The Triumphs of Banking Regulation

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David R. Evanson

Present Value: Essays on Community Banking, Winter, 2005

A black-and-white orientation toward regulation is not nuanced enough, because deregulation is not simply the opposite of regulation. In fact, deregulation is very much a part of regulation and, when viewed as a whole, the two have proven to be a successful enterprise.

More accurately, deregulation represents the lessening of regulation, since — at least for banking — regulation will never disappear altogether. This ebb and flow of oversight is dynamic and attempts to be responsive to the prevailing environment.

A fruitful examination of regulation requires some new thinking on the topic, and we do that by examining the most influential regulatory initiatives: those governing interstate banking and those governing interest-rate ceilings. Between the discussions of these initiatives, we take a quick look at the Sarbanes-Oxley Act of 2002 and the repeal of the Glass-Steagall Act, which surprisingly had little of the anticipated effect.

The deregulation of interstate banking has aided banks, investors, and the economy in several fundamental ways that are nothing short of a triumph. But what about the enactment of these laws? Did they represent a triumph as well?

The geographic restrictions developed in the 19th century were intended to prevent bankers from choosing inaccessible locations that would deter depositors from redeeming notes. Regulators also believed that the absence of restrictions on where banks could locate would lead to an undesirable concentration of financial power.

As late as 1939, these views prevailed. The secretary of the Independent Bankers Association testified before Congress that branch banking would “destroy a banking system that is distinctively American and replace it with a foreign system . . . a system that is monopolistic, undemocratic and with tinges of fascism,” a point of view that likely reflects Germany’s aggression in Eastern Europe at the time.

One of the unintended consequences of interstate and intrastate banking laws was the creation of a large pool of banks. This proliferation was an obvious outcome. After all, the inability to open branches meant that a number of banks had to be created to serve the needs of discrete markets. This worked well with the localized economies of the 19th century. But did the architects of these regulations imagine that this pool of banks, the largest in world, would have such a fundamental and important impact on the creation of wealth more than a century later? In the same way that we imbue the Founding Fathers with wisdom that seems to transcend the ages, did regulators of another era see into the next century and realize that a great engine of capitalism would require many banks to distribute debt capital wherever it was needed?

Perhaps not. Regardless, progress marched forward. The completion of the transcontinental railroad meant transcontinental commerce, and for the companies that were doing business on this scale, transcontinental banking needs. The result were so-called “chain banks,” which were confederacies of banks all owned principally by the same investors. These were followed in 1890 by the first bank holding companies.

Once the needs of businesses took on national proportions, the drive to eliminate interstate banking laws officially and inexorably began. Still, the deregulation of the most vital institutions of the nation –- literally, the custodians of the country’s newfound and hard-won wealth –- was not about to happen quickly. By 1975, only 14 states allowed statewide branching, while a dozen states still prohibited it altogether.

While the forces of the economy brought the issue of interstate banking to a head, it was technology, as well as the thrift crisis, that may have propelled it to completion. Specifically, the arrival of the ATM machine, combined with the rise of money market mutual funds, increased competition in deposit markets. Suddenly, the quaint notion of remaining accessible to depositors didn’t apply anymore. The inability to collect deposits from a wide area was a distinct disadvantage. Meanwhile, a burgeoning crisis in thrifts and savings and loans was giving currency to the notion that depository institutions were subject to a concentration of risk if they had no way of diversifying their loan portfolio.

Technology may have played another role in opening up lending markets. With the increased accessibility of knowledge — including heretofore obscure trade data as well as borrower-specific information — the value of the knowledge that bankers traded in and used to protect their local markets diminished. Suddenly, it was feasible for bankers to risk capital in new markets and new industries on the other side of the state or county line.

A major chink in the armor of interstate banking laws occurred in New England. Beginning with Massachusetts in 1982, several New England states enacted statutes lifting the so-called Douglas Amendments of the Bank Holding Company Act of 1956, which prohibited the Federal Reserve Board from approving interstate bank acquisitions. These statutes permitted interstate acquisitions on a reciprocal basis within their geographic regions. The Massachusetts Act allowed an out-of-state bank holding company to establish or acquire a Massachusetts-based bank or bank holding company as long as it met three criteria: its principal place of business had to be in one of the other New England states — Connecticut, Maine, New Hampshire, Rhode Island or Vermont; it could not be directly or indirectly controlled by another company outside of New England; and the other New England state had to accord equivalent reciprocal privileges to Massachusetts banking organizations. In June 1983, Connecticut followed suit by adopting its own statute, which was substantially similar.

Two months after Connecticut passed its statute, the Bank of New England applied to the Federal Reserve Board, seeking approval of the merger for its subsidiary, CBT Corporation (CBT), a Connecticut bank holding company, to acquire the Connecticut Bank and Trust Company, N.A., of Hartford, Conn. This merger was challenged on constitutional grounds by then Citicorp (now Citigroup), among others. The case, which ultimately went to the Supreme Court in 1985, was decided for the Bank of New England on several points of constitutional law and new interpretations of the Douglas Amendments.

