Breaking Down the Walls and Building Giants: Bank Powers and Consolidation in the Twenty-First Century

by James M. Rockett *

Banking is, and during the past 25 years of my legal practice has been, a highly regulated industry. I recall sitting in the Board of Directors room of United California Bank and listening to a senior executive proclaim the end of the world because an amendment of Regulation Q was being debated which would allow interest on demand deposit accounts, an unthinkable concept. In those days, banks and bankers relished regulation because competition was in a very narrow band and the customer was a hostage of the inefficiencies created by governmental oversight. Now as we approach the Millennium we hear revolutionary thoughts of deregulation. HR 10 is debated with every imaginable interest group fighting to preserve its special position in the current regulated hierarchy. Politicians line up to choose sides (and incidentally solicit campaign contributions) in a debate that will possibly affect the future delivery of financial services in the United States. But rather than focus on the numerous issues of HR 10, I propose instead to review the philosophical underpinnings for banking powers and consolidation.

In actuality, the revolution in banking has been more subtle than we at first glance realize. In fact, through the forces of the marketplace, changes have evolved making the role of politicians increasingly irrelevant. Viewed over the past two decades, expansion of banking powers has been dramatic: Banks offer securities in their branches and sell insurance on their premises; they have sweep accounts for corporate customers (thus circumventing the remaining limitations of Reg. Q); bank products are offered over the Internet to customers without geographic limitation. And changes such as these have taken place without any significant statutory revisions. Yet the pall of regulation continues to inhibit banking opportunities which would benefit customers, shareholders and communities.

Similarly, consolidation has become a defining force in banking. Suddenly even the largest institutions are being sold and merged at a prodigious rate. Small community banks and regional institutions seem to be a dying breed. The rush to bigness appears to have no bounds. The zeitgeist commands size and little thought is given to the consequences as mergers create bureaucratic behemoths.

The market forces behind expanded banking powers and consolidation could be no more dramatically demonstrated than when, in a breathtaking moment last year, Citibank and Travelers announced a merger creating a giant financial services company that appeared to defy current law. And, within minutes after that announcement NationsBank acquired Bank of America to become the largest retail banking franchise in the world. At the same time, some of the country's largest insurance carriers and industrial companies have entered the world of banking through the side door by acquiring thrift charters from the Office of Thrift Supervision.
These charters have evolved to include most if not all of the characteristics of a commercial bank, and the companies entering banking through this route are theoretically prohibited from commercial banking. Other companies are availing themselves of even greater freedom by chartering state-regulated, FDIC-insured, deposit-taking institutions called industrial loan companies in states like Utah, Nevada and Arizona. Yet, no comprehensive (or comprehensible) scheme exists to rationalize the incongruencies of these actions and the underlying rationale for existing law. Regulators continue to beat up on the obvious and easiest targets, while our regulated financial institutions struggle to be competitive in the face of restrictions dating back 60 years.

The topic at hand is the current regulatory scheme and whether and to what extent banks should enjoy greater freedom from regulation. As a Federalist, I am and will always be skeptical of governmental intrusion on the free market. I have yet to meet a regulation, no matter how well intended, that provides the ultimate benefits promised. Yet the pragmatist in me recognizes that because it provides deposit insurance, the government will play a role in controlling banks and the real question must be how to balance regulation with competition. And in establishing that balance, we must consider whether there are necessary limits on powers that would allow banks to compete effectively while not adversely affecting the parallel protections intended to protect the public through regulation. For instance, should industrial companies be precluded from owning commercial banks and, if so, why? Or, should banks be denied the authority to underwrite securities, or offer insurance for sale in branches or become an Internet service provider? If any of these powers should be denied, what is the basis for such a determination?

We also need to consider the impact of consolidation on all of the constituencies of banks, their shareholders, customers, employees and communities. Is the rush to size consistent with the best interests of any or all of these constituencies? Certainly, shareholders in the short term seem to be in favor of combinations. But customers and communities appear to be both short term and long term losers. In my experience in bank mergers, very little thought, other than nodding recognition, is given to the needs of the customers and the communities served by the combining institutions. It is hard to believe that, in planning a merger, bankers do not first evaluate the customer base and focus on fulfilling the needs of that constituency as a primary priority; and yet, time and again this is the least considered element of a merger. As importantly, the communities served by the target institution often are alienated and the resultant animus can take years to mend.

