FROM THE OFFICE OF PUBLIC AFFAIRS

I am skeptical of the view that the future of financial services will be all about financial conglomeration. I expect that small and nimble financial institutions will compete effectively in the coming years and, thus, I expect that well-managed community banks will prosper.

I concede that large banks and financial firms have some important advantages, among them greater potential for diversification. Effective diversification is a powerful tool in financial intermediation. It spreads risk and stabilizes earnings. Yet while large banks have the opportunity to benefit from diversification they must work continuously to effectively diversify their exposures and to avoid risk concentrations lurking inside seemingly diversified portfolios of assets.

Community banks have options and advantages that can counter-balance large banks' built-in diversification advantage.

First, advances in information and communication technology offset some of the scale and diversification advantages that large banks may have. The theory that supports large firms and conglomerates is that it is cheaper to move information inside a single corporation than between and among different corporations. The communications revolution that we have lived through in the last twenty years challenges this theory.

Today technology permits small firms to outsource many functions and thereby recapture some of the advantages previously associated only with economies of scale. In fact, small banks increasingly have been employing technological and financial innovations to improve efficiency and diversify operating and balance sheet risks. More of you are turning to nonbank technology providers as a means of outsourcing administrative and payments functions and other activities. Eighty percent of community banks now have web sites, up from 21 percent in 1997. More and more banks are taking advantage of the secondary markets to enhance liquidity and reduce balance sheet risks.

Second, small banks operate and make decisions closer to their customers. Small banks provide a level and continuity of services that their customers appreciate. The proximity of community bank management to the household and business customers benefits the credit decision process in a way that large banks find difficult to replicate.

Third, in a world in which real and nominal interest rates are converging, and in which inflation expectations are both low and stable, the franchise of deposit taking will be increasingly valuable. Consider how competitive community banks have been in recent years in attracting deposits. As Chairman Greenspan recently testified, after adjusting for the effects of mergers, banks below the top 1,000 on average increased in asset size almost twice as fast as the top 1,000 since the mid-1990s. And, in spite of the perception that that the largest banks have a "too big to fail" funding advantage, banks below the top 1,000 increased their uninsured deposits at twice the rate of the top 1,000 during the same period.

Small bank profitability has remained relatively strong and stable for the past several years. FDIC data reveal that banks with assets under $1 billion achieved higher returns on assets (ROAs) on average than larger banks in 7 of the last 10 years. And small banks remain sound: banks under $1 billion in assets have consistently reported higher capital ratios and lower nonperforming asset ratios than their large bank counterparts. Perhaps the most revealing indicator of the robust health of community banking is the chartering of over 1,350 new banks and over 180 new thrifts during the last 10 years.

In short, community banks are quite healthy, continue to adapt successfully to the changing financial and technological environment, and remain valued by millions of customers who rely upon your special quality of service. Consequently, I expect well-managed community banks to continue to play an important role in financial intermediation in America.

Let me turn to two issues of importance to the Treasury where I think you can play an important role: financial education and predatory lending.

A world in which smaller institutions can manage risk by selling assets into the secondary market is, unfortunately, also a world in which problems such as predatory lending may emerge. Let me be clear: I think that the secondary market is a great development, one that has helped both banks and consumers. But it does change the incentive structure at the margin.

When loan originators sell their production into the secondary market they have an increased incentive to pursue volume, which may be inconsistent with a thorough credit review and fair dealing with customers. Secondary market holders of the credit risk manage broadly diversified portfolios in which credit risk management practices differ from those used by a traditional originator and holder of credits. Because the secondary market approach to financing credit may sever the ongoing customer relationship an originator has with a borrower, at the margin, there is both an incentive and an opportunity for bad actors to enter the scene.

At Treasury, Assistant Secretary Sheila Bair has done a terrific job - in so many ways, but also - in addressing the problem of predatory lending by encouraging the development of best practices throughout all segments of the mortgage industry - brokers, lenders, and secondary market participants. A number of mortgage industry participants have developed best practices and Assistant Secretary Bair has been evaluating these efforts. While your banks and other federally regulated depository institutions are generally not associated with predatory lending problems, we urge you to adopt practices that help your banks avoid predatory lending situations. In doing so, you model good corporate citizenship in this area and establish a standard for others in your communities to follow.

