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Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, 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 am pleased to appear before the subcommittee on behalf of the Federal Reserve Board to discuss issues associated with interstate banking. For many years, the Board has believed that full interstate banking would benefit bank customers and lead to a stronger and safer banking system. Although we have concerns about certain specific provisions of the bills before you, we strongly support the thrust of these legislative initiatives. I would like to explain the reasons for our support and to evaluate the concerns voiced by the critics of interstate banking. To assist the subcommittee in its deliberations, the appendixes to my statement provide an up-to-date summary of state laws regarding interstate banking, a discussion of recent trends, and several statistical tables that provide relevant information.(1)

Interstate banking is now a reality and has been for some time. For years, both domestic and foreign banks have maintained loan production offices outside their home states, have issued credit cards nationally, have made loans from their head offices to borrowers around the nation and the world, have solicited deposits throughout the United States, have engaged in a trust business for customers domiciled outside the banks' local markets, and - through bank holding companies - have operated mortgage banking, consumer finance, and similar affiliates without geographic restraint. Since the early 1980s, moreover, the individual states have modified their statutes to permit - under the Douglas Amendment to the Bank Holding Company Act - out-of-state bank holding companies to own banks within their jurisdiction. Indeed, today only Hawaii prohibits bank ownership by out-of-state bank holding companies.

Although state legislatures have supported interstate banking and more than one-fifth of domestic banking assets are already held in banks controlled by out-of-state bank holding companies, the Board believes that congressional action is needed. Our dual banking system has a desirable genius for resisting government-imposed uniformity, but the large number of significant differences among the states impedes the interstate delivery of services to the public and reduces the efficiency of the banking business. The differences in state laws are discussed in the first appendix to this statement, but notable examples include restrictions on the home state of banking organizations allowed to enter some states, reciprocity requirements in some other states, the prohibition of de novo entry, and variable caps on the deposit shares of new entrants in still other states. In short, the states have made clear that they accept - and perhaps prefer - interstate banking, and their legislatures have made interstate banking a substantial reality today, but actions at the state level have resulted in a hodgepodge of laws and regulations that permit interstate banking in an inefficient and high-cost manner.

Restrictions on both intrastate and interstate banking were imposed in an era in which commercial banks were the dominant provider of financial services to households and businesses. These restrictions were clearly intended to limit competition and thereby insulate local banks from market pressures. Over time, branching and other geographic restraints became part of the totality of regulations designed to protect bank profits through limitations on entry and deposit rate competition. In recent years, however, banks have seen their market position eroded by nonbank providers of financial services that are not subject to bank-like regulation. Indeed, the unwinding of the historically protected position of banks, such as the removal of deposit rate ceilings, has proceeded on most fronts as a lagged response to market developments that had themselves been encouraged by those same restraints on banks. Attempts to maintain antiquated geographic restrictions will only protect inefficient banks, disadvantage consumers of bank services (particularly those like small businesses that still have relatively few alternative sources of credit), encourage the entry of less regulated nonbank competitors, and increase the stress on the safety net as the long-run viability of banks is undermined.

Action to provide more uniform rules for interstate banking would provide several public benefits. First, reducing obsolete barriers to entry would increase actual and potential competition in the provision of financial services to those customers that for one reason or another have, at best, very limited access to out-of-market banks, nonbank lenders, or the securities markets. Bank customers would benefit from the resulting lower prices for credit, higher rates on their deposits, and improved quality and easier access to banking and related services. In addition, a significant proportion of our citizens live in areas in which state borders intersect; interstate banking would provide households and businesses in these regions with significantly increased convenience in conducting their banking business.

Second, greater opportunities for geographic diversification through interstate banking could help restore a level of stability to the banking system that once was accomplished, in part, through protection of local banks from competition. Although increased competition from nonbanks has undermined the protection intended to be provided to banks through controlled entry and geographic constraints, those same restrictions have made it more difficult for banks to diversify their risks and seek out new opportunities. Thus, many banks operating in a region that has experienced a local economic contraction have been neither protected by limits on bank competition nor able to avoid the disastrous impacts of dependence on one market for both deposits and loans. Being able to cushion losses in one region with earnings in others would make banks better able to contribute to the recovery of their local economy, and more diversified banks would expose the federal safety net to fewer losses. Clearly, greater geographic diversification would have provided more stability over the past decade to banks operating in the agricultural areas of the Midwest, the oil patch of the South-west, and the high tech and defense regions of New England and California. In short, the elimination of geographic restraints would provide an important tool in diversifying individual bank risk, thus providing for stability of the banking system and improving the flow of credit to local economies under duress.

