differ betweenrural and urban markets and between already con-centrated and more competitive markets.

The effect of consolidation on small businesslending will continue to be the subject ofresearch. Although the outcome of such researchcannot be predicted in detail, one important con-sideration is the possibility that consolidationmay create opportunities for the remaining com-munity banks. Any reduction in small businesslending by large banks should invite increasedlending by community banks, while also encour-aging the formation of new banks to serve theneeds of these borrowers. The presence of a sub-stantial community bank sector and the prospectof new market entrants are potentially importantsafeguards against the possibility that bank con-solidation will make small business credit lessavailable.

Combinations of Banking and Commerce

As is well known, banking consolidation has beenaccompanied by affiliations of banks and otherfinancial service firms. GLB permitted combina-tions of commercial banks, securities firms, andinsurance companies. Looking ahead, one canexpect market forces to push in the direction ofmore mixing of banking and commerce. Theunderlying policy issues are whether permittingaffiliations among banks and commercial entitiesserves the public interest and, if such combina-tions are to occur, what is the appropriate regula-tory framework for them.35

With respect to the first question, there are twodominant views as to the desirability of maintain-ing a separation between banking and commerce.Proponents of one view argue that the failure tomaintain a line of separation—especially in termsof ownership and control of banking organiza-tions—would have potentially serious conse-quences, ranging from conflicts of interest to anunwarranted expansion of the financial safety net.

34 Evidence on the effect of consolidation on small business credit is dis-cussed in Avery and Samolyk (2003).35 The section on combinations of banking and commerce is based on the FOBpaper by Blair.



Proponents of the other view argue that, if ade-quate safeguards are in place, the benefits fromaffiliations between banking and commerce canbe realized without jeopardy to the federal safetynet. Among these safeguards are requirementsaffecting bank capital and the enforcement offirewalls to protect the corporate separateness ofthe bank.

With respect to the appropriate regulatory frame-work, the Federal Reserve Board maintains thatsupervision of the insured bank’s parent and affili-ated companies is necessary if the associated risksare to be understood and controlled. The FDIChas long argued that national and state-charteredbanks, regardless of size or holding company affili-ation, should be able to choose the ownershipstructure that best suits their business needs ifadequate protections are present. Thus, at theheart of the debate is the question of whether thepublic interest requires federal regulatory over-sight of the entire banking organization or just ofthe bank.

Although the current prohibitions on corporateownership of banks are sometimes defended onthe grounds that banking and commerce havealways been separate, the history of U.S. bankingreveals no evidence of a long-term separation.Certainly the activities permitted to banks havealways been subject to prohibitions, but the pro-hibitions on affiliations with commercial firmsthat are currently in effect stem from the BankHolding Company Act of 1956 and its amend-ments. Despite these regulations and prohibitions,however, extensive links between banking andcommerce have existed and still exist. And themarket pressure for more business combinationsbetween banks and commercial firms can beexpected to continue. Moreover, the potentialrisks of allowing banking and commerce to mix—conflicts of interest, concentration of economicpower, and expansion of the safety net—can becontained through the use of adequate safeguardsand firewalls. Thus, these risks do not appear tojustify a separation of banking and commerce.

Does the mixing of banking and commerce con-stitute good public policy? The evidence suggests

that the answer is a qualified yes: with adequatesafeguards in place, the careful mixing of bankingand commerce can yield benefits without exces-sive risk. The issue facing policy makers is howthese combinations of banking and commercewill be regulated. Specifically, will increasingamounts of commercial activity be subject toumbrella supervision, or will the insured entity bethe focus of supervision? Regulators and policymakers should consider what additional powers, ifany, are needed for regulators to be able to effec-tively ensure the corporate separateness of theinsured entity, while also ensuring that banks canchoose the corporate structure that meets theirbusiness needs.

Large-Bank Supervisory Issues

Large, complex banking organizations pose uniquechallenges to regulators.36 Traditional methods ofexamining banks were suited for smaller institu-tions, and as financial institutions became largerand increasingly complex, bank regulation andsupervision had to adapt. The regulatory andsupervisory issues raised by the growth of thesebanking organizations may be considered in thecontext of the New Basel Capital Accord, orBasel II. As is well known, the new accord restson three pillars:

Pillar 1: Minimum Capital Requirements

Pillar 2: Supervisory Review Process

Pillar 3: Market Discipline.

