Statements to the Congress.

Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, September 24, 1991

I am pleased to appear before this committee on behalf of the Federal Reserve Board to discuss issues related to mergers among U.S. banking organizations. The last ten years have seen considerable consolidation of our banking system, a process that probably will continue for some time. And while banking consolidation is in many ways a natural response to the evolution of the overall banking environment, the significant changes that we have observed do raise a number of public policy questions and concerns. In the Board's view, the primary objectives of public policy in this area should be to help manage the evolution of the banking industry in ways that preserve the benefits of competition for the consumers of banking services and to ensure a safe, sound, and profitable banking system. My statement today will focus on how, within the context of existing law, the Federal Reserve is pursuing these goals and will review the potential economic effects of bank mergers.

MERGER TRENDS IN THE 1990S

It is useful to begin a discussion of the public policy and other implications of bank mergers with a brief description of recent bank consolidation trends. The statistical tables in appendix A of my statement provide some detail that may be of interest to the committee. I

From a variety of perspectives the pace of bank mergers has accelerated over the last decade. For example, excluding acquisitions of failed or failing banks by healthy banks, in 1980 there were 188 bank mergers involving about $9 billion in acquired assets; by 1987 the annual number and the dollar value of mergers peaked for the decade at 710 mergers and $131 billion of acquired assets. In 1989, the number of mergers dropped back to an estimated 550, involving an estimated $60 billion of acquired bank assets. The number of mergers involving large bank holding companies also increased. In 1980, there were no mergers or acquisitions of commercial banking organizations in which both parties had more than $1 billion in total deposits. The years 1985 through 1990 averaged 13 such transactions per year.

Another perspective is provided by the fact that the total number of U.S. banking organizations declined steadily throughout the 1980s. In 1980, there were 12,679 banking organizations including 14,737 banks); by 1985, 11,377; and in 1990, about 9,688 (including 12,526 banks), a 24 percent decline in organizations and a 15 percent decline in numbers of banks from 1980. These trends have been accompanied by an increase in the share of total banking assets controlled by the largest banking organizations. For example, the proportion of domestic banking assets accounted for by the 100 largest banking organizations went from 48 percent in 1980, to 55 percent in 1985, to 62 percent at year-end 1990.

The trends that I have just described must be placed in proper perspective because, taken by themselves, they hide some of the key dynamics of the banking industry. For example, although a major reason for the decline in the number of banking organizations over the 1980s was the fact that almost 1, 100 banks failed, the decline in the total number of banks was offset considerably by the fact that over that decade about 2,700 new banks were formed. Similarly, while more than 6,600 bank branches were closed during the 1980s, the same period saw the opening of well over 16,000 new branches. Perhaps even more significant, the total number of banking offices increased sharply, from about 48,500 in 1980 to almost 60,000 in 1990, a 23 percent rise.

Data on the nationwide concentration of U.S. banking assets must also be viewed in perspective. None of the increase in such concentration among the 100 largest banking organizations has occurred among the very largest-the 10 largest-banks. Rather, the large regional banks have accounted for all of the increase in the concentration ratio. Of course, if the recently announced mergers of some of our largest banks are implemented, concentration among the top 10 will increase.

Given the Board's statutory responsibility to ensure competitive banking markets, it is critical to understand that these nationwide concentration statistics are not the important concept for assessing competitive effects. Virtually all observers agree that the relevant issue is competition in local banking markets. And the facts are that, over the last decade, the average proportion of bank deposits accounted for by the three largest firms in urban markets has increased only I percentage point and has remained virtually unchanged in rural markets. These ratios have actually declined in both types of markets since the mid-1970s. The apparent contradiction between increased concentration ratios nationally and virtually unchanged ratios locally can be explained by several factors. As my statement will describe in more detail, key considerations include, first, the fact that most mergers are between noncompeting banks and, second, the fact that those mergers between entities in the same market have faced new entrants and antitrust constraints and have found that smaller bank competitors effectively limit their ability to increase market share.

Overall, then, the picture that emerges is that of a dynamic U.S. banking structure, with the number of banking offices increasing sharply and with their location extremely sensitive to the demands of consumers. In such an environment, it is potentially very misleading to make broad generalizations without looking more deeply into what lies below the surface. In part, for the same reasons that make generalizations difficult, the Federal Reserve devotes considerable care and substantial resources to analyzing individual merger applications.

