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Statements to Congress.

I appreciate this opportunity to present the views of the Federal Reserve Board on issues raised by various emerging electronic payment technologies that go under such names as "digital cash" or "electronic money." Spurred by recent advances in computing, communications, and cryptography, this nascent industry holds the promise of improving the efficiency of the payment system, particularly for consumers.

While the potential for exciting developments in this field is certainly there, we should all keep the latest round of innovations in historical perspective. First, the concept of "electronic money" is not new; electronic transfer of bank balances has been with us for years. Indeed, some of the new proposals simply make available to consumers and smaller businesses capabilities that large corporations and banks have had for many years. Second, no one knows how this industry will evolve--either qualitatively or quantitatively. Some of us, for example, can recall predictions made a generation ago that the United States would soon be a cashless, checkless society.

This last point reminds us that, at present, we do not know which, if any, of the many potential electronic innovations will succeed commercially. In this testimony, I will concentrate on stored-value cards and other types of so-called "electronic cash" because they seem to raise the most challenging public policy issues. In particular, depending on their design, they could amount to a new financial instrument--an electronic version of privately issued currency. But even the concept of private currency is not entirely new. Travelers checks are, of course, familiar to everyone. And in the nineteenth century the United States had considerable experience--not always happy--with private bank notes. But widespread use of private electronic currency would certainly raise a number of policy questions.

On behalf of the entire Board, I want to state clearly at the outset that the Federal Reserve has not the slightest desire to inhibit the evolution of this emerging industry by regulation, or to constrain its growth. On the contrary, the Board has encouraged, and will continue to encourage, innovations in payments technologies that benefit consumers and businesses. I am here today to raise questions and to bring some issues to the attention of the Congress, not to provide answers. Given the considerable uncertainties surrounding the design and ultimate usage of these products, it is far too soon for answers.

Nonetheless, it is not too early to begin thinking about a number of interesting and complex issues that may be raised by electronic currency. These issues include the impact on federal revenues, the legal and financial structure for these products, risks to participants, the application of consumer protection and anti-money laundering laws, and some issues related to monetary policy. Some of these issues may need to be addressed by the Federal Reserve and other regulatory agencies and some by the Congress. Some may need prompt attention, while others can wait. The present is, we believe, an appropriate time for public debate and discussion but a poor time for regulation and legislation.

Seigniorage and the Budget

Let me start with a potential revenue issue that will arise if the stored-value industry grows large. The federal government currently earns substantial revenue from what is sometimes referred to as "seigniorage" on its currency issue. In effect, holders of the roughly $400 billion of U.S. currency are lending interest-free to the government. In 1994, for example, the Federal Reserve turned over about $20 billion of its earnings to the Treasury, most of which was derived from seigniorage on Federal Reserve notes.

Should some U.S. currency get replaced by stored-value products--which are private monies--this source of government revenue would decline. Indeed, one of the major economic motives for institutions to issue prepaid payment instruments is to capture part of this seigniorage, just as issuers of travelers checks do now. Because the demand for stored-value products and the degree to which they will substitute for U.S. currency is totally unknown at present, the loss of seigniorage revenue is impossible to estimate. It is likely to be small. But it is something that the Congress should keep an eye on. We should not, by the way, jump to the conclusion that the government's lost seigniorage will go to the companies that issue stored value--though that will probably happen at first. It may be technically feasible to pay interest on stored-value products. To the extent that competition forces issuers of these products to pay interest, the lost seigniorage will accrue to holders rather than to issuers.

This discussion raises the question of whether the federal government should issue electronic currency in some form. (In posing this question, I refer to general-purpose, stored-value cards, not to special-purpose instruments such as government benefit cards, which, in our view, do not raise major issues.) Government-issued electronic currency would probably stem seigniorage losses and provide a riskless electronic payment product to consumers. In addition, should the industry turn out to be a "natural monopoly" dominated by a single provider, either regulation or government provision of electronic money might be an appropriate response.

