Commercial banking - Industry Overview

Commercial banks have, for the past several years, been operating in an environment fraught with economic and financial problems. These include bad real estate loans in portfolios already burdened with borrowings for takeovers and for third world loans, the failure of a number of well-known financial institutions, the aftermath of the savings and loan crisis, and finally the economic downturn of 1990-91. The problems have given rise to numerous corrective suggestions from the Administration, Congress, banking regulators, and the commercial banking community itself.

These suggestions cover a wide range of options, such as establishing new ratios for capital, liquidity, earnings, risk concentration, and asset quality, as well as modifications in regulatory and supervisory procedures, limitations on deposit insurance, authorizing of new bank activities in securities and insurance, and expansion into interstate banking.

In an effort to be more competitive both domestically and internationally, many large banks have decided to join forces with other large banks, creating new combinations of giant financial institutions with more capital and assets, and larger branch networks. This trend of mergers and acquisitions will most likely spread over the next few years to medium and small banks, as they, too, try to face one of the principal weaknesses of the U.S. banking system, namely the lack of product and geographic diversification. Product diversification would involve abolishing the National Banking Act of 1973, known as the Glass-Steagall Act, which separates banking and commerce, while geographic diversification would involve abolishing the McFadden Act of 1927 and the Douglas Amendment to the Bank Holding Company Act of 1956, which prohibit banks and bank holding companies from interstate deployment.

Failures and Problem Banks

Despite the problems that banks continue to face with their loan portfolios, fewer banks failed in 1990 than in each of the three previous years. The failure total for 1990 was 168, compared to 206 in 1989, 200 in 1988, and 184 in 1987. Any sustained improvement, however, is unlikely, although much will depend on the strength of the overall economy. Projections by the Federal Deposit Insurance Corporation (FDIC) put bank failures at 180 in 1991, and 160 in 1992.

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Banks on the problem list of the FDIC also fell in 1990. This decline, which started in 1987, continued into 1990 when 1,045 banks made the list. This compares to 1,110 in 1989, 1,415 in 1988, 1,443 in 1987, and 1,484 in 1986.

As a consequence of the bank failures, the Bank Insurance Fund, which totaled $8.4 billion at the end of 1990, is expected to fall to $4 billion at the end of 1991, and $3.5 billion at the end of 1992. To make up for the losses, the FDIC in mid-1990 boosted the insurance premiums banks pay, from 19.5 to 23 cents for each $100 of domestic deposits.

Profitability of Banks

The profitability of insured commercial banks declined once again in 1990 from the already depressed level of 1989, according to the Federal Reserve (Table 1). The weakness in earnings reflected substantial additions to loss provisions by medium and large banks for commercial real estate and domestic business loans. Specifically, the average return on assets, measured by net income as a percentage of average fully consolidated assets, went from 0.51 to 0.50 percent for all banks, although the drop was more pronounced for larger banks.

The average return on equity, measured by net income as a percentage of average equity capital, also decreased for the industry as a whole, going from 7.94 in 1989 to 7.77 percent in 1990. As with the return on assets, the decline was more pronounced for larger banks.

The profitability of several large banks continued to be depressed in the first half of 1991 due mainly to mounting real estate loss provisions and declining performance of loans to highly leveraged firms.

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INTERNATIONAL ACTIVITIES

Having grown steadily throughout the 1970's and 1980's, the number of foreign bank offices in the United States reached 727 at the beginning of 1991 (Table 2). These offices include 370 branches, 224 agencies, 101 subsidiaries more than 25 percent owned by foreign banks, 22 Edge Act and Agreement Corporations, and 10 New York State Investment Companies. Nearly one-half of the offices are in New York, with most of the rest in California, Illinois, and Florida. Japan, Canada, France, and the United Kingdom have the largest number of bank offices in the United States. Assets of foreign bank offices in the United States have increased significantly in recent years, rising from $198 billion in 1980 to $787 billion in 1990.

Owing to consolidation and restructuring of U.S. banks, both domestically and internationally, there has been a decline in the number of U.S. branches operating in foreign countries. By the end of 1990, 126 Federal Reserve member banks were operating 819 branches in foreign countries and overseas areas of the United States, a decline from 916 branches at the end of 1985. Of the total 126 banks, 99 were national banks operating 702 branches, and 27 were state member banks operating the remaining 117 branches.