FEDERAL RESERVE METHODOLOGY FOR ANALYZING PROPOSED BANK MERGERS

The Federal Reserve Board is required by the Bank Holding Company Act (1956) and the Bank Merger Act (1960) to assess the effects when (1) a holding company acquires a bank or merges with another holding company or (2) the bank resulting from a merger is a state-chartered member bank. The Board must evaluate the likely effects of such mergers on competition, the financial and managerial resources and future prospects of the firms involved, the convenience and needs of the communities to be served, and Community Reinvestment Act requirements.

This section of my statement briefly discusses the methodology that the Board uses in assessing a proposed merger. In light of the committee s specific questions, emphasis is placed on competitive factors. In addition, more detailed discussion of the legal and economic bases for the Board's assessment of competition is found in appendix B.

Competitive Criteria

In considering the competitive effects of a proposed bank acquisition, the Board is required to apply the same competitive standards as those contained in the Sherman and Clayton Antitrust acts. The Bank Holding Company (BHC) Act and the Bank Merger Act do contain a special provision, applicable primarily in troubled bank cases, that permits the Board to balance public benefits from proposed mergers against potential adverse competitive effects.

The Board's analysis of competition begins with defining the geographic areas that are likely to be affected by a merger. Under procedures established by the Board, these areas are defined by staff members at the local Reserve Bank in whose District the merger would occur, with oversight by staff members at the Board. To ensure that market definition criteria remain current, and in an effort to better understand the dynamics of the banking industry, the Board has recently sponsored several surveys, including the 1988 National Survey of Small Business Finances, the national Survey of Consumer Finances, and telephone surveys in specific merger cases, to assist it in defining geographic markets in banking. These surveys and other evidence continue to suggest that small businesses and consumers tend to obtain their financial services in their local area. This local geographic market definition would, of course, be less important for the financial services obtained by large businesses.

With this basic local market orientation of consumers and small businesses in mind, the staff constructs a local market HerfindahlHirschman index (HHI), which is widely accepted as a sensitive measure of market concentration to conduct a preliminary screen of a proposed merger. The merger would not be regarded as anticompetitive if the HHI and the change in that index do not exceed the criteria in the Justice Department's merger guidelines for banking. However, although the HHI is an important indicator of competition, it is not a comprehensive one. Besides statistics on bank concentration, economic theory and evidence suggest that other factors, such as local market services available from nonbank providers of financial services and potential competition, may have important influences on bank behavior. These other factors have become increasingly important as a result of many recent procompetitive changes in the financial sector. Thus, if the level and change in the HHI are within the Justice Department's guidelines, there is a presumption that the merger is acceptable, but if they are not, a more thorough economic analysis is required.

Because the importance of the other factors that may influence competition often varies from case to case and market to market, an in-depth economic analysis of competition is required in each of those merger proposals in which the Justice Department HHI guidelines are exceeded. To conduct such an analysis of competition, the Board uses information from its own major national surveys noted above; from telephone surveys of consumers and small businesses in the market being studied; from on-site investigations by staff; and from various standard databases with data on market income, population, deposits, and other variables. These data, along with results of general empirical research by Federal Reserve System staff members, academics, and others, are used to assess the importance of various factors that may affect competition. To provide the committee with an indication of the range of "mitigating" factors that the Board may consider in evaluating competition in local markets, I shall briefly outline these considerations.

Potential competition, or the possibility that other firms may enter the market as a result of the merger, may be regarded as a significant procompetitive factor. It is most relevant in markets that are attractive for entry and in which barriers to entry, legal or otherwise, are low. Thus, for example, potential competition is of relatively little importance in markets in which entry via intra- or interstate branching is severely restricted, or in markets in which branching is restricted and it may be difficult for investors to raise the minimum capital needed to start a bank. For potential competition to apply, it will generally be necessary for there to be potential acquisition gets as well as meaningful potential entrants. This factor is most likely to be relevant in urban markets.

Deposits at thrift institutions are now typically accorded 50 percent weight in calculating statistical measures of the impact of a merger on market structure for the Board's analysis of competition. In some instances, however, a higher percentage may be included if thrift institutions in the relevant market look very much like banks, as indicated by the substantial exercise of their transactions account, commercial lending, and consumer lending powers.

Competition from other depository and nonbank financial institutions may also be given weight if such entities clearly provide substitutes for the basic banking services used by most consumers and small businesses. In this context, credit unions and finance companies may be particularly important.

