The Independent Banks of South Carolina
Hilton Head Island, S.C.
It is a pleasure to be with you today, and I thank you for inviting me. Community banks such as those you represent and the Federal Reserve System share a long and productive history providing stable and dependable financial services across America. I'd like to talk with you today about our continuing partnership and the future we both face.
When the Fed opened for business in 1914, it began operations with several mandates: to foster a flow of money and credit that ensured orderly and stable economic growth; to act as fiscal agent for the U.S.; to issue Federal Reserve notes; to hold deposits of and make loans to member banks; to help supervise and regulate banks; and to provide various financial services that promoted an efficient payments system and helped banks serve their customers.
Your mandates were more personal. Through the years, your institutions have provided the foundations that support your friends' and neighbors' homes and businesses. Your resources have helped your communities thrive and prosper or recover from setbacks beyond their control. You've made it possible for dreams to become reality and for entrepreneurs to find their place in the world of commerce. In the finest tradition of community banking, you continue to offer hope and promise along with loans.
But banking as you and I know it is undergoing fundamental change. Some is legislative; some is the result of the technological advances and macroeconomic forces of our time.
There are some observers who predict a significant weakening of community banking and a substantial reduction in the number of community banks nationally in the years ahead. These people believe that many community banks will be unable to prosper in the face of growing competition from large interstate banks and nonbank financial institutions. I disagree. I respond to their predictions as Mark Twain responded to his premature obituary. I too believe the reports are greatly exaggerated.
To support my argument, let me briefly review some of the transformations that are increasing the intensity of banking competition. Next I will discuss a particular feature of community banking that helps explain its durability and why I expect it to remain healthy. Finally, I will consider how the Federal Reserve can contribute to the continuing success of community banks--yours and others.
Interest rate ceilings removed From 1933 until the early 1980s federal law gave the federal government authority to set interest rate ceilings on many bank deposit products. Banking was treated like a public utility. As in other important industries such as airlines and trucking, however, banking was subjected to sweeping deregulation in the early 80s. As we all know, banks today set interest rates in response to market forces and engage in aggressive rate competition.
New competition from nonbanks A major catalyst for deposit rate deregulation was the rapid growth, at the expense of bank deposits, of money market mutual funds. Money fund balances increased from less than $4 billion in 1978 to $235 billion in 1982. High inflation, federal limits on bank interest rates, and technological advances that lowered the cost of offering small dollar investments to a wide retail audience are thought to account for money funds explosive growth. In addition to money market funds, stock and bond funds recently have claimed an expanding share of American households savings. Today investment in all mutual fund shares equals $3.4 trillion, about equal to the sum of all U.S. bank deposits.
Banks have locked horns with other hardy external competitors. Beginning in the mid-1970s large banks lost many of their highest quality corporate borrowers to the commercial paper market. Smaller banks have also faced stiff new competition. Many small businesses--traditionally bank customers--have substituted loans from brokerages and finance companies for bank loans. A recent newspaper story on a small business financing conference reported that a Boston computer consulting firm chose to borrow from Merrill Lynch because of its frustration with the rigid lending standards of banks. The story also reported that a telemarketing firm borrows from a finance company to escape what it regards as banks less flexible lending standards.
In-state branching liberalized Additionally, during the 1980s a number of states relaxed restrictions on in-state branch banking. In 1980 a dozen states prohibited bank branching outright. By 1990 there were only two such states. Over the same period the number of states allowing statewide branching increased from 21 to 36. Consequently, local banking markets faced growing competition from new entrants as the number of branches grew by almost 20 percent to 63,000.