But such a conclusion seems quite premature. And the availability of alternative payment mechanisms would mitigate any potential exercise of market power. Further, government issuance might preempt private-sector developments and stifle important innovations. Finally, the government's entry into this new and risky business might prove unsuccessful, costing the taxpayer money. So, while we would not rule out an official electronic currency product in the future, the Federal Reserve would urge caution.

Legal and Regulatory Structures

One area that may need prompt attention from both policymakers and the industry is clarification of the legal and regulatory structure that will govern electronic money products. In this case, failure of the government to act may, ironically, impede rather than facilitate private-sector developments.

As with other payment mechanisms, issuers and holders of electronic currency take on some degree of ongoing credit, liquidity, and operational risks. The risk to a consumer using a stored-value card for small "convenience" purchases may be inconsequential. But such risks can become significant when larger amounts of money become involved--for example, when merchants and banks accumulate and exchange significant amounts of stored-value obligations during the business day.

Risks to participants arise from a number of sources. Cards might malfunction or be counterfeited. Issuers might invest the funds they receive in exchange for card balances in risky assets so as to increase their earnings. But riskier investments can turn sour, possibly impairing the issuer's ability to redeem stored-value balances at par and imposing losses on consumers and other holders (if the obligations are not insured). Further, the clearing and settlement mechanisms for stored-value cards and similar products--if they become widely used--could generate significant credit and other settlement risks.

We believe that both the industry and the government should focus on answering several mundane questions that seem to be receiving little attention amid the continuing publicity about these products. Some examples follow:

* Whose monetary liability is the particular form of electronic money?

* If an issuer were to become bankrupt or insolvent, what would be the status of the claim represented by a balance on a card or other device?

* In such a situation, when and how would funds be made available to the holder?

* Who is responsible for the clearing and settlement mechanism?

Developers of these products have discussed a variety of possible options, but the industry does not appear to be converging on one or more models that would be transparent and readily understood by users. In addition, there is no specialized legal framework for stored-value transactions as there is for checks and other common retail payment mechanisms. For example, state or federal law specifies when an obligation is discharged by cash, check, or wire transfer--but not if payment is by stored value.

From the Federal Reserve's perspective, new and exciting technological developments in payments mechanisms should not overshadow the conventional and ongoing need for clear and soundly based legal and financial arrangements. It is essential that developers and issuers clarify the rights, obligations, and risks borne by consumers, merchants, and other participants in new systems before these products are widely introduced.

The need to attract and retain customers will naturally drive developers and issuers of electronic money products toward investment policies and operational controls that make their products useful and safe. So, to some extent, the market will be self-policing. Nevertheless, it could be costly and difficult for consumers and merchants to monitor and evaluate the safety of electronic money products, especially given their technological complexity. So the government is likely to become involved as well.

To guard against financial instability and to protect individual consumers, the government has, in the past, mandated a range of regulatory measures for private financial instruments. Three principal approaches are used.

1. Disclosure and surveillance. In the case of mutual funds, securities laws generally require disclosures about asset holdings. Audits and examinations of investment funds also help ensure that reported assets are actually held.

2. Portfolio restrictions. In some cases, standards or restrictions on portfolios help limit the riskiness of the assets. Money market mutual funds, travelers checks in some states, and, historically, privately issued bank notes are familiar examples.

3. Government insurance. Balances in depository institutions, of course, receive the most comprehensive protection mechanism available: federal deposit insurance. At some point, though certainly not now, the Congress will have to decide which, if any, of these protection mechanisms should be applied to stored-value products.

For example, if stored-value obligations of banks are treated as insured deposits--which is, by the way, another legal question that needs to be cleared up--then credit risk is effectively transferred from consumers to the government. In fact, the European central banks have gone so far as to recommend that only banking institutions be permitted to issue prepaid cards, presumably because that gives such cards the same degree of protection and financial oversight as traditional bank deposits.

The Federal Reserve Board has not viewed such a restrictive policy as appropriate. But the regulatory structure for electronic money products does merit further analysis. At a minimum, we believe that issuers of stored-value cards and similar products should clearly disclose the various risks that holders bear, including their coverage, if any, by deposit insurance.