The competitive significance of the target firm can be a factor in some cases. For example, if the bank being acquired is not a reasonably active competitor in a market, its market share might be given a smaller weight in the analysis of competition than otherwise.

Adverse structural effects may be offset somewhat if the firm to be acquired is located in a declining market. This factor would apply when a weak or declining market is clearly a fundamental and long-term trend, and there are indications that exit by merger would be appropriate because exit by closing offices is not desirable and shrinkage would lead to diseconomies of scale. This factor is most likely to be relevant in rural markets.

Competitive issues may be reduced in importance if the bank to be acquired has failed or is about to fail. In such a case, it may be desirable to allow some adverse competitive effects if this means that banking services will continue to be made available to local customers rather than be severely restricted or perhaps eliminated.

A very high level of the HHI could raise questions about the competitive effects of a merger even if the change in the HHI is permissible within the Justice Department criteria. This factor would be given additional weight if there has been a clear trend toward increasing concentration in the market.

Finally, factors unique to a market or firm would be considered if they are relevant to the analysis of competition. These factors might include evidence on the nature and degree of competition in a market, information on pricing behavior, and the quality of services provided.

Some merger applications are approved only after the applicant proposes, or agrees to, the divestiture of offices in local markets when the merger would otherwise violate Justice Department guidelines and cannot be justified using any of the criteria that I have just discussed. We believe that these divestiture actions have deterred many banking organizations from applying for mergers that would be acceptable to the Board only with divestitures that the applicant is not willing to make. Safety and Soundness Criteria In acting upon merger applications, the Board is required to consider financial and managerial considerations. In doing so, the Board's goal is to promote and protect the safety and soundness of the banking system and to encourage prudent acquisition behavior by applicant banking organizations.

The Board expects that holding company parents will be a source of strength to their bank subsidiaries. In doing so, the Board generally requires that the holding company applicant and its subsidiaries be in at least overall satisfactory condition and that any weaknesses be addressed before Board action on a proposal. The holding company applicant must be able to demonstrate the ability to make the proposed acquisition without unduly diverting financial and managerial resources from the needs of its existing subsidiary banks.

The Board has long stressed the importance of capital in reviewing applications to expand. It is the Board's policy that acquisitions or mergers should not result in a diminution of the overall capital strength of the combined organizations. For this reason, the Board has generally expected that significant acquisitions or mergers be funded in whole or in part by the issuance of additional capital.

In this connection, the Board has held that banking organizations undertaking significant growth, either internally or through acquisitions or mergers, should operate with capital ratios well in excess of the supervisory minimums, without significant reliance on intangible assets. The Board has indicated that this cushion should be at least 100 to 200 basis points above the minimum ratios; still larger margins could be called for, depending on the actual financial condition of the organization and the risks being undertaken. This emphasis on capital underlies the Board's strong preference that expansionary applications be substantially financed from the proceeds of equity.

Applications from organizations that do not meet these capital standards would not be approved unless the organization has under way a capital augmentation program and can demonstrate the ability to raise additional tier I (essentially equity) capital contemporaneously with the acquisition. As noted, additional capital may also be required to correct any weaknesses in the bank or company to be acquired. This public policy serves to protect the existing satisfactory financial strength of the organization and to prevent an undesirable decline in capital adequacy caused by the acquisition of significant additional assets. It also can serve to moderate the rate of expansion and enable the organization to absorb the additional risks.

These general principles apply regardless of the type of acquisition-banking or nonbanking. The financial and managerial analysis of the applicant includes an evaluation of the existing bank, nonbank subsidiaries, the parent company, the consolidated organization, and the entity to be acquired.

Community Reinvestment Act Criteria

The Community Reinvestment Act (CRA) performance of banking organizations that seek the Board's approval to acquire a bank or a thrift institution is a major component of the "convenience and needs" criteria that must be considered by the Board. In making its judgments, the Board pays particular attention to CRA examination findings. In addition, any comments received from the public regarding an applicant's CRA performance become part of the official record, and such comments are reviewed carefully. Indeed, the Board has just announced its intention to hold public meetings in various locations on the CRA record of the banks involved in a major merger application.