Interstate banking and branching Similarly, in the 1980s banking across state lines became possible through bank holding company acquisitions of out-of-state banks. Federal law prohibited these acquisitions unless specifically authorized by the laws of the state in which the bank was located, and initially most states did not authorize such acquisitions--in fact in 1980 only Maine had a law that did so. During the 1980s, however, most states opened their borders to out-of-state bank holding companies, and by 1990 all but four states allowed out-of-state banks to enter, although in many states there were regional limitations under the terms of so-called "regional compacts." This change gave us regional banking Goliaths such as First Union, NationsBank and Banc One.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 went beyond the state law framework to allow bank holding companies to acquire banks in any state beginning in September 1995. As of June 1, 1997, the Act allowed interstate bank branching in any state that did not "opt-out." Since only Texas and Montana opted out, banks may now have branches in most other states in the nation. Riegle-Neal is likely to mean further consolidation of the banking industry, largely through combinations previously prevented by the regional constraints set out under state laws. Large banks may now seek more distant partners outside their regions. Recent examples of such acquisitions are First Union s purchase of First Fidelity Bank in the Northeast and NationsBank s purchase of Boatmen s Bankshares in the Midwest.
Entry by large outside competitors often has meant the disappearance of community-based businesses. There is every reason to believe, however, that independent banks will not only survive but prosper. Community banking has remained viable through the period of rapidly growing interstate activity over the last decade and should continue to do so. While larger banks are likely to be the low cost providers to some borrowers, community banks will probably remain the most efficient providers of credit to at least one clearly identifiable and extremely important economic group: the small business borrower for whom standard creditworthiness information is difficult to obtain.
Three points seem fundamental to understanding the continuing viability of community banking: the effect of interstate banking on community banking; the future of small business itself--which is the bread and butter of community bank commercial lending-- and the significant advantages community banks hold in lending to small businesses. Let me deal briefly with each of these points in turn.
Community banks and interstate banking Immediately following the passage of state laws allowing out-of-state entry and the initial growth of interstate banking activities, the share of banking assets held by community banks experienced a notable decline. Much of the state legislation permitting out-of-state entry was adopted between 1985 and 1989; community banks share declined from about 29 percent of domestic banking assets in 1984 to about 19 percent in 1996.
Yet a good bit of the decline may not have been the result of interstate banking at all. At the same time states were dropping barriers to interstate banking, many were liberalizing in-state branching requirements. Banking market adjustment to the in-state branching law changes probably accounts for a significant portion of community banks market share losses. Since by now most states have had fairly liberal in-state branching rules for several years, this adjustment has probably run its course.
The General Accounting Office studied community bank market share over the period from 1986 through 1992, a period of especially intense interstate activity. The study included as community banks all U.S. banking companies--both independent banks and bank holding companies--smaller than $1 billion in assets. According to the study, community banks lost market share in a number of states. But these losses occurred mostly in states that relaxed in-state branching restrictions during the same period. In contrast, in states with liberal in-state branching rules already in place before interstate banking began, community banks gained market share even as interstate activity was increasing. In retrospect it seems apparent that the restrictive environments in less liberal states had supported the existence of weaker competitors that could not survive significant new competition, whether from in- or out-of-state.
Community banking remains an exceptionally important sector of the banking industry despite the decline in its overall market share over the last 10 years. For the nation as a whole, community banks today account for almost 20 percent of banking assets. Further, community banks are numerous. At of the end of 1996 there were about 6,900 independent banks and banking companies with assets less than $1 billion. Additionally, in terms of return on assets, return on equity, and capital adequacy, community banking is profitable and healthy.
Nowhere is the continued health and viability of community banks more evident than in South Carolina. As elsewhere in the nation, South Carolina community banks have lost market share to larger banks since interstate banking began in early 1986. At the end of 1985, South Carolina s banks and banking companies smaller than $1 billion held 29 percent of the state's banking assets. By 1996 the figure was 17 percent. Out-of-state acquisitions of several South Carolina community banks accounts for some of the decline. A significant portion, however, was simply the result of growth as several large community banks climbed above the $1 billion threshold and out of the smaller bank category.
In contrast to the market share decline, the number of South Carolina community banks is about the same today as before interstate banking activity accelerated. In 1985 South Carolina had 69 independent community banks and banking companies; at the end of 1996 there were 63. Additionally, since early 1996 new community banks have formed almost monthly. This rush of new entry clearly demonstrates the attractiveness of community banking in your state and its potential for growth.
At first glance the $1 billion size threshold I have used to delineate community banking institutions may seem somewhat high, so let me take a moment to explain. Traditionally we tend to think of community banks as serving only one community and having a minimum number of branches. Such banks will be much smaller than $1 billion. But a community bank--or, a community banking company--may actually operate in several areas and still focus on the unique needs of its communities. This focus, of course, is the essence of community banking.