Consumer Protection and Law Enforcement

The question of whether and how to apply the Electronic Fund Transfer Act (EFTA) and the Federal Reserve's Regulation E to these products has received considerable attention from industry participants, at the Federal Reserve, and in the Congress. Among other things, Regulation E limits consumers' liability for unauthorized electronic withdrawals from their accounts, provides procedures for resolving errors, and requires institutions to provide disclosures, terminal receipts, and account statements. Uncertainty regarding the application of Regulation E may be holding back the development of the industry, and resolving this question would help clarify some of the major risks that consumers may bear.

H.R.1858 would exempt all stored-value cards and a potentially wide range of other products, including transactions through the Internet, from the EFTA and Regulation E. The industry seems worried that without such an exemption, the Federal Reserve will apply Regulation E in a heavy-handed manner. On behalf of the Board, I would like to assure industry participants and this committee that we have no such intention. The Board recognizes that some of the requirements of Regulation E should not be applied to certain of these new payment products. For example, it makes little sense to require either printed receipts at ordinary vending machines or periodic statements detailing small transactions.

It seems premature, however, to legislate a blanket exemption from the EFTA without first exploring some of the basic issues raised by these new payments mechanisms. Disclosure policy is a good example. If a consumer who loses a stored-value card with a balance of several hundred dollars is not entitled to a refund, he or she should know this fact when the card is purchased. In this case at least, Regulation E requirements could be beneficial at minimal additional expense. The Federal Reserve would like to develop, and then put out for public comment, proposals for applying parts of the EFTA, such as appropriate disclosures, to stored-value cards--and for exempting them from the remainder. We would hope to be able to accomplish this within a few months.

Another issue related to consumer protection is privacy. While physical cash leaves no audit trail, many electronic currency products would. Such a trail may be desirable for certain purposes. But consumers would almost certainly be concerned if each purchase from a vending machine was recorded for possible reporting to marketers and others. Privacy is not a traditional Federal Reserve issue, but we do think it should be of concern to members of the Congress.

The mention of privacy leads naturally to some potential, future law-enforcement concerns. While we would caution against establishing restrictive rules that could stifle innovation, the eventual opportunities for money laundering using electronic products may be serious. At present, the menu of new products proposed for distribution in the United States holds little appeal for illicit activities because of their relatively low balance limits, the potential audit trail, and their limited acceptability as a means of payment--at least in the near term. In fact, most of the proposed stored-value products are not designed to circulate freely like currency and thus should be of limited concern to law-enforcement authorities. Over the longer term, however, it seems possible that electronic mechanisms that can hold large balances and make large untraceable transfers over communications networks could become attractive vehicles for money laundering and other illicit activities--especially if they are widely used and bypass the banking system. Existing anti-money laundering regulations may then need modification.

A related side issue is the possibility that nonbank entities could offer banking services illegally over the Internet. Using the term "bank" to market banking services without an appropriate license is generally a violation of federal or state laws. But new electronic technologies may challenge both traditional definitions of "banking services" and the ability to enforce existing laws. At some point, therefore, the Congress and the state legislatures may want to review the basic legal concepts that define banking and their methods for preventing fraud and unlicensed banking activity. Because electronic messages show little respect for national borders, these issues will likely require the coordinated attention of the banking authorities in various countries.

Monetary Policy Issues

Finally, let me say a few words about monetary policy. Concerns have been expressed that introducing what amounts to a form of private currency might damage the Federal Reserve's control of the money supply and lead to inflationary pressures. I can assure you that this is most unlikely. The Federal Reserve currently issues or withdraws currency passively to meet demand, adjusting open market operations accordingly to keep monetary and credit conditions on track. We would presumably continue to do this if private parties began issuing electronic currency that reduced the demand for paper currency.

In any event, electronic currency, if it grows large, will be only one of several changes in financial markets in the years ahead. Some of these may change the details of how monetary policy is implemented, just as financial innovations have in the past. We believe we have the capability of adjusting to these changing circumstances while continuing to meet our traditional responsibilities for economic stability.