Pillar 1 (capital requirements). On June 26 2004,the Basel Committee on Banking Supervisionreleased the framework for the new Basel capitalaccord. It outlines the minimum requirements forcredit, market, and operational risk. The targetfor implementation of the new accord was year-end 2006, with the most advanced approachavailable for implementation by year-end 2007.The proposed accord includes two primarychanges to the current capital standards. First, itmodifies the approach to credit risk; second, itincludes explicit capital requirements for opera-

36 This section is based on the FOB paper by Bennett and Nuxoll.



tional risk. Most U.S. banks will continue to usethe existing risk-based capital rules, but all verylarge, internationally active banks will be requiredto adopt the new capital standards and to use theAdvanced Internal Ratings-Based (AIRB)approach to credit risk. Under the AIRBapproach, the probability of default, loss givendefault, and exposure at default will be estimatedinternally by the banks. With respect to opera-tional risk, the new accord proposes that banksusing the AIRB approach will also estimate oper-ational risk internally.

As a member of the Basel Committee, the FDIChas three basic goals for Basel II: (1) capital regu-lations should preserve and maintain minimumcapital requirements; (2) the standards should bedesigned so that they may be implemented andsupervised effectively in the real world; and (3)any new standards should not produce substantialadverse unintended consequences. Among suchunintended consequences is the possibility thatsmaller banks will be adversely affected comparedwith large banks. As noted above, the FDIC alsobelieves that a minimum regulatory capitalrequirement should be adopted in addition to therequirements based on the banks’ internal esti-mates as contemplated by Basel II. This belief isconsistent with the FDIC’s principle that a strongcapital base not only is necessary for a safe andsound banking industry but also can equip theindustry to weather downturns in the economy orthe onset of unanticipated events.

Pillar 2 (supervisory review). The supervision oflarge banks is challenging because of the com-plexity of these institutions. Four sources of com-plexity are size, geographic span, business mix,and nontraditional activities. Given the sheervolume of transactions and types of assets, it isdifficult to gather, aggregate, and summarize infor-mation in a manner that is meaningful for riskmanagement. The wide geographic span of theseinstitutions, including both domestic and foreignoperations, may obscure correlations among expo-sures. More sophisticated products and a widerrange of business activities also complicate super-vision. As major business units are acquired or

sold, the risk profile of the organizations maychange considerably. Supervisors will be stronglychallenged to develop the expertise necessary formonitoring the activities of large, complex bank-ing organizations, as well as to avoid extendingthe safety net to nondeposit products.

Pillar 3 (market discipline). Investors in the varioussecurities issued by banks have interests similar tothose of supervisors. This similarity of incentiveshas led to a number of suggestions that supervi-sors rely on market discipline for informationabout and control of the riskiness of banks. Asalso discussed in a later section, there are twocritical questions about market discipline. First,do investors know what the bank is doing? Sec-ond, can investors control what the bank isdoing? Various views have been expressed aboutwhether banks are opaque to the investor, andrecent corporate scandals provide grounds forskepticism as to shareholders’ ability to controlmanagement. The effectiveness of market disci-pline is likely to remain a subject of furtherresearch.

Governance Issues

Failures of corporate governance can cause enor-mous financial losses, not only to individual cor-porations and their stockholders but also tosociety as a whole.37 One widely quoted estimateof the cost of U.S. corporate governance failuresis $40 billion a year, or the equivalent of a $10 abarrel increase in the price of oil.38 Enron share-holders alone lost $63 billion in Enron’s failure.Recent corporate governance scandals haveresulted in new legislative, regulatory, and judicialinitiatives to counteract perceived corporate gov-ernance failings.

Because of their special and important role insociety, banks need to be particularly carefulabout conflicts of interest, or the appearance of

37 The section on governance issues is based on the FOB paper by Craig.38 Litan (2002).



them, so as to maintain public confidence. As aresult of earlier banking legislation, current bankcorporate governance standards are higher thanthe standards for nonbank enterprises, and mostbanks to which the Sarbanes-Oxley Act of 2002applies have little trouble meeting that act’srequirements.39 In fact, many of the provisions ofthis legislation are derived from bank governancestandards; this law introduces nonbanking busi-nesses to standards that banks have been observ-ing for years.