Banks supervised by the Federal Reserve System-regardless of the size or the geographic scope of a bank's operations-are examined for CRA purposes at least every eighteen to twenty-four months. Banking organizations with identified weaknesses in their consumer compliance are examined even more frequently. Our practice is to review the performance of banks with large intrastate branching systems by examining a sample of branches, which consists of all major branches plus one-tenth of all small branches selected on a rotating basis. This type of system probably could be used for large, interstate branch systems as well if the Congress agrees to permit interstate branching. Some adjustments may be necessary, however, to ensure that the CRA examination process continues to work well for banking organizations that span several states.

The Board expects that banking organizations will have policies and procedures in place and working well to address and implement their CRA responsibilities before Board consideration of bank expansion proposals. These efforts must include methods for ascertaining the credit needs of the entire service area, including low- and moderate-income neighborhoods; credit products designed to meet those identified needs; outreach and marketing efforts throughout this service area; involvement by senior management and the institution's board of directors in establishing and supervising the implementation of those efforts; and a record of performance in helping to meet the community's credit needs through products that are consistent with the institution's overall business orientation.

The Board generally does not accept promises for future action in this area as a substitute for a demonstrated record of performance. Instead, the Board has accepted commitments for future action as a means of addressing areas of weakness in an otherwise satisfactory record. When commitments have been accepted, the Board monitors progress in implementing the proposed actions, both through reports and through the application process. Protection of the Deposit Insurance Fund In recent years, many bank merger and acquisition cases have involved failed or failing banks. By far the most common resolution method used by the FDIC has been the so-called purchase and assumption procedure. Under this procedure, a healthy banking organization assumes all or a part of the assets and liabilities of a failed or failing bank. The Federal Reserve favors continuing to give the FDIC some flexibility in how it resolves such banks.

The need for flexibility derives from our concern about the possibility of systemic risk associated with a failing bank. Systemic risk refers to the chance that financial difficulties at one bank, or possibly a small number of banks, may spill over to many more banks and perhaps to the entire financial system. In principle, systemic risk could develop if several smaller or regional banks were to fail. However, in practice systemic risk is more likely to be associated with failures of large institutions. In any event, in some individual cases the prevention of systemic risk can be an important factor in assessing a proposed merger or acquisition.

That systemic risk is most likely in cases of financial distress at large institutions raises a public policy concern with mergers that create large banking organizations. Clearly, it would be unwise to approve mergers that significantly increase systemic risk. For this reason, in any merger application that comes before it, the Board places great weight on the capital ratio and on other indicators of its financial strength that I have already discussed.

However, there is an additional point that should be stressed. The logical connection between bank merger policy and the potential for systemic risk emphasizes the interdependence between our discussion today and the need for comprehensive reform of our system of banking and financial regulation. If the United States is to have a safe, sound, competitive, and profitable banking system, then the Board strongly urges that the Congress pass a broad reform package along the lines of that proposed by the Treasury and supported by the Board. Such legislation would call for strong capital, prompt corrective action policies to deal with financially distressed depositories, frequent on-site examinations, increased opportunities for geographic diversification of risk and reduced costs through full interstate branching, and a broader range of permissible activities for financial services holding companies with well-capitalized bank subsidiaries. By increasing the safety and soundness of our banking system, these reforms would lessen the likelihood of a major systemic threat and would allow our banking system to adjust to evolving market and technological realities. But even with these reforms, the Board believes that it would be a mistake to eliminate entirely the ability of the authorities to act to protect the economy by assisting in the acquisition of a large failing bank in such a way as to protect all depositors. We agree that this approach has been overused in the past and requires some constraints. We urge, however, that the authorities' hands not be tied as they would be under H.R.6.

POTENTIAL IMPLICATIONS OF BANK MERGERS

The increased rate of bank mergers has raised several concerns regarding the potential effects of banking consolidation on consumers whose demands for banking services are primarily local in nature, on the performance of the merged banks including prices paid by consumers at those banks), and on the overall structure of the U.S. banking industry.

Effects of Mergers on Locally Limited Customers

The current merger wave in the banking industry is likely to have only modest effects on the availability of services to consumers and small businesses that rely primarily on local providers for their financial services. There are two reasons for this: (1) to date, most mergers have not been between banks operating in the same local banking markets and (2) the effects of intramarket mergers can be, and thus far have been, limited by antitrust constraints on such mergers.