However, there is a technical issue relating to our reserve requirements. Depository institutions are required to maintain reserves, either in cash or on deposit with Federal Reserve Banks, in proportion to their outstanding transaction accounts. Under current regulations, stored-value balances issued by depository institutions would be treated as transaction accounts and hence subjected to reserve requirements; the Board will need to review this treatment as stored-value devices come into use. But the Federal Reserve does not currently have the authority to impose reserve requirements on nondepository institutions. Thus there is a potential issue of disparate treatment of bank and nonbank issuers.

Depository institutions benefit from their access to the federal safety net; but they pay for this privilege by being subject to reporting obligations, reserve requirements, regulation, and supervision by the banking agencies. Nonbank issuers are free of most such burdens and hence may have a competitive advantage over banks in certain product lines. The Federal Reserve has often expressed concern in the past about potential competitive inequities that disadvantage banks. But because of the pervasive uncertainties that I emphasized at the outset, it is far too early to have any useful insights into the implications of this disparity. We simply want to call it to your attention.


In summary, it is clear that new electronic payment products raise a number of diverse policy issues, both for the Congress and for the Federal Reserve. I have not had time to mention all of them here. But, at this point, the uncertainties regarding the future of "electronic money" are so overwhelming that we mainly suggest patience and study rather than regulatory restrictions. We do believe, however, that certain rules need to be clarified and that future developments should be monitored closely. We look forward to working with the Congress and other regulatory agencies in this regard.

I am pleased to appear before this subcommittee on behalf of the Federal Reserve Board to discuss issues related to mergers among U.S. banking organizations. The past fifteen years have seen considerable consolidation of our banking system, a process that probably will continue for some time. This ongoing consolidation is in many ways a natural response to the changing banking environment. However, the very large bank mergers that have been consummated or announced in recent years, and particularly in recent months, have raised 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 and sound 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.

Trends in Mergers and Banking Structure

It is useful to begin a discussion of the public policy and other implications of bank mergers with a brief description of recent trends in merger activity and overall U.S. banking structure. The statistical tables in the appendix of my statement provide some detail that may be of interest to the subcommittee.(1)

Bank Mergers

From a variety of perspectives, the pace of bank mergers (including mergers of banks and bank holding companies and acquisitions of banks by bank holding companies) has accelerated since 1980. For example, excluding acquisitions of failed or failing banks by healthy banks and bank holding companies, in 1980 there were less than 200 bank mergers involving about $10 billion in acquired assets; by 1987 the annual number of mergers reached about 650 with almost $125 billion of acquired assets. In 1989, the number of mergers dropped back to 350, involving about $43 billion of bank assets acquired. In the 1990s, however, the number of mergers began to rise again, to nearly 450 in 1994 with about $1 10 billion of acquired assets. Through September 1995, the pace of merger activity has remained high, and there has been an exceptional number of very large bank merger announcements including Chase-Chemical, First Union-First Fidelity, NBD-First Chicago, Fleet-Shawmut, and PNC-Midlantic. Very large mergers occurred with growing frequency after 1980. In 1980, there were no mergers or acquisitions of commercial banking organizations in which both parties had more than $1.0 billion in total assets. The years 1987 through 1994 averaged fourteen such transactions per year and--reflecting changes in state law--an increasing number of these reflected interstate acquisitions by bank holding companies. Three of the largest mergers in U.S. banking history took place during 1990-94--Chemical-Manufacturers Hanover, NCNB-C&S Sovran, and BankAmerica-Security Pacific. These mergers would all be surpassed by the recently announced proposal to merge Chemical and Chase Manhattan.

