FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman and members of the Committee, I am pleased to appear today to discuss issues that may be raised by several large financial institution mergers that have recently been proposed. I will not address the particulars of the proposed transactions, and I will leave to the bank and thrift agencies having regulatory jurisdiction in this area questions about the standards and method of reviewing such transactions. Instead, I will discuss factors that we believe may underlie the trend toward consolidation in the banking industry, the potential effects of such mergers, and the relevance of some of these mergers for proposals to modernize our financial system.

I.Factors Driving Large-Scale Mergers

Several factors have contributed to recent and proposed large-scale mergers. The significance of each factor may vary depending on the size of the merger, whether it involves institutions that operate in the same markets, and whether the merger involves only combinations of depository institutions or also other financial services providers. The Treasury Department study prepared by Robert Litan and Jonathan Rauch last year described these factors, which I will briefly summarize.

Technological advances in information pr ocessing and telecommunications have greatly increased the speed and decreased the cost of transferring information and funds. For some lines of financial business, large firms are better able to afford the technological sophistication required to compete successfully, with potential cost savings for consumers.

Technological advances have spurred financial innovations, especially securitization and derivative instruments that improve the identification, dispersion, and pricing of risks. The result has been a broad array of financial products available at lower cost and a blurring of traditional boundaries among types of financial services providers.

With dramatic growth in transnational finance during the last two decades, financial institutions need to expand sufficiently to compete in global markets for corporate customers seeking the best funding options worldwide.

The growth of nonbank providers of financial services (e.g., money market mutual funds and commercial paper underwriters) has also accelerated the blurring of distinctions between types of financial services firms. Commercial banks have seen their share of total financial intermediary assets decline from about 60 percent at the end of World War II to roughly 25 percent today. Banks have responded by moving into new financial product areas themselves, sometimes through acquisition or merger.

Mergers have provided a way for many firms to increase efficiency and profitability by taking advantage of economies of scale and scope, and to diversify risks that stem from geographic or product concentrations of earnings sources.

Regulators and lawmakers have played a significant role in the recent structural changes in the industry by gradually removing barriers to competition. The elimination of geographic restrictions on banking has been a prime example. Starting in the late 1960s, restrictions on intrastate branching by banks, which had limited the ability of banks to expand by merger, began to disappear. Intrastate expansion through the multibank holding company format picked up momentum after the 1970 amendments to the Bank Holding Company Act. In the 1980s the states began to feel more comfortable with the entry of out-of-state banking organizations, and we began to see the rise of interstate "compacts" that permitted holding companies to make acquisitions across state lines, initially on a reciprocal basis within defined regions and then more broadly. This movement culminated in the Riegle-Neal legislation of 1994, which facilitated not only nationwide holding company acquisitions, but nationwide branching as well. As a result of these developments, restrictions on geographic expansion have virtually disappeared, as is reflected by the fact that the annual number of interstate bank-to-bank mergers, which had been in the single digits through 1994, jumped to 189 by 1997.

II. Potential Effects on Industry Concentration

In response to the recent spate of mergers, some have raised the question of whether increased concentration in banking could adversely affect competition. Consideration of this question may be aided by a review of concentration trends.

Traditional antitrust analysis of bank mergers, guided by the Supreme Court's landmark decision in the 1963 Philadelphia National Bank case, has focused concern on the competitive effects of mergers in local markets. Individuals and small business customers of banks, who have been seen as locally limited in their choice of banking alternatives, have traditionally relied on depository institutions in their local market for credit and other banking services, while larger businesses have typically had a wider geographic range of choices.

Recognizing that market shares are likely to be smaller as the geographic market in which they are calculated becomes larger and thus the apparent competitive effects of a particular merger less significant the courts and enforcement agencies have applied measures of acceptable concentration almost exclusively in locally defined markets. Where particular transactions have threatened to exceed acceptable levels in local markets, antitrust objections have frequently been addressed through selected local divestitures. Because of the focus on local markets, however, and the inability of existing antitrust rules to reach bank mergers and acquisitions that involve market extensions and that do not present unacceptable local market overlaps, larger and larger combinations have been possible as restraints on geographic expansion have disappeared.

As a consequence, concentration in local markets has remained constant through the merger wave of the 1980s and 1990s, even as concentration has increased nationally and the number of banking organizations nationwide has declined -- by more than 40 percent since 1980. Federal Reserve data show that the average share of commercial bank deposits held by the top three banks in metropolitan markets has held steady between 65 and 68 percent in every year from 1980 (66.3 percent) through 1997 (65.4 percent). In rural markets, this three-bank concentration ratio has held between 88 and 90 percent during the same period. These data do not, of course, tell the whole story, for while nominal concentration in local markets has not materially changed, the nature of local banking has changed profoundly in many areas, as locally owned institutions have been absorbed into larger statewide or regional organizations headquartered far away. I will discuss the potential effects of this trend on consumers, small businesses, and communities later in my statement.