However, the combination of the Sarbanes-Oxleylegislation and new stock exchange rules, recentSEC actions and recent court decisions, a newactivism on the part of blockholders, and height-ened public scrutiny of business behavior has pro-duced a changed corporate governanceenvironment, one that continues to evolve. Themajor changes in this environment that willaffect banks are changing norms of board inde-pendence, increased shareholder involvement,and changing and uncertain standards of boardaccountability. In particular, bank interlockingdirectorships may run up against the changingnorms for board independence. In addition, pub-lic dismay over excessive executive compensationis likely to prolong shareholder scrutiny of boards’compensation policies—and likely to increase thepressure on some boards.

Banks, like other businesses, must be prepared tomeet these evolving standards of corporate gover-nance. The most effective way to avoid corporategovernance problems is to select a knowledgeable,engaged, and independent board of directors.However, increased commitments of time byboard members, increased liability issues, anemphasis on financial expertise, and the trendtoward more independent boards are likely tomake it more difficult for banks, and other busi-nesses, to recruit board members. Some observerssuggest that banks and other businesses will needto focus on recruiting people who have tradition-ally not been members of boards in large num-bers—women and both younger and oldermembers: for example, more division directorsrather than sitting CEOs, and more retired people

who have the time and expertise to devote toboard membership. In this demanding and chang-ing corporate governance environment, banksand other businesses may need to expand theirvision of what constitutes a qualified board mem-ber.

Financial Services Regulatory Issues

In the 20 years since the last major study of thefederal financial regulatory system,40 the financialsystem has continued to evolve and become morecomplex. Yet, its regulatory system remains root-ed in the reforms of the 1930s. Regulation andsupervision of large, mutli-product, international-ly active financial organizations that span numer-ous federal financial regulatory agencies posechallenges for a system designed largely to regu-late smaller, distinct, locally based organizationsAlthough changes have been made—especiallyover the past decade—to improve the regulationand supervision of these new financial conglomer-ates, it is time to take a hard look at the currentfederal financial regulatory structure.41

As the financial services industry grows larger andmore complex, the question is increasingly raisedas to whether our fragmented, piecemeal systemof regulation is up to the task. Since the mid-1980s a number of countries have examined theirfinancial regulatory structures and concluded thatchanges needed to be made. Internationally, thetrend has been to consolidate all—or most—financial services regulation within one agencyand to move that function outside the centralbank.

39 The Sarbanes-Oxley Act applies to publicly held institutions—institutions thatissue securities registered with the SEC or with a federal financial regulatoryagency. In addition, nonpublic banking institutions with more than $500 mil-lion in assets are required to comply with the SEC’s definition of auditor inde-pendence.40 See The Report of the Task Group on Regulation of Financial Services(1984).41 This section is based on the FOB paper by Kushmeider.



Reform of the U.S. financial regulatory structureraises complex issues regarding deposit insurance,the role of the central bank, and the dual bankingsystem. Although many observers would arguethat in the absence of a crisis, regulatory restruc-turing is not a topic that will generate muchpolitical interest in the United States, there areissues that will affect how the financial regulatorysystem is organized and operates regardless ofwhether full-scale restructuring is desired. Amongthese issues are funding for the Office of theComptroller of the Currency and the Office ofThrift Supervision, federal preemption, the cross-ing of functional regulators, and umbrella supervi-sion for all financial conglomerates that own aninsured depository institution.42

The options outlined in the paper represent possi-ble ways in which reform or restructuring of thefederal financial regulatory system could occur.They focus on the least-intrusive, most easilyaccomplished reforms (those that regulators couldundertake themselves or that require little legisla-tive change) to a full-scale restructuring of thefederal financial regulatory system. There arevalid arguments for taking either approach oreven for finding some middle ground, such as athorough restructuring of the bank regulatory sys-tem. Within each option there is room for debateover how regulation might be structured—forexample, what entities might be included. Thepaper is designed to provide background regardingissues that will influence the debate over regula-tory restructuring and to provoke thought anddiscussion about the design of the U.S. federalfinancial regulatory system.

Bank Liability Structure

Growth in core deposits (total deposits less timedeposits in denominations of more than$100,000) has failed to keep pace with the corre-sponding growth in bank assets.43 There may bemany reasons, either singly or in some combina-tion, for this phenomenon. The supply of coredeposits may be growing at a slower rate thanbank assets, banks may be increasingly using alter-native funding sources that have lower costs, and

some alternative sources may offer risk reducingfeatures. As all of these explanations are likely tobe true, the mix between core deposits and alter-native funding sources will continue to change.This prospect suggests continued reliance onwholesale funding sources (such as Federal HomeLoan Bank advances and brokered deposits) andefforts to expand other nondeposit sources offunds.