Third, interstate banking would facilitate the allocation of resources to regions that offer both safety and higher return and would assist in the reduction of excess banking capacity. We hope that the United States will continue to be a dynamic economy. Such economies grow more rapidly but are characterized by both expanding and declining industries and by expanding and temporarily declining regions. Banks pinned by artificial geographic restrictions to local areas that experience difficulties have no choice but to pull in their horns, as it were, to protect their own viability. Only through interbank credit extensions and loan participations can they diversify their portfolio to move their assets to borrowers unaffected by the depressed local economy. Indeed, many of these institutions no doubt tend to have lower loan-to-deposit ratios in part because of their inability to find bankable local credits. Note that, given banks' long-run interest in geographic diversification, banking offices would still remain in regions experiencing difficulty but would be in a stronger position to finance local expansion when growth opportunities return.

The benefits from removal of restrictions on geographic expansion could occur through either the acquisition or de novo chartering of bank subsidiaries of bank holding companies headquartered in another state or through the establishment of branches of a bank in another state. All the interstate banking laws enacted by the states provide for interstate banking through bank subsidiaries of bank holding companies, although some states permit interstate banking through branches for state nonmember banks. Two of the three bills before the subcommittee, H.R.2235 and H.R.459, would authorize interstate banking on a nationwide basis through bank subsidiaries. This step removes the last few vestiges of restrictions on interstate banking through bank subsidiaries, and the Board strongly supports such statutory change. The Board also supports removing the McFadden Act's restrictions on interstate branching for national and state member banks. This removal would permit banks to choose between alternative combinations of subsidiary banks and branches in the manner that best balances their own perceived costs and benefits.

The evidence from virtually all of the limited number of studies that compare interstate banking to branching suggests that, on average, both delivery systems have about the same cost structure. However, such evidence is also consistent with the view that for some banks branching may have the lowest cost structure. Indeed, as a matter of logic, the Board believes that the cost savings from elimination of separate boards of directors, separate management teams, and separate capitalization for banks that could be branches would be significant for some organizations. In any event, we believe that no good public policy purpose is served by restraining the freedom of choice of individual banking organizations, which know best what is the least cost operating structure for them. We therefore applaud the provisions of H.R.256 and H.R.2235 that would permit, immediately upon enactment, interstate banking offices to be converted to branches, should a banking organization choose to do so.

We also support H.R.2235's approach that would extend interstate branching powers to only those banks that are at least adequately capitalized and adequately managed (which we assume means having acceptable supervisory ratings). In the Board's statements during the drafting of and debate about the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), the Board supported the principle of expanded activities only for strongly capitalized banks. In drafting recent regulations, the banking agencies have attempted, when possible, to apply this principle. Examples include the reduced documentation requirement on small and medium-sized business loans and the Board's amendments to Regulation F implementing section 308 of FDICIA with regard to interbank liabilities. A policy that rewards stronger banks is a desirable supplement to the regulatory limits imposed on weaker banks. However, the subcommittee may wish to consider amending this provision of H.R.2235 to permit the banking agencies to authorize a less than adequately capitalized bank to expand into another state if it would, in the agency's judgment; improve the financial condition of the bank.

State supervisors would no doubt prefer interstate operations through separate banks in each state because it is much easier for them to supervise the activities of a single organization in their jurisdiction. It seems to the Board, however, that the criterion of ease of regulation for states is only one part of a broader cost-benefit test. So long as safety and soundness are not compromised, efficiency and least cost are far more important factors on which to base policy. We applaud the solution to this problem proposed in H.R.2235 and in the Nationwide Banking and Branching Act, H.R.459. As we understand it, under the provisions of both bills, the state in which branches of an out-of-state bank operate would negotiate a supervisory agreement with the supervisor of the bank's home state that is acceptable to both states and to the relevant primary federal regulator. Failure to reach agreement would require that the primary federal supervisor conduct examinations without deferring to the state authorities. Such an approach creates desirable incentives for the states to reach reasonable accord.