In contrast to local markets, concentration of banking at the national level has increased appreciably. Federal Reserve data show that the share of commercial bank deposits held by the top 10 banking organizations has increased from about 19 percent in 1980 to 30 percent in 1997. While Congress has evidenced concern about concentration on a national level, in part by establishing a 10 percent nationwide deposit concentration limit on bank merger and acquisition applications, antitrust rules have not yet established the entire country as a relevant market in which to evaluate the competitive impact of bank mergers in the product market comprised of the bundle of products and services included within commercial banking. Moreover, companies that have a national range of alternative lending sources may well have the ability in today's financial marketplace to borrow, securitize assets, or issue commercial paper worldwide.

Despite this trend toward increased concentration nationwide, small banks remain profitable and new banks continue to be established, even as the elimination of restrictions on nationwide branching makes it easier for large banks to enter new markets de novo. The OCC has reported that about 460 new national and state-chartered banks began operations from 1994 through 1997.

III.Effects on Consumers, Small Businesses, and Communities

Recent merger proposals have understandably raised concerns about the effects of increased concentration on consumers of banking services -- what they pay, the quality of service, the adequacy of consumer protections, the effect on communities, and the availability of credit for individuals and small businesses. These are clearly important questions for policy makers.

While structure data indicate that local market concentration is not generally increasing, the absorption of locally owned and operated banks into large institutions headquartered in distant cities presents conflicting considerations. On one hand, large institutions should be able to bring to local markets the benefits of greater efficiencies and product diversification. However, surveys indicate that many individual customers of local banks acquired by larger institutions believe they are losing benefits that only smaller banks can offer particularly the more personalized service that smaller banks provide. Other survey data also provide some evidence that large banks charge higher fees than smaller ones. While higher fees charged by large banks may in part be offset, for example, by lower lending rates and a greater variety of services, the tangible and intangible benefits that individuals obtain from their local bank relationships demonstrate why consumers are so troubled about the potential for acquisition of the banks they have come to know.

These consumer attitudes also explain in part why community banks continue to thrive in spite of recent consolidation trends, and why many new banks continue to be established every year. Small banks provide a level and continuity of services that their customers appreciate, and the presence of federal deposit insurance provides customers assurance that funds invested in a small bank are not at risk.

These developments and consumer attitudes make it particularly important that the protections of the Community Reinvestment Act be maintained, and not weakened, as some have proposed. They also make it especially important that in considering such transactions the regulators assure that large combinations involving the disappearance of local institutions will not result in an erosion of the commitment and obligation of banks to serve effectively the convenience and needs of the local communities that they have been chartered to serve. However the banking system may evolve, CRA must continue to be looked to as a first line of defense for ensuring that the credit needs of local communities are being met.

The continued focus of antitrust analysis on the effects of mergers on locally limited small business borrowers is also of great importance. Even though concentration in local markets may not be increasing, a recent Federal Reserve paper found that mergers may initially reduce small business lending, even though subsequently other banks may move in to fill the void or the merged institution may refocus its efforts to retain or expand its small business customer base. Antitrust analyses of individual mergers have traditionally paid special attention to the potential impact on lending to small business, and we are confident that this focus will continue in the future.

IV.Effect on Supervision

The advent of mergers of unprecedented size also raises an important question whether the apparatus of bank supervision is capable of dealing effectively with institutions of vastly increased size. Indeed, some have questioned whether institutions are being created that may be too big to manage effectively. I will defer to the regulators for a discussion of the adequacy of supervision to address the challenges of large-scale mergers.

It is important to note, however, the significant role Congress has already played in ensuring that strong safety and soundness safeguards undergird the banking system as it continues to evolve. In particular, the FDIC Improvement Act of 1991 (FDICIA) required supervisors to ensure that banks maintain appropriately high levels of capital, and it mandated a regime of prompt and increasingly stringent corrective actions by supervisors in the event bank capital levels should begin to fall. As a result of FDICIA, bank capital levels are now at significantly higher levels than they were during earlier periods. Both the Treasury Department's Financial Modernization proposal as well as the bill reported out by this Committee last year would build on the foundation laid by FDICIA by requiring that banks engaging in new financial activities, whether through subsidiaries or affiliates, be and stay at the highest level of capitalization. This focus on the maintenance of high levels of bank capital is of critical importance not only in the context of financial conglomeration under Financial Modernization, but in the context of very large bank mergers.

We would also note that any assessment of the capacity to adequately supervise large financial holding companies must account for functional regulation, which our Financial Modernization proposal and others strengthen. Supervision of large financial holding companies with banking, securities, and insurance units would be shared among the Federal Reserve, the appropriate federal banking regulators, the SEC, and state insurance authorities.

