Changing Financial Industry Structure and Regulation

By Brewer, Elijah, III; Evanoff, Douglas D. | Chicago Fed Letter, September 2000 | Go to article overview

Changing Financial Industry Structure and Regulation

Brewer, Elijah, III, Evanoff, Douglas D., Chicago Fed Letter

On May 3-5, 2000, the Federal Reserve Bank of Chicago held its 36th annual Conference on Bank Structure and Competition, focusing on the changing financial industry structure and regulation. As barriers to geographic expansion have been removed, there has been a significant increase in the number and size of bank mergers in the U.S. Between 1990 and 1999, bank mergers and acquisitions averaged about 550 per year compared with 345 per year in 1980-89. As a result, the number of banks operating in the U.S. has declined about 30% since 1990.

Beginning in the 1980s, market, legal, and regulatory developments allowed commercial banking organizations limited entry to products and services that were previously offered exclusively by other segments of the financial industry. With the passage of the Financial Services Modernization (Gramm-Leach-Bliley) Act of 1999, which allowed the operation of commercial banking, investment banking, and insurance underwriting in the same holding company, consolidation in financial services is expected to continue.

What opportunities does the recent trend present for the financial services industry and what changes will be required of regulators? How will the industry structure be affected by the development of Internet banking? Will these developments curtail the role of the smaller community bank or might they actually enhance it? How might the "unbanked" sector of the population be affected by these developments? Alan Greenspan, chairman of the Federal Reserve System, addressed these questions in his keynote speech. To further explore the conference theme, a special session was held, featuring James M. McCormick, First Manhattan Consulting Group; J. Robert Kramer II, U.S. Department ofjustice; James Chessen, American Bankers Association; Malcolm Bush, Woodstock Institute; and Thomas K. Brown, Second Curve Capital.I In his keynote address, Greenspan observed that the "most dramatic change in the financial landscape that the Gramm-Leach-Bliley Act may have induced is not the combination of banking, securities underwriting, and insurance, but rather the generalized merchant banking powers for financial holding companies." These powers give banking organizations the authority to make equity investments in nonfinancial firms and will have a significant impact on the structure and effectiveness of the industry. Greenspan's comments underscored the necessity for regulators to monitor and control the risks of these activities and to ensure they are managed in ways that do not undermine the viability of the banking and federal deposit insurance systems.

New opportunities for financial service providers

In the theme panel discussion, Chessen described the banking environment as "constant whitewater," with deregulation and technological innovations providing important strategic opportunities. The Gramm-Leach-Bliley Act allows banks to offer one-stop financial services to their customers. McCormick and Brown argued that banks' success will depend on their ability to adapt and operate efficiently in this new environment. Since economists often examine efficiency by concentrating on cost advantages from increases in a firm's scale of operation, scale could be used to spread the fixed cost of the new technology over a larger customer base and improve the organization's overall efficiency.

The most typical conclusion from studies of scale economies among LT.S. banking firms is that potential gains from scale economies via internal growth or merger are relatively limited. Brown argued that "scale has never been important in banking." Brown and McCormick criticized the consolidation trend in banking, citing it as one of the causes of the poor performance of bank stocks. According to Brown, there are no substitutes for good management with a thorough knowledge of the demands of the customer base. He outlined six steps that banking organizations need to take to be successful in this new environment: 1) recognize the need for dramatic changes in the way they do business; 2) sharpen the focus of the company; 3) become totally customer centric; 4) build and maintain an innovation engine; 5) improve the speed of the company; and 6) have the right personnel to deliver high-quality services. …

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