When interstate banking is implemented through bank subsidiaries, the bank in each state has all the powers that go with its charter - national or state. However, should interstate banking occur through branches, legislation must clarify whether those branches must limit their activities to those permitted to banks chartered in their host state, to activities permitted to banks in their home states, or - for national or state banks - to the powers granted to national banks. The issue of the powers that interstate branches should be permitted to exercise requires balancing several competing concerns, including preserving the dual banking system and creating incentives that could make certain types of bank charters more attractive than others. We read all three bills before the subcommittee as achieving the same balancing of the conflicting concerns. All the bills provide that interstate branches of state-chartered banks may not engage in any activities in the host state that are not permitted for banks chartered by the host state. National banks would still have the same powers regardless of which states they were in, except that, as at the present time, and consistent with the McFadden Act, branching within the host state would be limited by the laws of the host state. These provisions seem like a reasonable approach.

The interstate operations of foreign banks doing business in the United States raise issues similar to those for U.S. banks operating across state lines. It has been a long-standing policy of the U.S. government to grant foreign banks treatment equivalent to that given to U.S. chartered banks - so-called national treatment. In the present context, such an approach would permit foreign banks to operate interstate on the same basis as U.S. banks, and it is this position that the Board supports. We believe that the provisions of H.R.2235 and H.R.459 that require the banking agencies to consult the Treasury on the foreign bank's capital equivalency before approval of the first branch of the foreign bank are inconsistent with national treatment, as well as unnecessary. The Board recommends that these provisions be dropped. In addition, the Board believes that the requirement in H.R.2235 that branching be permitted only through a U.S. subsidiary bank if that structure is needed to verify adherence to U.S. standards by a foreign bank is also unnecessary. The Foreign Bank Supervision Enhancement Act of 1991 already provides that a foreign bank may not establish a branch in the United States unless its capital is determined to be equivalent to that required of a U.S. bank. Consequently, the Board recommends that this provision also be deleted.

Whether interstate banking is achieved through bank subsidiaries, bank branches, or both, and regardless of how powers are exported from the home state to the branching host state, the arguments used by opponents of interstate banking must be carefully reviewed.

The first concern is that interstate banking would result in undue concentration - and ultimately higher loan rates and lower deposit rates - as large out-of-state banks drive small in-state banks out of business. In-state market evidence simply does not support this contention. All the relevant evidence indicates that small banks generally survive entry by large out-of-market banks and are most frequently more profitable than the entrant. Similar evidence indicates that new large bank entrants to local markets, whether by de novo or by acquisition, are able to expand market share by only modest amounts, if at all.

In the 1970s, for example, when statewide branching was authorized in New York State, several large New York City banks sought an upstate presence by acquiring small banks in these markets. By the early 1980s, the acquired banks had gained on average less than one percentage point in market share, with the largest gain less than three percentage points. The acquired banks or branches continue to have small market shares or they have been sold to local banks, as the New York City banks have exited the market. Experience in California also illustrates the ability of small banks to remain viable in the face of competition from much larger organizations. California has permitted unrestricted statewide branching since 1927, and several of the state's banking organizations, most notably BankAmerica, have operated extensive branch networks for years. In spite of these extensive branch banks, California continues to have many successful independent banking organizations. For example, as of year-end 1992, 101 of the 395 banking organizations in California had less than $50 million in assets. Moreover, over the period 1981 through 1991, about 311 de novo banks (almost 11 percent of the U.S. total of de novo banks) began operation in this unlimited branching state.