It is obviously impossible to predict with certainty the future course of banking consolidation and what that course may imply for your banks. While liberalized interstate entry made possible by Riegle-Neal may result in further community bank market share losses, in the final analysis it seems more likely that interstate entry poses little threat. Most states now have liberal in-state branching laws. Consequently, most community banks are already competing successfully with much larger banks based either in- or out-of-state. This is certainly the case here in South Carolina. Future entry by out-of-state competitors is not likely to threaten the success of today s community banks in any material way.
The vitality of community-based businesses Up to this point we have considered the challenges community banks face within the banking industry. What about the challenges from broader ongoing changes in the general economy? In particular, small business lending is the traditional specialty of community banks. But isn't the small business sector diminishing in importance in view of all of the consolidation occurring in so many industries? We are all familiar with the demise of the corner grocery. Earlier in this century the grocery business was dominated by locally-owned stores; today it is dominated by national or regional chains such as Food Lion and Safeway. More recently, entry by K-Mart, Wal-Mart, and similar nationwide discount department stores is blamed for the decline of the smaller, locally-owned general purpose department store.
Consolidation has taken place in these and other industries because the demand for standardized products allows large firms to enjoy economies of large-scale production, marketing and distribution. But consolidation can proceed only so far in many business sectors. In particular, there are many businesses where there is enough variation in regional and local customer tastes that knowledge of local demand conditions and the ability to tailor products to meet those conditions is important. Here local specialization is more important than the cost savings that standardization makes possible. Locally-owned businesses catering to these markets cannot be replaced by the "big box" discounters of the world.
An example that comes immediately to mind is the restaurant business. While large chains have claimed a part of the restaurant market, almost every local market contains locally-owned restaurants catering to the special tastes of that community. Local restaurants frequently offer the best food in town, since they are not required to meet rigid standards set to appeal to a mass audience, as the national franchises are. For example, has anyone ever discovered a national chain that sells good barbecue? Beyond the restaurant business, others where consolidation has been limited are construction, specialty manufacturing, and many service businesses such as law firms and real estate agencies. In these locally-focused businesses, the benefits of being able to appeal to diverse local tastes exceed the benefits of lower cost production and distribution.
There is one other reason why small businesses survive in competition with much larger firms. In a growing economy, where there is rapid technological progress, the newest technology tends to be developed by smaller firms. Larger companies are often hesitant to produce or market new technologies that might undermine their existing lines of business.
Community banks and small-business lending Community banks have a significant comparative advantage in lending to small businesses. Detailed, robust, company-specific knowledge resulting from close ties to small-business borrowers and their communities is fundamental in some kinds of small-business lending. Successful small businesses often lack elaborate financial records, their lines of business may be nontraditional, or their credit requests unusual. As a result, there is great value in the ability to gather thorough background information through informal means. Community bankers are likely to have inexpensive access to just this type of information.
Large banks may be able to some degree to mimic the community bank s information gathering abilities by hiring small-business lending officers from the communities they intend to serve. But community banks often can use such information more efficiently than larger banks. The senior management of all banks, large and small, must monitor loan officers. Most of all, monitoring means verifying the information used by loan officers in making their lending decisions. Community bank managers can inexpensively verify much of the special information the loan officers gather because they are likely to be in close touch with many of the same sources. Managers in larger banks are often centrally located in major cities and consequently can verify special local information only at considerable cost. Therefore, large banks tend to require local loan officers to justify loans with standardized, objective criteria that do not take into consideration all the special information that may be available.
Consider the case of a hypothetical small bank, Littletown National Bank. Littletown National s president knows all the small business owners in town. Monitoring his one lending officer is simply a matter of meeting once a week for lunch and discussing loan opportunities and the condition of outstanding small-business loans. The loan officer knows he must be frank and honest because the owner knows a great deal about the town's small businesses. Consequently, Littletown's president is comfortable with the lending decisions his loan officer makes.