National Banking Structure

The high level of merger activity since 1980, along with a large number of bank failures, is reflected in a steady decline in the number of U.S. banking organizations from 1980 through 1994. In 1980, there were more than 12,000 banking organizations, defined as bank holding companies and independent banks; the independent banks and banks owned by bank holding companies numbered nearly 14,500 banks. By 1990 there were about 9,200 banking organizations, and in 1995 the number of organizations had fallen to about 7,700 (including more than 10,000 banks)--declines of more than one-third in organizations and more than one-fourth in numbers of banks from 1980. These trends have also been accompanied by a substantial 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 just more than one-half in 1980, to nearly two-thirds in 1990, to more than 70 percent in June 1995.

The trends I have just described must be placed in perspective because taken by themselves they hide some of the key dynamics of the banking industry. Although there was a large decline in the number of banking organizations over the period 1980-94, reflecting about 1,500 bank failures and more than 6,300 bank acquisitions, about 3,200 new banks were formed, in spite of a sharp decline in formations after 1989. Similarly, although during the period more than 13,000 bank branches were closed, the same period saw the opening of well over 28,000 new branches. Perhaps even more important, the total number of banking offices increased sharply from about 53,000 in 1980 to more than 65,000 in 1994, a 23 percent rise, and the population per banking office declined. Fewer banking organizations clearly has not meant fewer banking offices serving the public.

Data on the nationwide concentration of U.S. banking assets must also be viewed in perspective. The increases in nationwide concentration and mergers reflect to a large degree a response by the larger banking organizations to the removal of legal restrictions on geographic expansion both within and across states. That is, the industry is moving from many separate state banking structures imposed by legal barriers toward more of a nationwide banking structure that long would have been in existence if legal restrictions had not stood in the way. The sudden adjustment to a new legal environment should not be a surprise, nor is the large adjustment necessarily one that will continue for an extended period.

The removal of legal restrictions on geographic diversification began in earnest during the mid-1980s, as did the merger movement. For example, twenty-two states during the 1980s reduced branching restrictions compared with only six states during the 1970s. Also during the 1980s, most states passed laws allowing the acquisition of in-state banks by out-of-state organizations. As a result, although in 1987 only about 11 percent of banking assets were owned by out-of-state organizations, by mid-1995 that figure had risen to more than one-fourth. Looked at another way, even by 1987 almost 92 percent of U.S. banking assets were open to access by at least some out-of-state bank holding companies, and by September 1995 that proportion had risen to more than 99 percent. Passage of the Interstate Banking and Branching Efficiency Act in September 1994 further expanded geographic diversification opportunities--opening up interstate branching by banks and all interstate banking to common rules. It is undoubtedly a major factor behind the several large bank mergers and announcements of mergers during 1995 as firms expand into new areas or respond to the potential for major firms entering their markets.

Other forces have also been transforming the banking landscape, and the resulting acceleration of competitive pressures has encouraged many banks to seek merger partners. Chief among these is technological change: the rapid growth of computers and telecommunications, which has allowed a scale of operations that would not have been manageable previously. Technological change has also encouraged financial globalization, with expanded cross-border asset holdings, trading, and credit flows, and, in response, foreign and domestic banks and other financial institutions have increased their cross-border operations. The resulting increase in domestic competition, especially for larger banking organizations, has been intense. Today, for example, more than 40 percent of the domestic commercial and industrial bank loan market is accounted for by foreign banks.

Local Market Banking Structure

Given the Board's statutory responsibility to ensure competitive banking markets by applying antitrust standards, it is critical to understand that nationwide concentration statistics are not the appropriate metric for assessing competitive effects. Virtually all observers agree that in the vast majority of cases the relevant issue is competition in local banking markets. From 1980 through 1994 the average percentage of bank deposits accounted for by the three largest firms in both urban and rural markets has remained steady or actually declined slightly even as nationwide concentration has increased substantially. This trend has continued since the mid-1970s. Essentially similar trends are apparent when local market bank concentration is measured by the Herfindahl-Hirschman Index (HHI). Because of the importance of local banking markets, I would like to provide somewhat more detail on the implications of bank mergers for local market concentration.