Even in those places in which in-market mergers have occurred, the effect on competition has, on average, not been substantial. This situation, of course, does not mean that no consumers have ever been harmed by mergers. No policy can guarantee that result. But it does suggest that increases in local market concentration have been limited by the Board's application of antitrust standards to within-market merger applications. In addition, the Board's policies have almost certainly discouraged some potential bank mergers before an application was ever filed. Moreover, considerable intramarket consolidation could occur without significant anticompetitive effects. Many urban markets could see a relatively large number of in-market mergers before antitrust guidelines would be violated. Recent legislative changes have made thrift institutions more important competitors for banking services, and this competition has helped to reduce concerns about anticompetitive effects from intramarket bank mergers.

Although, as I shall be discussing shortly, small banks remain viable competitors in markets after larger bank mergers, some research suggests that large banks may adopt new banking technologies-such as automated teller machines and bank credit cards-more rapidly than small banks. Thus, bank mergers may enhance consumer convenience. On the other hand, in-market bank mergers often lead to some branch closings, raising concerns that consumer convenience may be harmed. Indeed, one of the factors reviewed in a CRA examination is the bank's record of opening and closing offices. However, as I pointed out earlier, there has been a substantial increase in the number of bank offices in the United States in recent years. More important, there is no reason to suspect that the market factors that have led to this increase in the number of offices have changed. Indeed, the abolition of constraints on interstate branches would greatly facilitate this process. That is, if merging banks should close branches, the opening of branches by existing competitors or by new entrants to the market is, based on past experience, likely to occur, and would become even more so with full interstate branching. If consumers demand locational convenience, banks of all sizes will need to be responsive if they expect to remain viable. Effects of Mergers on Bank Performance Federal Reserve System staff members have conducted several studies over many years on the effects of bank mergers and acquisitions. Some of these studies have focused on the effect of mergers on bank profits and prices, while others have looked at the potential for cost savings and efficiencies derived from mergers. At the committee's request, a detailed review of the studies appears in appendix C.

Of those studies concerned with profits and prices, some have looked at the effects of specific mergers, but a majority have approached this issue more indirectly by examining how bank profits and prices differ across banking markets. Each type of study is relevant to an assessment of the impact of bank mergers on performance.

Studies of differences in bank profitability across markets with varying degrees of concentration represent the oldest type of study relevant to the issue. Typically, such studies have found that banks operating in more concentrated markets exhibit somewhat higher profits than do banks in less concentrated markets. These higher profits may reflect the lesser degree of competition in more concentrated markets. Many people have argued, however, that these profits are simply an indication of the greater efficiency and lower costs of the largest firms in such markets. Because of this fundamental disagreement, there is no consensus concerning the meaning of this type of study for merger policy. Other studies have looked across banking markets for differences in the prices that banks charge their loan and deposit customers. For the most part, such studies have found that banks located in relatively concentrated markets tend to charge higher rates for certain types of loans, particularly small business loans, and tend to offer lower interest rates on certain types of deposits, particularly transactions accounts, than do banks in less concentrated markets. These studies tend to be clearer in terms of their implications for merger policy because they suggest that mergers resulting in relatively high levels of local banking market concentration can adversely affect local bank customers. That is, these studies support the need to maintain antitrust constraints if locally limited bank customers are to continue to receive competitively priced banking services.

Whether or not specific past mergers have resulted in higher loan rates, lower deposit rates, or in other ways disadvantaged banking customers is very much a different question. Studies of the competitive impact of individual bank mergers, in essence, focus on the issue of whether regulatory authorities have been successful in applying antitrust constraints.

In general, such studies have been rare, making generalizations hazardous. Of those studies that have been conducted, however, no evidence of significant anticompetitive effects attributable to past mergers has been found. One such effort examined the impact of the merger of two large in-state banks on two types of deposit rates and found no adverse effects on bank customers. Other studies using different approaches have also failed to find anticompetitive effects. Thus, it appears that while significant mergers, particularly intramarket mergers that directly affect market concentration, can in principle adversely affect banking customers, there is no direct evidence to date that those mergers passing regulatory scrutiny have, in fact, done so.

A related issue relevant to the effect of mergers is the prospect that, through merger, greater bank efficiency can be achieved, thus yielding a healthier, more competitive banking firm. As in the case of the bank pricing studies, studies of the effect of mergers on bank efficiency may be divided into those that do and those that do not look at the effects of specific mergers.

A large number of studies have sought to determine whether larger banking organizations exhibit lower average costs than do smaller organizations. In general, these studies of "scale economies" find that cost advantages of large firms either do not exist or are quite small, and most do not find scale economies to exist beyond the range of a small- to medium-sized bank.

