FDIC Advisory Committee
November 19, 2003

The operating environment for banks has undergone rapid and continual change over the past 25 years. Market forces, aided by technological change, have made the world smaller. Globalization has heightened competitive pressures in every corner of the economy, from mining to manufacturing to agriculture to financial services.

Demographic shifts and changing preferences have created a new breed of consumer. The aging of baby boomers, the influx of immigrants to the U.S., and the depopulation of rural areas in favor of suburbs continue to reshape household spending and saving patterns. Particularly over the past decade, households embraced an "investor culture" that spurred the growth of new investment vehicles and brokerage accounts.

In addition, financial innovation - including securitization, the development of derivative instruments and the commoditization of credit - has shaped a revolution in lending. These marketplace changes were profound, and have continued to challenge banks to be agile, to adapt, to drive innovation rather than chase it, and to find new ways to serve businesses and consumers.

Public policy also has played a role. Legislative reforms following the crisis period (FIRREA, FDICIA) introduced safeguards that did not exist previously. The firm footing provided by the post-crisis reforms led the way for the Riegle-Neal Act and Gramm-Leach-Bliley to adjust the regulatory framework to recognize market forces driven by geography, products and powers.

The Changing Role of Banks. Over the past 25 years, we have seen a dramatic transformation in the way funds are channeled from savers to spenders. Competition among financial service providers has intensified steadily throughout this period and, by some measures, it appears that banks are losing ground. However, bank managers took steps to adapt their business strategies to a changing environment. Other measures indeed suggest that banks may be holding their own and remain vital and necessary components of America's financial system.

In the last twenty years, financial activity in the U.S. increased significantly relative to the overall economy. This is evident in the explosion of non-financial sector debt relative to GDP, which was stable for some 30 years prior to the mid 1980s but subsequently has grown by more than 50 percent (from 1.3 to nearly 2.0).

The banking industry's share of this expanding financial activity has not kept pace. Since 1980, the total value of money market, mutual fund and deposit instruments in the U.S. grew from just under $2 trillion to some $11.6 trillion. During this time, the share of these instruments issued by money market funds and mutual funds increased from seven percent to 55 percent, while the share issued by banks fell from 90 percent to 41 percent. On the asset side, banks' share of debt owed by the non-financial sector declined significantly over the same period.

Nonetheless, other signs are more favorable. First, the banking industry's share of financial sector net income has remained relatively stable over the past twenty years (Figure 1). Further, banks' share of important markets stabilized recently. Banks remain the leading providers of credit to small businesses.

Moreover, looking only at balance sheet data understates the services provided by commercial banks. For example, banks originate significantly more mortgages than they directly fund. Seven of the ten largest mortgage originators are FDIC-insured institutions or their affiliates.

For both mortgage and credit card securitizations, banks often originate, service and monitor the accounts. The banks then channel receivables into packages that can be funded by investors. This has markedly altered banks' role in providing credit.

Taken together, these facts leave us with two possible views of banking: a declining industry that is likely to play a diminished role in the future financial system, or a changing industry that is adapting effectively to financial innovation and evolution.

Industry Consolidation. From 1984 through June 2003, the share of industry assets held by the ten largest organizations rose from 19 to 44 percent. While the pace of merger activity among the largest institutions may slow going forward due to statutory limitations, there is considerable room for mergers among those in the next tier, primarily the large regionals.

Should we be concerned about increasing concentration? The U.S. banking industry is not particularly concentrated relative to those of other developed nations and is significantly less concentrated than many non-financial industries in this country (Table 1). Nonetheless, it is important for regulators to understand large, complex risk exposures and to prevent undue concentrations of risk. Large-bank supervisory efforts are focused on these objectives.

The numbers of community banks have shrunk dramatically since 1985, from over 14,000 to under 7,500 today. This reflects two distinct eras, the crisis period and, later, the period of restructuring ushered in by Congress's liberalization of interstate branching in the mid 1990s.

More recently, we've seen a slowdown in the pace of consolidation. Rural areas dependent upon declining industries have continued to lose community banks as people move to more prosperous areas, particularly suburbs. These areas commensurately have gained new banks. Over 1,200 new banks have been chartered in the past ten years, primarily in fast-growing suburbs. These patterns are likely to continue, with the numbers of community banks stabilizing overall.

Policy Issues. The industry's transformation and consolidation trends will present interesting questions to policymakers over the next decade. The answers to these questions will shape the future of banking. Among these are regulatory burden, privacy, capital regulation, and the mixing of banking and commerce.

Regulatory Burden. A particular concern for community bankers is regulatory burden. The FDIC is taking action to reduce undue regulatory burden for institutions of all sizes. We have established a special task force to reevaluate the FDIC's examination process and supervisory practices, and the FDIC also is leading an interagency effort to identify unnecessary burden, duplication, and outmoded restrictions (EGRPRA).

Privacy. While consumers today have access to a wide variety of means to conduct their financial business, the issue of secure personal information is increasingly a concern. There is a tension between the advantages provided by modern technology - speed, increased access to credit, portability of credit - and the same technology's potential for abuse. This is accompanied by customer concerns regarding identity theft and a general loss of privacy through the dispensing of personal information. Challenges lie ahead for the financial services industry in alleviating these concerns.

Capital Regulation. As a member of the Basel Committee, the FDIC has three basic goals for Basel II: (1) capital requirements should be sound, including preserving and maintaining minimum capital requirements; (2) the standards should be designed so that they may be implemented and supervised effectively in the real world; and (3) any new standards should not produce substantial adverse unintended consequences. Public comments have been filed and are being analyzed by the agencies. Whatever final form the agreement takes, it is bound to have a significant impact on both how banks manage risk and capital, but also on how the regulators handle the regulation of this critical banking resource.

Banking and Commerce. Looking ahead, it seems inevitable that market forces will push in the direction of more blending of banking and commerce. One question will be, what constitutes an appropriate and measured regulatory response?

At a July FDIC conference on this topic, participants observed that we may need to reconcile, or perhaps choose between, two regulatory approaches. The first is known as "umbrella supervision" of the overall organization. As more commercial activity becomes associated with banking, the commercial activity is subject to umbrella oversight. Some feel this is necessary because companies manage risk at the overall firm level. Under this approach, a greater share of economic activity would come under the umbrella over time and likely would be altered in some way by such oversight.

The second approach might be termed the "safeguard approach," which attempts to insulate the entity that has explicit safety net protection - the bank - from the risks and conflicts that may arise from non-bank affiliations. One benefit of such an approach may be that non-bank economic activity would continue to be overseen by market forces.

Finally, participants noted a more general concern about the mixing of banking and commerce, that over time, market forces could result in combinations of economic power that would be disturbing and even unacceptable.

This is by no means an exhaustive list. We've simply looked at the trends and identified several important issues that may emerge before policymakers in the short and medium term. The pace of change in the banking industry - and accordingly the policy questions that arise - will and should be a function of the marketplace's evolution. Nonetheless, these are issues we've looked at and would welcome input from the advisory panel about the best role for the FDIC in shaping the debate on these important questions.