These changes in liability structure raise severalissues for banking regulators. The one that hasreceived most attention recently is market disci-pline—particularly for large, complex bankingorganizations. The research to date shows thatunprotected investors monitor bank performanceand respond to changes in risk exposure. Supervi-sors play an important role in ensuring that mar-kets have accurate data on banks, since troubledbanks otherwise may overstate capital. The evi-dence is weaker on the ability of markets toencourage banks to reduce their risk exposurewhen trouble arises. And for the very largestbanks, market discipline may be diminished bythe perceptions of market participants that suchbanks are too big to fail—that is, the perceptionthat uninsured depositors and other creditorswould be protected if the institution failed. In thefuture, more emphasis should be put on disclosinginformation to the markets as well as on increas-ing the use of market data to inform and enhancethe supervisory process.

Another issue raised by banks’ heavier reliance onwholesale funding sources and rate-sensitivedeposits for funding is liquidity risk exposure,which has increased. Regulators have respondedby updating their examiner guidance on liquidityrisk. It may also be worthwhile to seek better waysto measure liquidity risk and better ways to han-dle the operational challenges associated with liq-uidity failures.

42 The last issue has implications for the operation of U.S. financial conglomer-ates in Europe, where they must meet a requirement for consolidated supervi-sion.43 This section is based on the FOB paper by Bradley and Shibut.



A third issue concerns the assessment base, and afourth concerns depositor preference. To theextent that asset growth is funded by nondepositliabilities, the exposure of the FDIC tends toincrease without any increase in the assessmentbase on which premiums are calculated. (Theassessment base is essentially the amount ofdomestic deposits after certain adjustments.) Inthe past, various proposals were advanced toexpand the assessment base. And changes in theliability structure have highlighted the impor-tance of domestic depositor preference whenbanks fail. Some observers have questioned thecost savings attributed to the present priority pro-vision and have pointed to the provision’s poten-tial effects if a multinational banking organizationwere to fail. In light of changes in the structure ofbank liabilities, it may be useful to consider theadvisability of revising the assessment base toensure that premiums are properly aligned withthe risks to which the FDIC is exposed, and theadvisability of reviewing the effects of the presentsystem of domestic depositor preference.

The Economic Role of Banks

Historically, banks have been regarded as a specialclass of intermediary because they perform fourunique functions: (1) they issue transactionaccounts that have universal acceptability and areavailable at par on demand, (2) they fund idio-syncratic (and illiquid) loans with liquid liabili-ties, (3) they serve as backup sources of liquidity,and (4) they play a key role in the transmission ofmonetary policy.44 Consequently, policy makershave maintained a government safety net thatprotects and regulates the banking industry toensure that it operates with minimal disruption.Yet, over the past quarter of a century, revolution-ary advances in IT and telecommunications havecombined with the economic and political forcesof globalization and deregulation to fundamental-ly alter the operations of financial intermediaries(both bank and nonbank) and the markets inwhich they operate. One result of these changes isthat financial markets are much more complete,efficient, and competitive today than they were25 years ago. This development has led some

observers to argue that banks are no longerunique among financial institutions and thereforedo not merit the current level of government pro-tection or regulation.

This study concludes, however, that banks havenot lost their importance as financial intermedi-aries and that they have in fact evolved to meetthe challenges and demands of the new world offinance. Banks, for example, are still at the centerof the payments system. Indeed, virtually everyfinancial transaction that involves a net transferof wealth is still eventually settled through thebanking system. Banks also continue to play animportant role in the transmission of monetarypolicy. And despite signs of disintermediation andwhat some see as a decline in the relative impor-tance of banks, banks continue to serve as the pri-mary sources of credit to important segments ofthe economy (such as small businesses and smallfarms).