Another strand of research has attempted to discover whether there are important differences in the efficiency with which banks use inputs to produce a given level of services. These studies, which essentially focus on management skills, suggest that some banks, both large and small, are just a lot better than others at using their inputs, such as labor and capital, in a productive way. Indeed, estimates of these so-called cost inefficiencies suggest that management skills dominate any benefits from economies of scale. In addition, there is some evidence that these differences in management efficiencies play a role in the incidence of bank failure. More than 50 percent of the bank failures in the 1980s are estimated to have come from the highest (noninterest) cost quartile of banks, while less than 10 percent are estimated to have occurred in the lowest cost quartile.

In the past couple of years, several researchers have sought to determine whether individual past mergers have resulted in cost savings. Typically, such studies examine the changes in noninterest expenses observed before and after the merger and, in some cases, compare them to the same changes observed concurrently in banks that did not participate in mergers. With one or two exceptions, these studies generally have not found evidence of substantial cost savings beyond those associated with shrinkage of the firms in question after merger.

However, the previously noted evidence indicating substantial differences in the relative efficiency of banks suggests that substantial cost savings are theoretically possible for many banks. For example, a study recently completed at the Board has estimated that annual cost savings of about $17 billion would result if the lowest-cost banks in the country were to acquire the highest-cost banks and if the costs of the acquired banking organizations were subsequently reduced to the level of the acquiring banks. Although some of these cost differences may simply reflect differences in the level of services offered to the public, such results nevertheless suggest potential gains from acquisitions of inefficient firms by efficient ones. Indeed, as banking becomes even more competitive, such results indicate that it may become increasingly common for relatively efficient banks to take over relatively inefficient ones and convert them into viable, low-cost competitors. Surely consumers of financial services could only be better off if such a future were to be realized and competitive markets were to be maintained.

Once again, however, I would point out and emphasize the connections between our discussion here today and the need for fundamental reform of our banking and financial regulatory system. Achievement of the scenario that I have just described depends heavily upon creating an environment not only in which banks can compete more effectively but also in which the likelihood that the deposit insurance funds will suffer losses is greatly reduced, such as would occur with higher capital, more frequent examinations, and prompt corrective action. Such reforms would put even more pressure on inefficient banks to achieve cost economies. In this regard, I would emphasize one more key point. Care should be taken to ensure that the bank reform package does not impose costly new regulations on banks that would substantially offset the cost savings that result from other reform actions. A competitive, safe, and sound banking system must also be one in which banks can make a profit.

Effects of Mergers on Banking Structure

Ultimately, the effects of bank mergers on consumer welfare depend to a substantial extent on the resulting degree of concentration in local banking markets. As I have already indicated, one of the tasks of public policy is to apply the antitrust standards in such a way as to maintain competitive banking markets. Because it appears that anticompetitive concerns are normally most serious in local banking markets, this section provides somewhat more detail on the implications of bank mergers for local market concentration. In addition, because the committee's letter of invitation asked for some ideas on what the U.S. banking industry might look like in the twenty-first century, I shall briefly address this inherently highly speculative issue.

Metropolitan statistical areas (MSAs) and nonMSA counties are often used as proxies for urban and rural banking markets. The average three firm concentration ratio for urban markets so measured increased only I percentage point between 1980 and 1990. Average concentration in rural counties was virtually unchanged. Thus, despite the fact that there were more than 5,000 bank mergers during the 1980s, concentration in local banking markets has remained about the same.

Why haven't all of these mergers increased concentration by a greater amount? There are several reasons. First, as I have already indicated, many mergers are between firms operating in different local banking markets. Although these mergers may increase national or state concentration, they do not increase concentration in any local banking market.

Second, as I have also already pointed out, there is new entry into banking markets. In most markets new banks can be formed fairly easily, and some key regulatory barriers, such as restrictions on interstate banking, are much lower than they used to be. Anecdotal evidence suggests that new independent local banks have been formed in many of the banking markets that are dominated by the large multistate banks.

Third, the committee may be surprised to discover that the evidence overwhelmingly indicates that banks from outside a market usually cannot increase their market share after entering a new market by acquisition. An oft-mentioned example here is the inability of the New York City banks to gain significant market share in upstate New York. More general studies indicate that when a local bank is acquired by a large out-of-market bank, there is normally some loss of market share. The new owners are not able to retain all of the customers of the acquired bank.

