Statement by Richard F. Syron, President, Federal Reserve Bank of Boston, before the Subcommittee on Financial Institutions Supervision, Regulation and Deposit Insurance of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, June 22, 1993.

I appreciate this opportunity to appear before you to discuss the issues surrounding interstate banking and branching. Today I will confine my remarks to issues related to the ways that interstate banking can improve credit flows, rather than to specific issues that are addressed in the various legislative proposals.

Current restrictions on interstate banking and branching are an anachronism; they reflect the state of banking when local banks were almost the exclusive source of loans, deposits, and services for both businesses and individuals. These restrictions are incongruous in the present banking environment, in which banking products have no geographic boundaries and are frequently provided by other financial intermediaries. The breakdown of geographic and institutional barriers is the inevitable outgrowth of improvements in technology and in information processing. As bank products have standardized and the economies of scale in information processing have grown, it has become much easier to provide cost-effective service independent of location.

Any new legislation should seek to promote the most efficient banking structure. By allowing bank management to choose a banking structure that improves its ability to diversify and that reduces its costs, banks will realize efficiency gains that will benefit borrowers and depositors alike. Alterations to our antiquated banking structure are already occurring without federal legislation. Not only do intermediaries far removed from the customer's location provide many banking products, but, in addition, a large number of states, including all six New England states, have adopted interstate banking laws. Thus, in many banking areas we already have de facto interstate banking.

I will first describe the limited interstate banking that has been in operation in New England for some time. Unfortunately, the expansion of New England bank holding companies under regional compacts has not extended much beyond the region.

Second, I will discuss the de facto interstate provision of many banking services that is already in place; for example, the markets for mortgage loans, consumer loans, and large business loans are now national in scope. Loans to small and medium-sized businesses remain primarily limited to local markets, however, and thus will continue to be adversely affected by any restrictions on the flow of bank capital across, geographic boundaries.

Third, I will describe the ways in which the recent regional economic shock has affected the availability of credit to small and medium-sized businesses in New England. The economic shock would have been less severe if banks had been better diversified through wider interstate banking and branching.

Finally, I will show that new evidence from New England suggests that large, multistate banks can offer improved services to borrowers and depositors without impairing the viability of small community banks because the markets served by smaller banks are often quite distinct from those in which the large banks operate.

Limited Interstate Banking

In New England

New England has had limited interstate banking for some time. Maine first allowed nationwide reciprocal banking in 1978 and later dropped the requirement of reciprocity. Regional reciprocal banking was first allowed in Connecticut in 1983, in Massachusetts in 1984, and in New Hampshire in 1987. All three states revised their laws in 1990, as Connecticut and Massachusetts adopted nationwide reciprocal banking and New Hampshire adopted nationwide interstate banking without requiring reciprocity. Agreements that allowed regional reciprocal banking that later converted nationwide reciprocal agreements were adopted in Rhode Island in 1984 and in Vermont in 1988.

The laws adopted in the mid-1980s to allow regional mergers were utilized by many of our largest bank holding companies. For example, among the two largest bank holding companies in New England, Bank of Boston has subsidiaries in all six New England states, and Fleet Financial Group has subsidiaries in every New England state except Vermont. However, the period since the more recent adoption of laws permitting nationwide interstate banking has not been long enough to result in substantial diversification outside the region.

If New England's recent economic downturn had been limited to one state, our largest holding companies could have weathered the problem more easily and lending activities would have experienced less disruption. Unfortunately, the shock was not localized within one or even a few New England states. All six New England states experienced a severe economic slowdown and falling real estate prices. Although banks in New England were diversified against very localized shocks, even large ones were not diversified against a widespread regional economic downturn.

The expansion of interstate banking and branching is not likely to have much effect on many aspects of bank lending. For example, pools of one- to four-family residential mortgages can be purchased from other parts of the United States, and credit card receivables are securitized and sold nationwide. However, the market for small to medium-sized nonresidential real estate loans is still primarily a local market. And, in particular, most small business loans depend on real estate for collateral. Because these loans cannot easily be securitized, portfolios of commercial and industrial loans tied to real estate cannot easily be diversified. Thus, the recent regional shock that deeply depressed real estate prices left many New England banking institutions quite exposed.

Interstate Banking Services

Most consumers are well aware of the de facto interstate provision of banking services. Frequently, neither the owner nor the services of a residential mortgage is located in the same state as the borrower. Similarly, consumers with good credit ratings are likely to have access to consumer credit through a financial institution located outside the states in which they reside. Problems with the service provided by one credit card issuer can easily be rectified by responding to one of the many mail solicitations for credit cards from out-of-state banks or nonbank sources.

The same pattern has emerged on the other side of the balance sheet. In placing their deposits, consumers have an array of alternatives to local depository institutions. Mutual funds and brokerage houses provide numerous alternatives to bank deposit accounts. The plethora of banks offering money market and mutual fund services indicates how substitutable many of these accounts are in a consumer's portfolio. Again, these alternatives are frequently provided by intermediaries located outside the consumer's home state.

Businesses have even greater access to credit outside their state. Large corporations often obtain financing directly from credit markets by issuing commercial paper and bonds. It is not unusual for firms that are not quite large enough to access the financial markets directly to seek bank financing outside the confines of an individual state. In fact, because both bank management and bank regulators impose restrictions on how exposed a bank can be to a single borrower, large borrowers may pose too large a concentration risk to get all of their financing from-in-state banks. Thus, in states with few large banks, large borrowers have long sought banking relationships outside their own state that can satisfy their loan demand without violating lending limits.