Moreover, as the capital markets have becomemore developed, banks have evolved to provideimportant behind-the-scenes support to much ofthe intermediation activity that occurs elsewhere.For example, almost all commercial paper issuesare backed by bank-issued stand-by letters of cred-it that enhance the paper’s credit rating andincrease its liquidity. In securitizations, banks areinvolved in originations, servicing, and monitor-ing and in the provision of credit enhancements.In this respect, banks remain an important playerin the intermediation process even though theyare no longer the primary lender or the directsource of the loaned funds. Finally and perhapsmost importantly, as has been demonstratedrepeatedly during a number of financial panicsand crises in the United States over the last threedecades, banks play an essential role as emergencysources of liquidity to the rest of the financial sys-tem and to the broader economy as well. Indeed,several studies have shown that banks may in facthave a comparative advantage in providing liq-uidity on demand.

44 This section is based on the FOB paper by Jones.



In conclusion, ample evidence is available to sup-port the position that banks (and the business ofbanking) are not fading away. Rather, in the morecomplex, sophisticated, and volatile financialworld of the twenty-first century, banks’ impor-tance may actually be growing.

Concluding Comments

This study views banking as a strong, competitiveindustry that continues to serve useful economicpurposes. Within the banking industry, we con-clude that each of the three main sectors—com-munity banks, regional and other midsize banks,and the largest banking organizations—has favor-able prospects for the years immediately ahead,even though the number of institutions is likelyto decline further. What could materially dimin-ish these relatively favorable prospects?

With respect to community banks, a number ofcompetitive and regulatory developments coulddiminish their market role and viability. One pos-sibility is that credit-scoring and other financialtechnology used by large banks and nonbankfinancial companies could advance to the pointthat it would supplant the relationship lendingpracticed by community banks in financing localcredit needs, including those of small businessesand small farms. And large banks might adoptorganizational structures more conducive to repu-tational lending—for example, by giving branchmanagers more authority. The consequencesmight be analogous to the results in home mort-gage lending, where a nationwide market hasmuch diminished the role once played by localportfolio lenders. Given the heterogeneous natureof small business loans and the organizationalproblems of controlling the activities of far-flungbranch systems, this result does not seem likely inthe time frame of this study—five to ten years—but it cannot be ruled out completely or indefi-nitely.

The burden of reporting and other regulatoryrequirements could also threaten the prospects forcommunity banks. Although the banking industryas a whole is a politically attractive vehicle for

implementing various nonbanking political andsocial programs, the fixed costs of such require-ments fall particularly heavily on smaller banks.The resulting regulatory burden could have effectsanalogous to those of earlier regulations thatweakened the ability of banks to compete withcredit unions and other nonbank institutions notsubject to similar burdens.

Community banks that lack adequate IT staffs arealso exposed to the possibility of attacks on thesoftware products they use. In addition to thedirect losses they might suffer, the inconvenienceto their customers and the damage to their repu-tations could be a serious competitive disadvan-tage.

For large banks, the principal issues are the risksassociated with size and diversity—the very fea-tures that are these banks’ main strengths. Prob-lems identifying and mitigating correlated risks,reputational risks arising from potential conflictsof interest and lapses in governance, and opera-tional risks associated with IT systems are amongthe most prominent of the risks faced by largebanks.

For all banks, the possibility of economic bubblesin markets where banks participate, like the bub-bles in energy, agriculture, and real estate marketsduring the 1980s, cannot be entirely discounted.This is particularly so as economic and financialdecision making related to banking is increasinglyin the hands of those who have experiencednothing but profits.

We consider these and similar possibilities to below-probability, high-impact events within thefive- to ten-year horizon of this study. In manycases these possibilities are being addressed bybank management and bank supervisory agencies.Nevertheless, it is important to keep them inmind as a cautionary accompaniment to the rela-tively favorable picture of banking painted in thisstudy.

At the same time, important policy issues willcontinue to command the attention of bankersand bank regulators. The consolidation of the



banking industry highlights the challenges ofsupervising large, complex banking organizations.The possibility of large-bank failures poses risksnot only to the deposit insurance funds but alsoto the banking system itself. Market forces arelikely to push for more business combinations ofbanks and commercial firms, raising again theissue of how best to regulate such combinations.The existing regulatory structure appears to be

increasingly out of alignment with the rapidlychanging financial products and markets. Thenature of the safety net itself may need to bereexamined to ensure that it effectively accom-modates an industry characterized by a few mega-banks alongside thousands of community banks.These difficult issues are likely to be prominent indiscussions of the future of banking in the yearsahead.