Besides their difficulties in winning customers away from existing banks, entrants by acquisition often are soon confronted with competition from a de novo bank organized by local citizens, at times led by the former managers of the bank acquired. The potential for entry - both de novo and by acquisitions by other banks outside the market - plus evidence of continued small bank success suggest it is unlikely that consumer harm would come from interstate banking. Although more than 5,000 banks have been absorbed by merger since 1979, about 3,500 new banks have been chartered. In addition, although almost 10,500 branches have been closed, 24,000 new ones have been opened during that period. The vast majority of local banking markets in the United States are incredibly dynamic and sensitive to consumer demand, and interstate banking seems likely to make them more so. The concern that interstate banking would lead to excessive concentration in local banking markets is mitigated further by the fact that antitrust enforcement in banking focuses on maintaining competitive local markets. Concentration ratios have not increased in local markets despite the substantial overall consolidation in banking in recent years. Local competition has been maintained, in part, because many bank mergers have been between firms operating in different local markets. In addition, increased concentration has been avoided by factors already noted: antitrust laws, limited ability of new large banks to increase market share, and continued vitality of small local competitors.

The importance of local markets and the evidence of little change in local market concentration suggest that attempts to ensure competition through statewide or national deposit caps are unnecessary at best and may, in fact, be anticompetitive to the extent that they prohibit entry. Indeed, the 30 percent individual bank cap that H.R.2235 would permit states to authorize would protect seventeen banks in thirteen states from out-of-state acquisitions; seven of the seventeen are already held by out-of-state banking organizations. The Board would recommend deletion of the imposition of statewide and national deposit share caps as contained in the Interstate Banking Efficiency Act. Similarly, H.R.2235 discourages entry by authorizing states to restrict entry only to acquisitions of banks or branches that are at least five years old. We see no public benefit from such restrictions, although entry is most likely to be by acquisition in any event.

Another concern of some is that new entrants will vacuum up local deposits and channel them to out-of-market loans or that managers brought into local markets will be insensitive to, or have no authority to adjust to, local demands. However, it is important to recall that an insured bank must fulfill its Community Reinvestment Act (CRA) responsibilities in all the markets in which it operates. Moreover, the ease of entry, just discussed, should soften concerns that out-of-market entrants will ignore local customers. If a local branch does not meet both the deposit needs and credit demands of the community, it will not succeed and it will attract a rival that will.

However, because the Board realizes that the expansion of nationwide banking raises several issues regarding the impact on local community credit needs, it does support provisions of H.R.2235 and H.R.459 that would arnend the CRA to require that performance of interstate institutions be assessed on a statewide or metropolitan area basis. This approach would maintain the concept embodied in the CRA that insured banks should be evaluated on overall performance without imposing arbitrary or costly regulatory requirements at the level of the individual branch.

On the other hand, imposing a regulatory regime that requires that individual out-of-state branches meet special credit availability requirements (H.R.2235 and H.R.459), or that establishes numeric tests for individual branch loan production (H.R.2235), would represent unnecessary and burdensome regulation of interstate branches. It would also be duplicative and unnecessary to impose new credit availability requirements on branches that are simply replacements for existing interstate banks of the same organization (H.R.2235). Evaluating the statewide or metropolitan area CRA performance of an out-of-state institution would, in the Board's view, provide adequate information to determine that an interstate institution is meeting community needs in the markets it serves.

Finally, in considering the needs of local markets, the Congress should consider the fact that large banks have higher loan-to-deposit ratios than do small banks. This could imply that large banks entering new markets would make both more in-market loans and more out-of-market loans. Many assume that most of the loans would, in fact, be made outside the community. However, as I noted, banks must both meet their CRA requirements and service their customers to remain competitive in the market. It should also be kept in mind that small, independent banks also export funds: They are relatively large lenders to other banks through the federal funds and correspondent deposit markets and purchase relatively more Treasury and out-of-market state and local bonds than large banks.

In sum, interstate banking promises wider household and business choices at better prices and, for our banking system, increased competitive efficiency, the elimination of unnecessary costs associated with the delivery of banking services, and risk reduction through diversification. By the record, most community banks are already providing services to their customers so efficiently that they have little to fear from out-of-market rivals. Those that are not providing such services should worry because interstate banking will - and should - mean either their displacement by a more efficient competitor or their rising to the competitive challenge and improving their own efficiency.

(1.) The attachments to this statement are available from Publications Services, Board of Governors of the Federal Reserve System, Washington, DC 20551.
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Publication:Federal Reserve Bulletin
Date:Aug 1, 1993
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