Fourth, it is important to emphasize that small banks have been, and continue to be, able to retain their market share and profitability in competition with larger banks. Our staff has done repeated studies of small banks; all these studies indicate that small banks continue to perform as well as, or better than, their large counterparts, even in the banking markets dominated by the major banks.

Finally, administration of the antitrust laws has almost surely played a role. At a minimum, banking organizations have been deterred from proposing seriously anticompetitive mergers. And in some cases, to obtain merger approval, banks have agreed to divest banking assets and deposits in certain local markets when the merger otherwise would have resulted in substantially adverse effects.

Future Banking Structure

Where will all of these mergers and changes in banking lead us? What will the future structure of the banking industry look like? To the extent that such forecasts can reasonably be made, it seems quite likely that the future will contain thousands of small banks, some regionals, some superregionals, and a small number of large nationwide banks. There is no reason to believe that small banks will not continue to remain viable head-to-head competitors in local markets with their larger rivals. These rivals will be both regional banks and a few nationwide banks with offices in hundreds of local markets coast to coast. Some of today's large bank mergers are probably the early stage of the formation of nationwide banks.

I hesitate to make a prediction about the number of banking organizations in the future. There is simply no way to know or forecast that number with any high degree of certainty. However, a recent study by Board staff members attempted to make some ball-park projections in this matter. Relying primarily on trends observed in the 1970s and 1980s and on the assumption that interstate banking would be allowed through holding companies rather than through branches, this study projected that the total number of U.S. banking organizations could be about 5,500 by the year 20 1 0. This number of holding companies probably implies the existence of 6,000 to 7,000 banks. These 5,500 banking organizations include a large number of local community banks as well as regional banks and large, nationally active banking organizations. I would guess that full interstate banking via branching would reduce the number of banking organizations only somewhat further because the staff study had already assumed interstate operations through the more expensive option of using multibank holding companies.

CONCLUSION

The increased pace of bank mergers since the early 1980s has greatly reduced the number of U.S. banking organizations and resulted in a substantially higher nationwide concentration of banking assets in the 100 largest banks. However, concentration in local banking markets, which is normally considered most important for the analysis of potential competitive effects, has remained virtually unchanged. In addition, there have been a large number of new bank entrants and a sharp increase in the number of banking offices. This development illustrates that the U.S. banking structure is highly dynamic and that sweeping generalizations are extremely difficult to make.

The dynamic nature of U.S. banking means that analysis of the potential competitive and other effects of individual bank mergers must be done case by case, market by market. The Federal Reserve devotes considerable resources to this end. All key factors are considered, including actual competition from bank and nonbank sources, potential competition, the general economic health of the market, a variety of factors unique to a given market, and in the case of mergers involving failed or failing firms, systemic risk. In addition, safety and soundness and CRA concerns are highly relevant. In the end, complex judgments are required to ensure the appropriate balance of benefits and costs in the public interest.

To date, the available evidence suggests that recent mergers have not resulted in adverse effects on the vast majority of consumers of banking services. It is certainly possible that some customers have been disadvantaged by some mergers. And, mergers can no doubt be very disruptive to bank employees as functions are consolidated and reorganized. But these disruptions do not appear to differ substantively from similar disruptions in other industries undergoing fundamental change.

It is also clear that substantial harm to consumers would occur if mergers were allowed to decrease competitive pressures significantly. Thus, it is crucial that antitrust standards be enforced by the bank regulatory agencies and the Department of Justice. Given the record of success to date, the Board believes that our current statutory authority in this area is sufficient to meet existing and foreseeable concerns. However, if future developments warrant, the Board would not be reluctant to seek additional authority in this area.

The evidence to date does not indicate that substantial cost savings have resulted from bank mergers. However, our staff work does suggest the potential for such savings if well-managed entities acquire and modify the operations of high-cost organizations. Given the continuing pressures for cost minimization in banking, it certainly seems possible that some of the potential will be realized in the future.

Last, I would emphasize once again the close link between our discussion here and the need for comprehensive reform of our system of banking and financial regulation. All of us want consumers of financial services to have available competitively priced, high-quality banking services, and we want to ensure that U.S. taxpayers are not exposed to excessive risk of loss through the deposit insurance fund. To achieve these objectives, U.S. banks must have the ability to compete effectively and profitably both at home and abroad, and U.S. regulators must be able to act in timely and effective ways. The Board therefore urges the Congress to pass the reform proposals that have been advanced by the Treasury and supported by the Board.