Metropolitan statistical areas (MSAs) and non-MSA counties are often used as proxies for urban and rural banking markets. The average three-firm deposit concentration ratio for urban markets increased only two-tenths of a percentage point between 1980 and 1994. Average concentration in rural counties actually declined six-tenths of a point. Similarly, the average bank deposit-based HHI for both urban and rural markets fell between 1980 and 1994. When thrift deposits are given a 50 percent weight in these calculations, average HHIs are sharply lower than the bank-only HHIs, but the trend becomes somewhat positive. On balance, the three-firm concentration ratios and the HHI data strongly suggest that despite the fact that there were more than 6,300 bank mergers between 1980 and 1994, local banking market concentration has remained about the same.

Why have not all of these mergers increased local market concentration? There are several reasons. First, many mergers are between firms operating primarily in different local banking markets. Although these mergers may increase national or state concentration, they do not tend to increase concentration in local banking markets and thus do not reduce competition.

Second, as I have 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, have been all but eliminated. New banks continue to be formed in states throughout the country, although the number of new bank formations has declined sharply during the 1990s.

Third, the evidence overwhelmingly indicates that banks from outside a market usually do not 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 members have 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. Indeed, size is not an important determining factor even for international competition. The United States has not had any banks among the largest twenty in the world since 1989 and even if all of the proposed mergers were consummated, U.S. banks would still not rank among the largest twenty. Yet those U.S. banks that compete in world markets are consistently among the most profitable in the world and include those that are ranked as the most innovative. It is notable that US. banks, besides being among the most profitable, have in the 1990s demonstrated their ability to attract capital. When measured by equity, two of the largest ten banks in the world are U.S. banks and the number will be three of the largest ten if the Chemical-Chase merger is consummated.

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 divested banking assets and deposits in certain local markets in which the merger would have otherwise resulted in substantially more concentrated markets.

Overall, then, the picture that emerges is that of a dynamic U.S. banking structure adjusting to the removal of longstanding legal restrictions on geographic expansion, technological change, and greatly increased domestic and international competition. Even as the number of banking organizations has declined, the number of banking offices has continued to increase in response to the demands of consumers, and measures of local banking structure have remained quite stable. 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 the Board uses in assessing a proposed merger. In light of the subcommittee's interests, emphasis is placed on competitive factors.

Competitive Criteria

In considering the competitive effects of a proposed bank acquisition, the Board is required to apply the same competitive standards 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 in Washington. In mergers in which one or both parties are in two Federal Reserve Districts, the Reserve Banks cooperate, as required. 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 and 1993 National Surveys of Small Business Finances, a triennial 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 households 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 households and small businesses in mind, the staff constructs a local market index of concentration, the HHI, which is widely accepted as a sensitive measure of market concentration, to conduct a preliminary screen of a proposed merger. The HHI is calculated based on local bank and thrift deposits. The merger would not be regarded as anticompetitive if the resulting market share, the HHI, and the change in that index do not exceed the criteria in the Justice Department's merger guidelines for banking. However, while the HHI is an important indicator of competition, it is not a comprehensive one. In addition to statistics on market share and bank concentration, economic theory and evidence suggest that other factors, such as potential competition, the strength of the target, and the market environment 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 resulting market share and the level and change in the HHI are within Justice Department 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 when the Justice Department 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 households and small businesses in the market being studied, from on-site investigations by staff members, and from various standard databases with information 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 subcommittee with an indication of the range of other factors 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, may be regarded as a significant procompetitive factor. It is most relevant in markets that are attractive for entry and when barriers to entry, legal or otherwise, are low. Thus, for example, potential competition is of relatively little importance in markets in which entry is unlikely for economic reasons, such as in smaller markets. For potential competition to be a significant factor, it will generally be necessary for there to be potential acquisition targets as well as meaningful potential entrants. These conditions are most likely to be relevant in urban markets.

Thrift institution deposits are now typically accorded 50 percent weight in calculating statistical measures of the effect 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 households and small businesses. In this context, credit unions and finance companies may be particularly important, and over time, nonbank competition has become substantially more 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 less than 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, other 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 the divestiture of offices in local markets, retention of which would otherwise violate Justice Department guidelines, and when the merger cannot be justified using any of the criteria I have just discussed. We believe that such divestitures have provided a useful vehicle for eliminating the potentially anticompetitive effects of a merger in specific local markets while allowing the bulk of the merger to proceed.