The likelihood of concentrated banking powers in New England, along with the attendant benefits to commerce, may have led to the overall easing of restrictions on interstate banking on a state-by-state basis. This process was rendered complete with the 1997 implementation of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which removed many of the remaining state-law restrictions on interstate branch banking.

The conventional wisdom predicted a rapid consolidation of the banking industry. To some degree, this thinking was correct. The number of commercial banks did shrink — from the 9,143 operating in 1997 to 7,769 today.

Interestingly and predictably, the number of commercial bank branch offices actually increased from 30,205 in 1975 -– the year interstate-banking deregulation began in earnest — to the current total of 67,390, underscoring the notion that with more centralized ownership, banks could operate more branches more efficiently.

The approximately 7,800 U.S. banks today, though diminished from their peak numbers, represent an amount that defies comparison with the rest of the industrialized world. According to the British Bankers Association, there are 385 banks in Britain; of these, only 184 are incorporated in the U.K. The rest are foreign banks. Japan has 509 banks, according to the Japanese brokerage firm Mizuho Securities. There are just 105 banks in Belgium. Australia has only 14 Australian-owned banks, according to the Australian Prudential Regulation Authority.

Studies suggest that since the removal of interstate and intrastate-banking restrictions, bank performance has improved. According to “The Benefits of Deregulation” by Federal Reserve economists Jith Jayaratne and Philip Strahan, which was published in the Economic Policy Review by the Federal Reserve Bank of New York in December 1997, the ratio of net charge-offs to loans fell from 1.2 percent when intrastate branching was permitted to 0.4 percent when interstate branching was permitted. However, no studies emphatically endorse the notion that bank profitability and efficiency are unequivocally linked to banking consolidation.

Within the very narrow context of economic development, the absence of such studies is irrelevant. What is relevant is this: Regulation created a banking infrastructure that financed a great engine of entrepreneurialism, and deregulation enabled this infrastructure to remain vital and vibrant as the entrepreneurial economy evolved toward more intrastate and interstate commerce.

It’s tenable to suggest that not all regulation has had the fundamental impact on banking that was anticipated. For example, the passing of the Sarbanes-Oxley Act of 2002, while far-reaching for many industries, has had dramatically less impact on banking. This may be attributable to banking’s legacy of regulation; the disclosure and transparency that Sarbanes-Oxley sought to achieve provided little challenge for bankers already subject to the oversight of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission, as well as state banking and securities regulators.

In 1999, after 12 attempts in 25 years, Congress finally repealed the Glass-Steagall Act of 1933. Finally, banks were permitted to engage in securities underwriting. Although industry analysts expected the repeal to make a significant impact, it had little influence on banking -– except among money center banks.

It’s true that even the smallest bank or thrift can now offer securities brokerage services through its branches. And many do this through third parties. But the impact on the vast majority of bank balance sheets has been limited.

In a perverse way, community and regional banks may have been aided by the repeal of Glass-Steagall, because some money center and superregional banks took their eye off of their basic consumer-banking businesses.

For instance, BankBoston bought technology underwriter Robertson Stephens from Bank of America in 1998 for $800 million. By July 2002, FleetBoston Financial, which bought BankBoston, had had enough and closed down Robertson after failing to find a buyer. In the process, FleetBoston took a $388 million charge.

The technology and Internet companies that Robertson underwrote — which were supposed to kill bank branches — ultimately killed Robertson itself. Just two years later, FleetBoston was actively celebrating and promoting its branch openings.

Here’s how InformationWeek described a Spring 2004 opening of a FleetBoston branch in Manhattan:

“Adorned with balloons, a FleetBoston branch across from New Yorkzzs Grand Central Terminal celebrated its grand opening one recent evening as commuters dashed to catch trains to Westchester and Fairfield counties.
“Here in the countryzzs media capital, Fleet intends this branch to be the latest in multimedia, ergonomics, and environmental design. Prominent signs bearing the Fleet logo will be replaced soon by ones bearing the logo of Bank of America, which merged with Fleet this year. The interior includes wall-mounted TV monitors displaying business and news headlines, an LCD stock ticker above the teller cages, and online banking and investment stations where customers check balances, transfer funds, pay bills and even trade stocks via Fleetzzs Quick & Reilly brokerage unit. Weight sensors in the floor tell the machine to automatically log off customers when they step away.”
Community and regional banks, absent the kind of distraction that investment banking offered FleetBoston, never lost sight of the importance of bank branches. As a result, it’s not surprising that community and regional banks, when adjusted for subsequent mergers and acquisitions, actually gained market share in deposits between 1985 and 2003.
The repeael of the Glass-Steagall Act was much anticipated to but ultimately inconsequential for the vast majority of banks. The case of Regulation Q is altogether different. The real effect from the deregulation of interest rates paid on time and savings deposits was not only one of the most profound in banking, but it was also unintended.