As we think about consolidation, the world of community banking is one which appears to be imperiled. The history of banking in the U.S. has been one in which there has been a diffusion of banks. Until recently, branch banking has been rare and unit bank states had a separate bank in every town. Community banking has been the backbone of our country's banking system. Consolidation would appear to be the end of the road for what is perceived to be a very inefficient structure. And yet, like the mythical Phoenix, community banks re-assert themselves as de novo institutions throughout the country. Is there a future for community banks? Can they survive consolidation? Will the giant institutions (not to mention the strengthened regional banks) render community banks incapable of true competition? How can independent banks survive in an era of increased technology? The betting seems to be that small banks have no future for these and other reasons.
Where would you place your bet?

My own thoughts are these: As to powers I submit that there is very little justification for restricting the financial services products that should be permitted to banks. Banks have a powerful distribution network and, if they can conveniently meet customer needs, those products should be available through banks. The Depression-era justifications for restrictions have no relevance today and, I submit, had no relevance then. That said, I have very severe reservations that banks, once handed a new sack of toys in the form of enhanced powers, would execute profitable business plans measurably adding to shareholder value or meaningfully changing the currently available product mix. In fact, the evidence is that grandiose business plans by bankers inevitably fail, not because the ideas are unsound but because the talent to execute such plans has been lacking and institutional focus becomes diffused.

Currently I watch Citigroup with a mixture of curiosity and skepticism. Thus far there is little indication that the sum of the parts is any greater than the value of each entity on a stand alone basis. And, there is empirical evidence that such a plan will ultimately fail. For example, one only has to examine the efforts of Sears Roebuck in the 1980s to see that grouping a series of apparently related financial services products under one flag is not a panacea. In that instance, Sears began with its retail stores, an incredible consumer-based platform from which to offer its products. It then brought together Allstate Insurance, Dean Whitter brokerage, Discover Card and added Sears Savings Bank, a one-stop consumer emporium of financial products. Yet, in the final analysis, consumers failed to respond and the parts became more valuable as stand alone entities. Granted Citi has an even greater platform from which to approach customers. But, can Citigroup manage to cross-sell its various units at a time when most banks find it difficult to cross-sell their own related products? I submit that until this happens, old fashion commercial banking will continue into the Twenty-First Century regardless of the outcome of the financial powers debate. Moreover, it will be response to the market place that will cause the evolution of new products and services, not the granting of greater powers.

As to consolidation of banking, I also am skeptical. Certainly there is economic evidence that our current diffused model of banking contains excess capacity. Economics will inevitably force consolidation in such circumstances. But, the idea that bigger is better has never proved to be true in banking. Ultimately the cost of bloated bureaucracies in our large institutions, with related customer dissatisfaction, results in inefficiencies that more than offset the gains in apparent delivery power. For this reason, I continue to believe that independent banking will not disappear in the next Millennium. Perhaps the smallest institutions will not be able to compete effectively, but there is a great deal of room for community based institutions that can execute a well defined, carefully focused business plan. The issue of technology, in my view, actually works to the benefit of small institutions. First, the research and development costs of sophisticated systems falls primarily on the largest institutions. Once they perfect the technology and gain customer satisfaction, follow-on technology is available in the marketplace at extremely competitive costs through third party vendors. This process has largely solved the technology gap of small institutions. Moreover, the availability of banking through the Internet minimizes the advantages of size and promotes competition based on pricing and products. Well-managed independent banks will be able to compete successfully on the internet and will prosper through a close relationship to their communities combined with personal service and the deployment of well considered technology.

* Mr. Rockett is a partner in San Francisco CA office of McCutchen, Doyle, Brown & Enersen LLP <>. This article is taken from his remarks before the Financial Institutions Practice Group's conference, Banking in the New Millennium, on June 4, 1999 in St. Louis, Missouri.


2001 The Federalist Society