V.Implications for the Safety Net

Some have raised concerns that larger and larger mergers may create institutions that would be considered "too big to fail" if they were threatened with insolvency, increasing pressure on the Government to protect uninsured depositors and other creditors from loss in order to avoid systemic risk.

Systemic risk refers to the possibility of a sudden, usually unexpected, event disrupting the financial markets quickly enough and on a large enough scale to cause significant harm to the real economy. The Treasury study prepared by Robert Litan identified three sources of systemic breakdown:

Cascades. Systemic risk may arise from the business that banks and other financial institutions conduct with each other, e.g., small banks typically hold deposits in larger banks. The failure of a large bank or other financial firm could trigger in domino-like fashion the failure of other firms to which it owes money. The fear of a cascade of losses was a major reason why the Government extended protection to all depositors of the failed Continental Illinois Bank in 1984. Inter-linkages among large banks and securities firms that have developed through the huge growth in derivatives contracts also raise the potential for cascading losses, as do the end-of-day net settlement practices of the privately operated large bank payments system (CHIPS).

Contagion. A deposit run on one troubled bank may become contagious when uninsured depositors at other banks decide to run as well out of fear for the safety of their funds. Unlike cascades, systemic risk manifested in the form of contagious deposit runs can cause banks to fail whether or not they have claims on each other. Contagion need not be limited to bank depositors, but could also affect markets for short-term debt instruments (e.g., commercial paper).

Asset implosion. A sudden and sustained drop in asset values is another source of systemic risk. A stock market crash, for example, could significantly harm consumer and business confidence and trigger an economic downturn. Elements of contagion and cascades that may accompany an implosion in asset values (e.g., selling induced by margin calls) may worsen the decline.

It is important to understand exactly what is meant by "too big to fail," for even in past cases in which government support has been provided for insured depository institutions facing an insolvency, significant losses have been experienced. Shareholders and subordinated debt holders, for example, almost always have suffered the loss of their investment, managers have lost their jobs, and directors and others responsible for the institution's demise have been held accountable in damages, and in some cases criminally.

The critical question is generally whether uninsured depositors and unsecured nondeposit creditors should be held harmless from loss. In a properly functioning marketplace, this should, first and foremost, be a question of expectations that is, what should uninsured claimants be led to expect will happen to their claims if the bank fails. If, as has been the case at some times in the past, government routinely steps in to assist takeovers in which uninsured claimants are made whole, so that an expectation of protection is created, it may be difficult or impossible to allow such claimants to experience losses when a particular insolvency arises.

On the other hand, if government policy both the applicable legal structure and regulatory practices are carefully crafted to negate such an expectation, there should be no institution that creditors should perceive to be so big that they could rely on governmental intervention to safeguard them against loss. Fortunately, Congress and the regulators have in recent years taken significant steps in this direction, and any creditor that advances funds to an insured depository institution today with the expectation of being fully protected is ignoring the history of recent years:

Least-cost resolution. Most importantly, in FDICIA Congress required the FDIC, when deciding how to resolve a depository institution facing default, to choose the method of resolution least costly to the deposit insurance fund, which generally would mean not protecting uninsured creditors. Although there is an exception to the least-cost rule where systemic risk may be threatened, that exception cannot easily be invoked, and there are significant consequences for the industry if it is. The law requires the consent of two-thirds of FDIC Board members and Federal Reserve Board members, as well as the consent of the Secretary of the Treasury, in consultation with the President, and the industry must repay to the insurance fund, through higher insurance assessments, any loss that the fund realizes as a result.

"Purchase and Assumption-Insured Only" Transactions. The least-cost resolution requirement of FDICIA altered the primary method by which FDIC resolves failing banks. For several years prior to FDICIA, the FDIC closed many failing banks using a "traditional" purchase and assumption transaction, whereby an insured bank purchased certain assets of the failing bank and assumed all deposits, insured and uninsured, with the FDIC providing financial assistance to fill the gap between liabilities and assets. From 1986 through 1991, 81 percent of the 1,072 bank failures were resolved by traditional purchase and assumption transactions and other methods that fully protected uninsured depositors. Since FDICIA, however, FDIC has closed failing banks primarily through "purchase and assumption-insured only" transactions, in which the acquirer purchases assets and assumes only insured deposits. While uninsured depositors may receive some funds from the FDIC in advance of the liquidation of bank assets, they have ultimately been forced to absorb a share of the losses. From 1992 through 1997, only 37 percent of the 188 bank failures were resolved by methods that fully protected uninsured depositors.

Depositor Preference. A law enacted in 1993 gives depositors a preference over other creditors in their claims against the estate of a failed bank, thus mitigating the need for government intervention to protect uninsured depositors in the event of a large bank failure and creating an incentive for nondeposit creditors to exercise greater discipline. The markets have reacted to depositor preference (and to least cost resolution) to reflect the changed status of nondeposit liabilities: for example, it is now routine in derivatives transactions to require collateralization of exposures.