On the other hand Big City Bank has 100 far-flung loan officers, and monitoring is much more costly than lunch once a week. BigCity s CEO and other senior managers cannot begin to know all of BigCity s small-business borrowers. Verifying its loan officers special information would require costly local investigative efforts. Rather than incur this expense, BigCity allows its lenders only to make loans to borrowers for which creditworthiness information is easily verifiable by headquarters. In other words, to borrow from BigCity a small business must meet certain well-defined and relatively inflexible standards.
An example of this fixed-standard approach for small-business lending is found in a loan product offered by one of the larger banks in our Federal Reserve District, which is especially well-suited to borrowers whose financial condition can be easily conveyed in a credit score statistic. Specifically, this bank uses an automated facility to sell standardized small-business loans to small-business borrowers nationwide who call in loan requests using an 800 number. The bank promises to respond to loan requests within 24 hours. The lending decision is made centrally, based on information provided over the phone or faxed by the borrower along with information the bank purchases from Dun & Bradstreet and credit bureaus.
Many small-business borrowers find this kind of product attractive. But the community bank approach will better suit others: specifically, borrowers with unusual loan requests or for whom standard creditworthiness information is difficult to obtain. As long as such borrowers exist there will be a need for the type of lending at which community banks excel.
So far I have been talking about the advantages that flexibility provides community banks in small business lending. Similarly, because detailed monitoring of particular transactions is less costly for community banks than for larger banks, community banks can permit their retail officers to customize savings and investment products to meet individual customer preferences--one more reason to believe community banking can and will remain viable for the long-term.
My discussion to this point hopefully has explained why I believe the community banking industry is perfectly capable of dealing with the current changes in the structure of the banking marketplace, dramatic though they be. What can the Federal Reserve do to help? Most of you will have a quick response to that: reduce the regulatory burden and then get out of the way and let us compete. I have a lot of sympathy with that view, and there is no doubt that we need to work with you to lighten the regulatory load you bear. But there are a couple of other things we can do to reinforce the health of community banks--specifically, maintain a low inflation environment and promote an efficient and accessible national payments system. Let me close with a few brief remarks on each of these points.
Ensuring low inflation For the past 15 years the United States has enjoyed the benefits of persistently declining inflation. Fifteen years of steady economic growth, punctuated by one relatively mild recession, is one of those benefits since the economic history of the U.S. and other major industrial countries suggests strongly that low inflation is an important contributor to sustained economic growth. Lots of things have contributed to the reduction in inflation, and I believe Federal Reserve monetary policy--especially our refusal to allow signs of impending inflationary pressures to go unchallenged--has been one of them. Rest assured that we are firmly committed to continuing this progress toward price stability and then maintaining it once it is achieved.
Low inflation is particularly beneficial to community banks since they are especially vulnerable to inflation s negative impact. Inherently, inflation encourages investors to seek investments that protect against inflation and the various risks that accompany inflation, often at the expense of traditional banking products. Community banks, whose mainstay is traditional banking, suffer as a result. We at the Fed will work diligently to keep inflation low.
An efficient payments system Almost since its founding the Federal Reserve has played a significant role in the payments system by offering nationwide check clearing. Since 1980 the Fed has made this and other payments services universally accessible to all depository institutions. It has also played a major role in the development of the automated clearinghouse system. And Fedwire, the Fed's large dollar transfer system, is vitally important to both the financial markets and the general economy. All told, over $1 trillion in payments are settled on the books of the 12 Federal Reserve Banks each day.
The banking environment has changed greatly over the last two decades, however, and the Fed must respond to these changes in order to promote efficiency in the payments system. As I am sure you know, last year Chairman Greenspan appointed a committee headed by Federal Reserve Vice Chair Alice Rivlin to develop information regarding the broad future role of the Fed in the retail payments system. The Rivlin Committee produced a set of five alternative scenarios that range from expanding Fed payments activities beyond the current level to liquidating our operations. The Committee has presented these scenarios in a series of public meetings around the country to gather input from interested parties and is now evaluating the responses received. By and large, the comments have been quite supportive of the Fed continuing to be an important participant in retail payments, including check and ACH services.