We must also do more to educate consumers so they are in a better position to provide a first line of defense against abusive lending practices. This brings me to a second issue of importance to both community banks and the Treasury: financial education. As Secretary O'Neill recently noted, while financial independence is a goal all Americans share, many Americans never learn the basics of personal finance. We must work to ensure that all Americans have the knowledge and the tools to build their own financial security. Our schools need to teach the basic rules of personal finance.

As part of our long-term commitment to improve financial education for all Americans, we recently established an Office of Financial Education at the Treasury, which will develop and implement financial education policy initiatives and will oversee and coordinate our outreach efforts. We are also collaborating with the Department of Education to encourage all schools to integrate financial education into their curricula.

By helping us promote financial education, you have an opportunity not only to help individuals become more financially astute, but to secure future generations of loyal customers. We applaud the ICBA's interest in "Bank on Your Schools," a partnership between schools and financial institutions to promote financial education in low and moderate-income areas. This initiative will encourage financial institutions to open student-run branches in high schools, or give students a chance to work in the institutions themselves. Students will get hands-on experience and they'll learn about the importance of saving and managing money.

Another issue I would like to touch on briefly has to do with an increasingly important source of funding for community banks, the Federal Home Loan Banks. Last fall, the Federal Housing Finance Board published a notice and solicitation of comments on the issue of a single depository institution concurrently belonging to multiple Federal Home Loan Banks.

Like the ICBA, we believe that a plain reading of the relevant language of the Federal Home Loan Bank Act strongly suggests that the Finance Board does not have legal authority to grant multi-district membership. Nor do we think that the relevant legislative history supports such an interpretation of the statute. We also question whether multidistrict membership serves the interests of the System's community banks and thrifts.

Finally, we share with you a common interest in deposit insurance reform. I've already described the recent strong performance of small banks and the bright future I see for you.

What I don't understand is why you want to pursue increased insurance coverage limits that will only worsen the problems of moral hazard and the regrettable perception that the largest banks are too-big-to-fail.

It is reasonable to be concerned that moral hazard increases costs born by healthy banks. Yet raising the deposit insurance coverage limit will worsen, not dampen, these problems. So I don't get it. Why expand moral hazard by increasing coverage limits when doing so will do absolutely nothing to improve the competitive position of small banks vis-à-vis large banks? This makes no sense to me, especially when you have demonstrated your ability to compete successfully for deposits, including uninsured deposits.

We also know that, with the BIF's reserves just above 1.25 percent, increased coverage will dilute those reserves to an extent that makes paying higher insurance premiums inevitable. And for every additional $30,000 in insured deposits you may be able to offer a customer, some of your large bank competitors will be able to offer multiples of that amount in insurance coverage through the control of several affiliated depository institutions.

There are so many aspects of deposit insurance reform where we agree. First, reforms we agree upon would compensate small banks for the adverse effects of "free riders" on the insurance fund. Rapid insured deposit growth from sweep programs conducted by a couple of large financial companies controlling multiple subsidiary banks - without compensating the FDIC - has reduced the BIF reserve ratio by 4 basis points. The proposed transition assessment credits offsetting future premiums would recognize the contributions that many of your banks made to reserve growth in the early-to-mid-1990s. Newer and recent fast-growing institutions would be eligible for proportionally fewer (or no) credits against future premiums. The proposed premium-setting reforms would also prevent future "free rider" inequities.

Second, merging the bank and thrift insurance funds would not only better diversify risks but - especially in light of the BIF reserve ratio's recent decline to 1.26 percent - reduce the size of any possible premium levied on the great majority of you that are BIF members.

And third, eliminating triggers in the current system that have the potential to force banks to pay very higher premiums at a time when the economy may be under serious stress just makes good sense for well-being of the financial system and for general economic stability.

In conclusion, let's recognize that the Treasury and the nation's community banks agree upon so many more things than we disagree. Let's work together to thwart abusive lending practices, to increase the financial literacy of our country's youth, and to preserve a strong deposit insurance system that promotes competition, fairly allocates costs, and protects taxpayers.