Prompt corrective action. Too often in the past, decisions about government intervention were confronted only after an institution's real economic net worth had run out. Indeed, in many cases, supervisory forbearance simply provided an opportunity for uninsured creditors to exit a failing institution, leaving the burden of loss with the FDIC. FDICIA's requirement that supervisors ensure that banks meet rigorous capital standards, and its mandate to undertake prompt corrective actions to correct capital and managerial deficiencies well before real net worth is exhausted, work toward protecting all claimants against loss.

Beyond these developments, which should send a strong signal to the marketplace that reliance on too-big-to-fail is exceedingly risky, other important changes have increased the protections against the effects of one bank's failure spreading to others:

Limits on interbank liabilities. The Federal Reserve's Regulation F has reduced too-big-to-fail concerns by prohibiting one bank from having an interday credit exposure to another bank in excess of 25 percent of the exposed bank's capital, unless the exposed bank can demonstrate that the correspondent is adequately capitalized. The regulation also requires that each bank establish policies and procedures to limit interbank credit exposures.

Improved Clearing and Settlement: Expedited clearing and settlement of transactions and increased use of clearinghouses for foreign exchange trading has worked toward reducing risk exposure from interbank liabilities.

Clearly, the most effective way to avoid confronting a too-big-to-fail situation is to avoid postponing supervisory action against troubled banks until failure is imminent. Regulators, through their actions, must condition expectations in the marketplace -- especially in good times -- that uninsured depositors and other creditors will not be bailed out if the institution gets into trouble. Only by such conditioning can the discipline of the market place be brought to bear on institutions.

We believe that Congressionally mandated reforms and market developments have to a large extent curtailed expectations of too-big-to-fail treatment. But the issue is sufficiently important that we should explore additional means of assuring against the prospect of having to confront a too-big-to-fail choice, and it is particularly appropriate that we do so at a time when the industry is in very good shape, as it is today. To this end, Congress might want to study a few recent proposals that could enhance market discipline and offset the damaging effects of too-big-to-fail perceptions and practices.

There have been several proposals, including one by Robert Litan in last year's Treasury study, that would require large banks to regularly issue publicly traded subordinated debt. Not only could subordinated debt act as a signaling device, alerting uninsured depositors and creditors to problems as subordinated debt holders demanded increased rates, but it would act as a disciplining constraint on bank management, who would be on notice that imprudent practices would be likely to raise their funding costs.

There are other interesting proposals, including one by the Minneapolis Federal Reserve Bank that would mandate that in the event of a failure of a very large bank (that is, a bank that may be covered by FDICIA's systemic risk exception to least-cost resolution), uninsured depositors and other deposit-like creditors would incur some loss. As with the FDIC's current resolution techniques, such a mandate would counter the expectation of full protection that may give rise to a governmental judgment that a bank is too big to fail.

Both sets of proposals could enhance market discipline, encourage even better disclosure of banks' true financial condition, and perhaps provide a basis for more risk-sensitive pricing of deposit insurance.

VI. Implications for Financial Modernization

The current large bank-to-bank mergers are proceeding under existing law, and can be expected to continue even in the absence of Financial Modernization legislation. Such legislation is relevant, however, to the proposed Citicorp-Travelers merger, as insurance and securities underwriting in the new company would otherwise be prohibited and restricted, respectively. Our Financial Modernization proposal and the House Banking Committee bill would have allowed such combinations to occur, but only in the presence of significant safety and soundness protections.

Any Financial Modernization proposal should provide strong safety-and-soundness protections for banks involved in such transactions. Thus our proposal and the House Banking Committee bill, by requiring that the bank be and remain well capitalized and well managed (with strong sanctions for failures to adhere to these requirements), direct supervisory attention to the most appropriate place. The further requirements that a bank take a capital "haircut" if new activities are conducted in an operating subsidiary, and that the firewalls of sections 23A and 23B be applied to transactions between a bank and its subsidiary, just as they apply to affiliate transactions, are strong additional protections.

The principle of functional regulation, also reflected in our proposal and the House Banking Committee bill, works to assure that insurance and securities regulators will safeguard the interests that they are required to address, even as the Federal Reserve, as the holding company regulator, and the supervisory agencies that have jurisdiction over depository institutions, continue to safeguard the interests of the entities under their jurisdictions.

VII. Conclusion

In conclusion, we do not believe that the proposed mergers create a need for responsive action by Congress. We continue to support Financial Modernization legislation that is free from the significant shortcomings we have noted in the most recent version of H.R. 10, however, and we think it is important for Congress and the regulators to carefully monitor trends in bank merger and acquisition activity to make assure that the banking system remains truly competitive and fully responsive to the needs of consumers, small businesses and communities.