At the same time the Fed is examining how it can increase the efficiency of its existing payments services and facilitate the transition to a more efficient national payments system. Again, banking markets and payments services are changing. If the Fed wishes to remain a competitive payments services provider it must be willing to make the necessary adjustments. As you are well aware, our examination has included consideration of closing some Fed facilities, one of which is our Bank's RCPC in Columbia. Our Bank's first vice president, Walter Varvel, and I have discussed this proposal in detail with many of you at earlier meetings, so I won't go into further detail today except to repeat that no decision has been made yet, and to assure you that when we do decide we will give full weight to the concerns you and others have expressed. To this end, we are working closely with representatives of IBSC to gather information from your banks that will help us understand these concerns fully, and we appreciate your assistance.
Reducing regulatory burden Like low inflation and efficient payments services, regulatory burden is especially important to community banks. Recent analysis indicates that the cost of regulatory compliance falls disproportionately on small banks; consequently, regulatory simplification and the outright elimination of unnecessary regulation is likely to yield particularly large benefits to community banks.
The Fed recently has taken several steps aimed specifically at reducing regulatory requirements for small banks. For example, in 1995 the Fed in conjunction with the other federal bank regulators revised the CRA compliance requirements, in part to ease the burden of compliance. One of the revisions was a streamlined CRA examination process for small banks which focuses on actual performance in serving local communities--your great strength--rather than paperwork. Additionally, in 1996 the Fed revised Regulation E, which covers electronic funds transfers, to exempt more small banks. Finally, manage- ment interlock requirements were recently revised, which will enlarge the pool of qualified directors for community banks, and the frequency of examinations has been reduced from every 12 months to every 18 months for banks under $250 million having CAMEL ratings of satisfactory or higher. Beyond these changes directed particularly at providing relief to smaller banks, the Fed has also eliminated or simplified a number of other regulations. In 1996 alone we rescinded two regulations and simplified seven. These changes do not go far enough, but more significant reduction is likely to require legislative action. Unfortunately such action is not easily achieved.
There are two major strongholds of resistance to reduced regulatory burden. On the consumer regulation side, legislative initiatives that might help are often met with tenacious opposition from consumer and community activist groups, and from some members of Congress. Such was the case during last year s attempts to attach regulatory relief to the SAIF bailout bill. Ultimately only minor relief was granted. Over the years consumer groups and others have successfully argued that the special privileges accorded the banking industry, particularly deposit insurance, justify imposing substantial regulatory requirements on the industry.
On the safety and soundness side, similarly, extensive deposit insurance makes passage of regulatory reform equally difficult. In private insurance markets, those with broad coverage are likely to face burdensome activity restrictions. Such restrictions are intended to protect the insurance underwriter from excessive claims. For example, while HMOs provide broad health expense coverage, they restrict patients to only those procedures approved by the primary care physician and limit patients to approved doctors and facilities. Similarly, broad deposit insurance coverage strengthens the arguments in Congress and elsewhere for very comprehensive safety and soundness regulation. As you know, this reasoning underlay some of the heavy-handed regulatory strictures imposed by FDICIA in 1991, just after the huge bailout of the savings and loan insurance fund. If the coverage were reduced--for example by limiting it to one account per customer--the case for less regulation would be correspondingly strengthened.
You've been very patient and I thank you for your attention. In closing, I'd like to tell you a story that I believe illustrates very effectively some of the points I have made.
One of my missions as president of the Richmond Fed is to meet bankers and business people in the smaller communities of our Fifth Federal Reserve District. To date, I have visited communities in all five District states, including Aiken here in South Carolina. On a recent visit to Asheville--in the other Carolina--I asked a group of local bankers about potential problems with overdues. One of your counterparts answered, "We don't have problems with overdues, because I call their mother-in-law."
And that is really the key point. There will always be a place in the American marketplace for locally-focused banks like yours that specialize in lending to and advising business firms and households on the basis of detailed--up close and personal--knowledge of the customer. That makes me optimistic about the future of the community banking industry. It also makes me optimistic about the prospects for the American economy as a whole, because it is precisely this kind of borrower who provides so much of the innovation and vitality that makes our economy the envy of the world.