Table 1 illustrates this point by providing the results of a 1992 loan survey by the Federal Reserve Bank of Boston of sources of financing for small and medium-sized businesses in New England.(1) Among those businesses that sought short-term credit, only 55 percent of firms with sales between $100 million and $249 million obtained all their short-term credit from a New England-based bank. The same percentage received some or all of their short-term credit from one the three largest bank holding companies in New England. Thus, for many medium-sized as well as large firms only large banks can satisfy their lending needs, and their financing may not only be out-of-state but also out-of-region, thus insulating these firms from local shocks to credit supply.

Smaller business are much more dependent on local bank financing to meet their credit needs. Many small businesses have neither the collateral nor the track record to secure financing from lenders unfamiliar with their firm and the economic environment in which they operate. Such "character lending" requires an intermediary with substantial understanding of the local community that can only be obtained by maintaining a presence in the area. As a consequence, these local-bank-dependent borrowers have few alternatives should local lenders be unwilling or unable to provide financing. Borrowers with annual sales ranging from $10 million to $49 million depend more on banks within the region than do larger corporations, but they are far less likely to borrow from the largest banking institutions. In addition, they most frequently mentioned having no short-term credit because their credit arrangements had been terminated within the past two years.

Regulatory Contraints In Banking

Most economics textbooks emphasize the role of reserve requirements in restricting expansion of bank assets and liabilities. Restrictions on capital ratios have received much less attention, even though currently they are having a substantial effect on the ability of many banks to expand.

A desirable feature of an efficient financial market is that scarce resources flow to the user that values them most highly. Unfortunately, there are many impediments to the flow of bank capital. Without nationwide banking and branching, regions of the economy experiencing severe regional shocks may be unable to attract additional bank capital when loan demand exceeds loan supply. Informational difficulties make new entry into a banking market particularly costly for a bank with little familiarity with the regional economic environment. Thus, even without regulatory impediments, the flow of bank capital is likely to be slow. In a region in which banks experience substantial losses, bank capital will be restored only with long time lags. However, if outside banks had already located branches or affiliates in the region, they would be in a position to quickly fill lending gaps.

The credit crunch experienced in New England over the past two years is an example of a severe regional economic shock that was magnified by the impaired capital position of most New England depository institutions. Figure 1 shows bank capital ratios for commercial banks in the United States and in the First Federal Reserve District, which encompasses New England. Capital ratios for commercial banks nationwide were largely unaffected by recession periods. However, as a result of the bursting of the real estate bubble and the consequent loss of bank capital, capital ratios declined dramatically for New England banks in 1989 and 1990.

This drop in bank capital was particularly untimely because it occurred while legislators,regulators, investors, and bank management were placing increased emphasis on improving bank capital ratios. Banks that were trying to improve capital ratios during a period of large loan losses were forced to dramatically decrease their assets. Research at the Federal Reserve Bank of Boston has found that banks with difficulty in satisfying capital ratios decreased their lending, particularly to bank-dependent borrowers.

If full interstate banking and branching had been available much earlier, these problems would have been mitigated or two reasons. First, many New England institutions could already have diversified outside the region. Although economic shocks that disproportionately affected New England would still have affected large New England institutions, the effect on their total capital position would have been lessened. And, with their overall capital position less impaired, they would have had a greater ability to lend to creditworthy borrowers. Second, outside institutions would have been able to establish branches or acquire subsidiaries to meet the demand for loans that could not be satisfied by capital-impaired banks in that locality.

Figure 1 illustrates the advantages of interregional diversification. Although New England banks suffered a severe capital shock, banks nationwide experienced no substantial reduction in capital ratios. Had some banks in other regions had a significant presence in New England, or had New England banks had a significant presence in other regions, capital ratios of individual banks would have been affected less, so that some banks would have been able to lend to borrowers that were cut off from financing primarily because of the impaired capital of their traditional local lender.

The Role of Small Banks

A major concern of opponents of interstate banking and branching is the continued viability of small banks when they are forced to compete with large multistate holding companies. Evidence from New England suggests that small banks have no difficulty competiting with their larger brethren. Table 2 lists the twenty most profitable commercial and savings banks in New England over the past five years. Sixteen of the twenty banks have less that $500 million in total assets. Each New England state is represented, and most of these banks face competition from the area's largest bank holding companies, which have affiliates throughout New England.

Small banks can profit by serving market niches not easily satisfied by very large banks. To manage and control a large banking organization a certain degree of standardization must occur. Although standardization works well for larger, low-margin loans, often it is not appropriate for smaller loans that require specific knowledge about the management and economic circumstances of a particular business. Small banks that are well established in the community, and whose management is familiar with the borrower and his business, are often in a much better position to make loans when the character of the borrower is a critical component of the loan.

Conclusion

The question is not whether we should have interstate banking but rather the degree and the form it will take. Many bank services are already provided interstate, and intestate acquisitions have been widespread within New England. However, the remaining artificial constraints on the movement of bank capital contributed to the severity of the recent credit crunch in New England, and they continue to place banks at competitive disadvantage with other financial intermediaries not so constrained. If we want to avoid future banking problems in other regions that experience economic downturns and if we want to prevent a further deterioration in banking in general, I strongly urge you to adopt legislation to permit interstate banking and branching.

[1.] The attachments to this statement are available from Publications Services, Board of Governors of the Federal Reserve System, Washington DC 20551.