Safety and Soundness Criteria

In acting upon merger applications, the Board is required to consider financial and managerial resources and the future prospects of the firm. 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. Indeed, except in very special circumstances, usually involving failing banks, the Board will not approve a merger or acquisition unless the resulting organization is expected to be strong and viable.

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 satisfactory overall 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.

These general principles apply regardless of the size or type of acquisition--banking or nonbanking. The financial and managerial analysis of an application includes an evaluation of the existing organization, including bank and nonbank subsidiaries, the parent company, and the consolidated organization, as well as an evaluation of the entity to be acquired. Also included in this analysis are the financial and accounting effects of the transaction, that is, the purchase price, the funding and sources thereof, and any purchase accounting adjustments. Numerous factors are analyzed for strengths and weaknesses, including earnings, asset quality, cash flow, capital, risk management, internal controls, and compliance with law and regulation. As the size of the applicant or resulting organization increases because of mergers or internal growth, so generally does the complexity of this analysis. Additionally, areas in which weaknesses or potential issues are identified receive more intense scrutiny. The financial condition and management of the resulting organization are expected to be satisfactory and financial and managerial resources to be sufficient in relation to the risk of the transaction; thus, significant problems or issues must be resolved for favorable action.

Community Reinvestment Act Criteria

The Community Reinvestment Act (CRA) performance of banking organizations that seek the Board's approval to acquire a bank or 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. The Board has developed a substantial record in this area.

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 generally every eighteen 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. The agencies will need to develop a similar procedure for large interstate branch systems as well. Some adjustments may be necessary, though, 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. 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.


The increased rate of bank mergers has raised a number of concerns regarding the potential effects of banking consolidation on those consumers whose demands for banking services are primarily local in nature and on the performance of the merged banks (including prices paid by consumers at those banks).

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 households and small businesses that rely primarily on local providers for their financial services and often have few convenient alternatives for such services. There are two reasons for this: (1) to date, most mergers have not been between banks operating primarily in the same local banking markets; and (2) the effects of intramarket mergers can be, and thus far have been, limited by both market forces and 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, of course, does not mean that users of bank services will never be harmed by mergers. No policy can guarantee that result. But, the trends in local market concentration I discussed earlier indicate that the Board's application of antitrust standards to within-market merger applications generally has preserved competition. 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. Furthermore, legislation passed during the 1980s made thrift institutions more important competitors for banking services, and this has helped to reduce concerns about anti-competitive effects from intramarket bank mergers. Proposed legislation before this subcommittee may make thrift institutions even more bank-like, encouraging even greater competition.

Although many 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, and the number of ATMs has increased dramatically (from almost 14,000 in 1980 to almost 110,000 in 1994). More important, there is no reason to suspect that the market factors that have led to this increase in the number of offices and ATMs have changed. Indeed, the abolition of constraints on interstate branches will 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 likely to occur as new profit opportunities arise. Such opportunities should become even easier with full interstate branching, which will take effect in June 1997 under the Interstate Banking and Branching Efficiency Act of 1994. If consumers demand locational convenience, banks of all sizes will need to be responsive if they expect to remain viable competitors for retail customers.

Effects of Mergers on Bank Performance

Federal Reserve System staff members and others have conducted numerous 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.

Of those studies concerned with profits and prices, some have looked directly at the effects of mergers, while 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 have argued, however, that they are simply an indication of the greater efficiency and lower costs of the largest firms in such markets. This challenge is suspect because if a market is competitive, above-normal profits, whatever their origin, should be driven down to a competitive level.

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 interest 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 have been less subject to question than profit studies and therefore tend to be clearer in terms of their implications for merger policy. In particular, 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.