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National Treatment Study

The National Treatment Study issued by the U.S. Treasury Department in 1990 focuses on efforts to eliminate discrimination and open foreign markets to U.S. financial institutions. For more backround information on the study see Chapter 47 (Commercial Banking) in the 1991 edition of the U.S. Industrial Outlook.

Results of the study conclude that U.S. Government efforts through bilateral and multilateral negotiations have contributed to greater liberalization and equality of competitive opportunity in banking and securities markets around the world. The U.S. Government has conducted discussions bilaterally with Canada, the European Community, the Republic of Korea, Japan, Venezuela, Mexico, Taiwan, and other countries, and multilaterally at the Organization for Economic Cooperation and Development, the World Bank, the International Monetary Fund, and the Uruguay Round of the General Agreement on Tariffs and Trade.

Despite outstanding problems, important strides have been made in opening and liberalizing Japanese financial markets, according to the study. In addition, significant improvements have been made in Canada, in many individual European countries, and potentially in the European Community (EC) under the Second Banking, the Investment Services and other financial directives. Only modest progress was made in newly industrializing economies, such as the Republic of Korea and Taiwan. One disappointing area is the lack of progress in gaining access to financial markets in most major Latin American countries.

Unfair Restrictions and Anti-Fraud Proposals

Two proposals pending in Congress in 1991 were aimed at lifting restrictions on U.S. banks abroad, and checking abuses in foreign banking in this country.

As a result of unfair restrictions imposed by other countries on U.S. banks and financial service companies, and because of significant denials of non-discriminatory treatment, the Fair Trade in Financial Services Act was reintroduced in 1991. Among other things, it would deny applications to operate in this country by banks in other countries that discriminate against U.S. companies.

In response to recent fraud and other criminal activity by a few foreign banks, another bill was introduced in 1991 to strengthen Federal and state supervision and regulatory authority over foreign banks operating in the United States. The Foreign Bank Supervision Enhancement Act of 1991 is aimed at correcting several supervisory gaps in the International Banking Act of 1978 and at ensuring that foreign bank operations in the United States are regulated, supervised, and examined in the same manner as U.S. banks.

Specifically, the Act would establish uniform Federal standards for entry and expansion of foreign banks in the United States, including a requirement of consolidated home country supervision and the application of the same financial, managerial, and operational standards that apply to U.S. banks. In addition, the Act would grant regulators the power to terminate the activities of a foreign bank that is engaging in illegal, unsafe, or unsound practices and provide regulators with the information-gathering tools necessary to carry out their supervisory responsibilities.

Outlook for 1992

Following a period of two years during which commercial bank loans had a slower than normal growth while, as a consequence, bank investments had a higher than normal growth, 1992 will usher in an economic upturn that will be readily financed by the considerable liquidity available in the banking industry. A flexible monetary policy together with measures on the fiscal front will combine to produce stable and sustainable economic growth in 1992.

Long-Term Prospects

The changes expected in the financial services sector over the next decade will have a profound effect not only on the commercial banking community but on the whole U.S. economy. In part, these changes result from efforts by Federal and state commercial banks to free themselves from what they perceive as regulatory burdens they feel have impeded their growth. The changes also are the culmination of intense competition generated on the retail level by credit unions, savings and loan associations; mutual savings banks, finance companies, and large retail stores, as well as at the wholesale level by commercial paper issuers, investment banks, Eurodollar markets, and foreign banks in the United States.

This competition between banks on the one side and retail entities on the other has resulted over the years in market changes and in regulatory and legal actions that have increasingly blurred the distinction between these establishments. Access to technological developments in computers, communications, and transportation have made the competition more intense.

Modernizing the System

In response to these competitive changes, the Administration and Congress in 1991 considered sweeping new proposals to modernize and strengthen the U.S. financial system. The proposals represent the most far-reaching restructuring of the industry since the series of banking and financial regulatory acts of the 1930's. Here are some of the main proposals, as embodied in the Administration bill entitled, Financial Institutions Safety and Consumer Choice Act:

* Deposit Insurance: The bill limits coverage for an individual to $100,000 per institution, plus an additional $100,000 per institution for a retirement account.

* Too Big to Fail: It authorizes the Treasury and the Federal Reserve to jointly determine if, in order to protect the nation's financial system, the coverage of uninsured depositors is warranted.

* Bank Insurance Fund: Leaves the FDIC with its existing $5 billion credit line from the Treasury, permits it to borrow up to $25 billion from the Federal Reserve Bank, and places a cap on the maximum aggregate assessment rate to be charged to Fund members.