Regulation Q was a Depression-era device designed to protect the banking industry from the undesirable effects of too much competition for deposits. The thinking was that a competitive market for interest paid on time and savings deposits would result in escalating interest costs, which in turn would cause banks to make increasingly riskier loans at higher rates to cover their interest expense.

The interest-rate ceilings contained in Regulation Q were nothing more than price controls. As discussed in Chapter 10, there are few instances in which price controls have salubrious economic outcomes. The effects of price controls are often, if not always, undermined by the basic precepts of supply and demand, which conspire to introduce new costs. Perversely, these new costs are sometimes in excess of the savings generated by price controls.

In the case of the Regulation Q interest-rate ceilings, there were several costs borne by other constituencies, namely savers, lower-income households and, finally, taxpayers. Most obviously, there was the cost borne by savers in the form of foregone interest income. With rates on time and savings deposits priced below the rates on high-grade, short-term securities, consumers were deprived of the spread between the two. There is no official tally, but between the enactment of the Banking Acts of 1933 and 1935 and their repeal commencing in 1980 with the Deregulation and Monetary Control Act, savers lost billions of dollars at the hands of Regulation Q.

Low-income savers were particularly hard hit, because the interest-rate ceilings began to lift on money-market certificates, which generally had minimum deposits of $10,000. Furthermore, there were no interest-rate ceilings on deposits in denominations of $100,000 or more. Thus, for savers with less than $10,000, all of their riskless investments were subject to interest-rate ceilings.
Another cost materialized in the form of a subsidy between savers and homebuyers, as a result Regulation Q’s application to thrifts and savings banks. That is, the interest foregone by savers enabled homebuyers to have access to artificially low mortgage rates. This subsidy was just the beginning of the real cost that would eventually be realized by taxpayers. Specifically, rates of interest on deposits as well as on loans, which were kept artificially low by Regulation Q, perpetuated the maturity mismatch on bank and thrift balance sheets. When this mismatch was calculated on a mark-to-market basis at the zenith of interest rates in 1982, the imbalance was $100 billion.
What was less apparent during this ebb and flow of capital, combined with the period of great turmoil in the banking industry, was the relationship between the regulatory framework overseeing banks and the executives of banking institutions.

In short, these regulations had a massive impact on the management talent of the banking industry. The stodgy and unimaginative image cultivated by banking executives at the turn of the 20th century through the 1970s was not without merit. This is not to impugn the track record of our forebears, who along with their staid image also stood watch over the greatest post-war industrial expansion in our nation’s history.

Our observation speaks not to the shortcomings of prior generations of bank executives, but rather notes that certain talents were simply not required of them. Specifically, the existence of interest-rate ceilings meant that bankers weren’t required to have a marketing orientation. This should come as no surprise, since the regulatory cocoon in which they operated meant that they did not have to think about competing for deposits; the decision on the primary marketing variable -– price — was already made for them.

The absence of a marketing mentality should not be underestimated. For it’s not just a promotional orientation that was absent in bank management, but also all of the downstream thinking that goes with it. This thinking includes product development, pricing policies, branching strategies and branch development, service levels, customer-service training and customer-relationship management, to name just a few.

The banking executives who took the helm of institutions in an era of deregulated interest rates possessed the dynamic character and talent that the rapid evolution in banking now requires. Evidence for this notion is supported by Fig. XXX, which comes from the Grant Thornton Survey of Community Bank Executives. It details bankers concerns in 1994 and 2004.

Top Concerns of Bankers, Ranked by Order of Importance
Financial cost of regulatory compliance
Documenting internal controls as required by the FDICIA

The cost of employee healthcare insurance
Truth in Savings compliance
Increasing non interest income
Time spent dealing with all regulators
Mark-to-market accounting
Proposed interest rate risk rules
Lender liability for environmental pollution
Minimizing corporate tax liability
Asset liability management
Complying with risk-based capital rules


Retaining key employees
Developing new sources of revenue
Offering Internet banking services
Updating/expanding technology to better track customer needs

Expanding services for business customers
Measuring customer profitability
Planning for management succession
Expanding traditional banking services
Offering broker/dealer services
Offering insurance services
Offering nontraditional services

The changes in bank management, which these data points imply, are covered in greater detail in Chapter 9: The Evolution of Bank Management. But for our purposes here, the overall implications are quite clear.

Today, community bankers are more concerned with expansion in a dynamic financial services environment than were their predecessors 10 years prior, who came of age during a period of regulated interest rates. Although there is no statistical data, we could posit that this shift in senior management talent and orientation is the single most important reason why the U.S. banking industry has not consolidated to just a handful of institutions, as was widely predicted after the enactment of the Reigle-Neal Interstate Banking and Branching Efficiency Act of 1994.

Given enough time, the question of whether regulated or unfettered markets are the true path to capitalist riches will be answered. But for now, we can say with assurance that regulation has had a positive influence on banking as well as on its investors.