REFERENCES

Future of Banking Papers

Anderlik, John, and Jeffrey Walser. 2004. Rural Depopulation: What Does It Mean forthe Future of Economic Health of Rural Areas and the Community Banks ThatSupport Them?

Bennett, Rosalind L., and Daniel A. Nuxoll. 2004. Large-Bank Regulatory Issues:Examination, Market Discipline, and Capital Standards.

Blair, Christine. 2004. The Mixing of Banking and Commerce: Current Policy Issues.

Bradley, Christine, and Lynn Shibut. 2004. The Liability Structure of FDIC-InsuredInstitutions: Changes and Implications.

Craig, Valentine. 2004. The Changing Corporate Governance Environment:Implications for the Banking Industry.

Critchfield, Tim, Tyler Davis, Lee Davison, Heather Gratton, George Hanc, and KatherineSamolyk. 2004. Community Banks: Their Recent Past, Current Performance, andFuture Prospects.

Golter, Jay and Martha Solt. 2004. Bank Technology: Past Forces, Current Conditions,Future Trends.

Gratton, Heather. 2004. Prospects for Regional and Other Midsize Banks: Recent Trendsand Short-Term Prospects.

Jiangli, Wenying. 2004. The Effect of Baby Boomers and Immigrants on Banks.

Kenneth D. Jones and Tim Critchfield. 2004. The Declining Number of U.S. BankingOrganizations: Will the Trend Continue?

Jones, Kenneth D. 2004. The Special Nature of Banks: A Reexamination.

Kushmeider, Rose M. 2004. The U.S. Federal Financial Regulatory System: RestructuringFederal Bank Regulation.

Murphy, Neil. 2004. The Impact on U.S. Banking of Payment-System Change.

Reidhill, Jack, Brian Lamm, and Steven McGinnis. 2004. The Future of Large, ComplexBanking Organizations.

Samolyk, Katherine. 2004. The Evolving Role of Commercial Banks in U.S. CreditMarkets.

Yom, Chiwon. 2004. Prospects for Limited-Purpose Banks: Their Specialities,Performance, and Prospects.

Other References

Avery, Robert B., and Katherine A. Samolyk. 2004. Bank Consolidation and SmallBusiness Lending: The Role of Community Banks. Journal of Financial ServicesResearch 25, nos. 2–3:291–325.



Bassett, William F., and Thomas F. Brady. 2001. The Economic Performance of SmallBanks, 1985–2000. Federal Reserve Bulletin (November): 719–28.

Boyd, John H., and Mark Gertler. 1994. Are Banks Dead? Or Are the Reports GreatlyExaggerated? Federal Reserve Bank of Minneapolis Quarterly Review 18, no.3:2–23.

Conference of State Bank Supervisors. 1978. A Profile of State-Chartered Banking.Conference of State Bank Supervisors.

Federal Deposit Insurance Corporation (FDIC). 1987. Mandate for Change. FDIC.

———. 1997. History of the Eighties—Lessons for the Future. Vol. 1, An Examination of theBanking Crises of the 1980s and Early 1990s. FDIC.

Litan, Robert. 2003. Remarks delivered at AEI/Brookings Joint Center for RegulatoryStudies, Conference on the Future of Corporate Governance. March 5.

Myers, Forest, and Kenneth Spong. 2003. Community Bank Performance in SlowerGrowing Markets: Finding Sound Strategies for Success. Federal Reserve Bank ofKansas City Financial Industry Perspectives: 15–30.

Rajan, Raghuram G., and Luigi Zingales. 2003. Banks and Markets: The ChangingCharacter of European Finance. NBER Working Papers 9595. National Bureau ofEconomic Research,

Reich, John M. 2004. Testimony on the Impact of Regulatory Burden on America’sCommunity-Based Banks before the Subcommittee on Financial Institutions andConsumer Credit of the Committee on Financial Services, U.S. House ofRepresentatives, May 12.

Standard and Poor’s Compustat.

U.S. Task Group on Regulation of Financial Services. 1984. Blueprint for Reform: TheReport of the Task Group on Regulation of Financial Services.

The Future of Banking in America - Farmer School …FDIC BANKING REVIEW 1 2004, VOLUME 16, NO. 1 The...

Documents

Transcript of The Future of Banking in America - Farmer School …FDIC BANKING REVIEW 1 2004, VOLUME 16, NO. 1 The...