* Risk-Based Premiums: Requires the FDIC to develop a risk-based assessment system that would base premiums upon the capital adequacy of a bank. Categories of risks will be established using the ratio of capital to risk-weighted assets.

* Interstate Banking: Amends the McFadden Act to permit national banks to branch interstate. It would also repeal three years after enactment the Douglas Amendment to the Bank Holding Company Act, thus removing restrictions on interstate acquisitions of banks by bank holding companies. A state would still be able to restrict interstate branching of all state and national banks operating within its borders.

* New Activities: Repeals some key elements of the Glass-Steagall Act. It requires all bank holding companies to become financial services holding companies (FSHC). Well capitalized FSHC'S could engage in securities, insurance, and mutual fund activities through affiliates. A number of strict firewalls would be erected to separate the bank from its new affiliates.

* Foreign Banks: Foreign banks in the United States that wish to engage in the new financial activities would be required to establish a FSHC. If they did not wish to engage in such activities, they would be able to continue to operate through agencies or branches. Any grandfathered nonbanking activities authorized under the International Banking Act of 1978 will be terminated three years after enactment of the bill.

* Banking and Commerce: Allow a commercial firm or a financial service firm to own a well-capitalized FSHC through a diversified holding company (DHC). These diversified holding companies would have no limits on the types of activities in which they could engage. However, a bank owned by a diversified holding company would be separated from commercial activities by stronger firewalls than those between the bank and financial affiliates.

* Regulation and Supervision: The existing four Federal regulators, i.e., Federal Reserve, Office of Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation FDIC), and Office of Thrift Supervision (OTS), will become two: the Federal Reserve and a new Office of Depository Institutions (ODIS) in the Treasury. The Federal Reserve will be responsible for all state-chartered banks and their FSHCS and DHCS, while the ODIS will be responsible for all national banks and their FSHCS and DHCS. Regulatory functions of the FDIC relating to state-chartered non-member banks will be transferred to the Federal Reserve. OTS and OCC activities will be taken over by ODIS.

These provisions seek to address many of the problems afflicting the U.S. banking industry, an industry in some turmoil today. They would, when enacted into law, strengthen the deposit insurance system, broaden the choice of financial products offered by banks to consumers, while also ensuring the safety and stability of U.S. financial markets through improved capitalization and regulation. At the same time, the restructuring is aimed at putting U.S. banks on a more competitive footing with foreign institutions, and with domestic retail entities. The next one or two years will be crucial in establishing the framework that will affect the operations of U.S. financial institutions in the closing years of this century.

Additional References

1991 U.S. Industrial Outlook, U.S. Department of Commerce. Available from Superintendent of Documents, Government Printing Office, Washington, DC 20402-9325. Telephone: (202) 783-3238. (S/N 003-009-00586-8, $28.) ABA Banking Journal, (various issues), American Bankers Association, 1120 Connecticut Ave. NW, Washington, DC, 20036. Telephone: (202) 620-7200. American Banker, (various issues), One State Street Plaza, New York, NY 10004. Telephone: (212) 943-6700. Annual Report 1989, Board of Governors of the Federal Reserve System, Washington, DC, 20551. Telephone: (202) 452-3000. Braverman, Philip, The Weekly Credit Market Report, (various issues), DKB Securities Corporation, One World Trade Center, Ste. 5147, New York, NY 10048. Telephone: (212) 488-0500. Brunner, Allan D., Duca, John V., and McLaughlin, Mary M., "Recent Developments Affecting the Profitability and Practices of Commercial Banks," Federal Reserve Bulletin, July 1991, Board of Governors of the Federal Reserve System, Washington, DC 20551. Telephone: (202) 452-3000. Candilis, Wray O. (ed.), United States Service Industries Handbook, 1988, Praeger, 521 Fifth Ave., New York, NY 10175. Telephone: (212) 685-5300. Federal Reserve Bulletin, (various issues), Board of Governors of the Federal Reserve System, Washington, DC 20551. Telephone: (202) 452-3000. Modernizing the Financial System: Recommendations for Safer, More Competitive Banks, February 1996, U.S. Department of the Treasury, Washington, DC 20220. Telephone: (202) 566-2000. National Treatment Study, 1990, U.S. Department of the Treasury, Washington, DC 20220. Telephone: (202) 566-2000. United States Banker, (various issues), Kalo Communications, Inc., 10 Valley Drive, Greenwich, CT 06831. Telephone: (203) 869-8200.

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