A related issue relevant to the effect of mergers concerns the prospect that, through merger, greater bank efficiency can be achieved, thus yielding a healthier, more competitive banking firm. Studies that are relevant to the effect of mergers on bank efficiency may be divided into those that do and those that do not look directly at the effects of 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 that most do not find scale economics to exist beyond the range of a small- to medium-sized bank. Thus, simply by achieving larger size, mergers seem unlikely to yield greater efficiency.

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 the efficiency effects of 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 efficiencies 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. It is estimated that more than 50 percent of the bank failures in the 1980s came from the highest (noninterest) cost quartile of banks, while fewer than 10 percent are estimated to have occurred in the lowest cost quartile.

In the past several years, numerous researchers have sought to determine whether past mergers have resulted in cost savings. Many 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. Other research has used the event study methodology to examine how the stock market reacted to merger announcements. The great majority of these studies have not found evidence of substantial efficiency gains from mergers. Evidence on the relative efficiency of acquiring and acquired firms is mixed.

Let me emphasize that most of these studies are based on many mergers and thus provide the basis for statistically valid generalizations. However, in some individual merger cases, cost savings and improved efficiency have been reported. Furthermore, 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 done at the Board a few years ago 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. While some of these cost differences may simply reflect differences in the level and types of services offered to the public, such results are nevertheless suggestive of potential gains from acquisitions of inefficient firms by efficient ones. In addition, it appears that in the evolving world of high technology and global markets for corporate banking, there is greater emphasis on efficiency to survive. This has probably played a role in the efficiency gains noted in some of the individual recent large mergers. On balance, a possible future scenario is that it may become increasingly common for relatively efficient banks to take over relatively inefficient ones and convert the more poorly performing institutions into viable, low-cost competitors. Surely consumers of financial services could only be better off if such a future occurs and competitive markets are maintained.


The recent wave of large mergers and merger announcements reflects to a large degree a natural response to new opportunities for geographic expansion as legal restraints are removed. The industry is moving away from a legally fragmented banking structure toward a nationwide banking structure. Rapid technological changes and global competition in corporate banking are almost certainly a motivating factor for the very large banks.

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 at the 100 largest banks. However, concentration in local banking markets, which is normally considered most important for the analysis of possible competitive effects, has remained virtually unchanged. In addition, there continues to be new bank entry and there is a continuing increase in the number of banking offices. This 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 on a case-by-case, market-by-market basis. The Federal Reserve devotes considerable resources to this end. Many factors are considered in the analysis, including actual competition from bank and nonbank sources, potential competition, the general economic health of the market, and a variety of other factors unique to a given market. In addition, safety and soundness and CRA concerns are highly relevant.

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 that have experienced or are undergoing fundamental change.

It is also clear that substantial harm to consumers would occur if mergers were allowed to decrease competitive pressures significantly. However, market developments and the removal of geographic restrictions on banks have significantly lessened the chances for anticompetitive effects. In addition, the antitrust standards enforced by the bank regulatory agencies and the Department of Justice have helped to ensure the maintenance of competition.

The evidence to date does not indicate that, on average, substantial efficiency improvements have resulted from bank mergers. However, in recent years, there appear to have been some cases of improvements in efficiency, and 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 this potential will be realized in the future.

In sum, law, regulation, and market forces have so far kept banking markets competitive, and the same forces should continue to do so as banks adjust to a new legal and more competitive environment. Bank consolidation to date has not reduced competition in any meaningful way, and we see no reason why it should begin to do so. While there have been only a few cases of demonstrable efficiency gains from past mergers, there is reason to expect that there may be a higher incidence of such gains in the future. Given that potential and the antitrust laws protecting competition, the Board sees no reason to be concerned if a banking organization's management and stockholders choose to respond to the changing environment by consolidating with other such organizations.

(1.) The attachments to this statement are available from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551.

Statement by Alan S. Blinder, Vice Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, US. House of Representatives, October 11, 1995

Statement by Janet L. Yellen, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services, US. House of Representatives, October 17, 1995
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Publication:Federal Reserve Bulletin
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Date:Dec 1, 1995
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