Risk & Other Four-Letter Words

Wriston, Walter B.
1986

Banking in Wonderland

Banking in Wonderland

To understand what's going on in the banking business in the United States, which you should because it's your money, it is necessary to take a cue from a certain professor of mathematics at Oxford.

His name was Charles Lutwidge Dodgson and he was noted in academic circles of his time as the author of Euclid and His Modern Rivals as well as for other abstruse mathematical works. He is far more widely known by his nom de plume, Lewis Carroll, and over many years millions have delighted in his better-known work, Alice in Wonderland. Though he wrote Alice to amuse a six-year-old girl, I sometimes think Professor Dodgson was really prophesying the shape of the U.S. banking system, which defies comprehension in rational terms.

Imagine, then, as you read this, that a white rabbit with pink eyes appears, pulls a watch from his waistcoat, and leads us all through the looking glass into a wonderland called the American banking system.

In Wonderland, you will recall, logic never seems to work quite the same way as it does in, say, Wisconsin, and things are never quite what they seem. So it is also in banking and the financial services markets. For example, it is an article of faith that American banks do not compete across state lines; that certain kinds of banks do not compete with other kinds; that stockbrokers do not offer banking services; that insurance companies do not sell stocks; or that retailers and steelmakers do none of those things. In banking wonderland, everything is neatly compartmentalized in theory, but actuality is another matter entirely.

It's as if the March Hare, or is it the Mad Hatter, is running around shouting, "No room! No room!" at the tea party when in fact there is clearly room for everybody. But, like Alice, Americans have "got so much in the way of expecting nothing but out-of-the-way things to happen, that it [seems] quite dull . . .for life to go on in the common way."

So no one is astonished to open the newspaper and discover that the major New York commercial banks are in head-on competition with the First Nationwide Savings, a thrift institution with 140 offices coast to coast, which the courts and the regulators assure us does not compete with commercial banks, and certainly not across state lines, except that it does but apparently hasn't yet been enlightened to that fact. To compound your confusion, I might point out that the organization I headed before retirement, technically a New York-based one-bank holding company, now operates savings and loan organizations in Florida, Illinois, and California. These have been blessed by the courts and regulators and are perfectly legal-illogical, perhaps, but legal.

If you asked me to explain this, since I am not an Oxford mathematician I would have to say, as Alice did to the Caterpillar, "I'm afraid I can't put it more clearly, for I can't understand it myself to begin with."

It can be described, however, and the place to begin is at the beginning.

Our banking system is a part of our frontier heritage. Whenever the wagon trains stopped to water the horses, a couple of guys dropped out and opened a bank. That is why the United States today has more than 14,000 banks, 3,800 savings and loan associations, 430 mutual savings banks, and 21,000 credit unions. Unlike Canada, Great Britain, and most other nations, where fewer than a dozen large banks operate nationwide, we have a grand total of 41,591 depository institutions that will take your money for safekeeping, pay you a rent called interest for the use of your money, and then lend it to a third party-if possible, at a rate sufficiently higher than the rent to cover their costs of operation and, if managed properly, make a profit to finance their future growth.

Most of these depository institutions are small. Ninety-five percent of the more than fourteen thousand commercial banks in the United States have fewer than two hundred employees and assets of less than three million dollars, which is a small number in the banking business. Many still reflect a nineteenth-century image in their buildings and style of operations, as well as in their thinking. Outside they look like fortresses; inside they are public palaces. Lavish interiors give customers something to admire while waiting in endless lines as tellers cash checks, take deposits, and record all transactions by hand, despite the popularity of automated teller machines which give faster, more efficient service. Too many banks are still rooted in the nineteenth century, when bankers, who would not tolerate sloppy penmanship, proudly boasted that their account books were works of art and employees worked long hours and had to adhere to strict moral standards. The following set of rules, found in Citibank's archives, was typical of nineteenth-century banking:

The office will open at 7 A.M. and close at 8 P.M. daily except on the Sabbath. Each employee is expected to spend the Sabbath attending church.

Each clerk will bring in a bucket of water and a scuttle of coal for the day.

Make your pens carefully. Whittle the nibs to suit your taste.

Men employees will be given an evening off each week for courting purposes, or two evenings if they regularly go to church.

Any employee who smokes Spanish cigars, uses liquor in any form, gets shaved at a barber shop, or frequents pool or public halls, will give us good reason to suspect his worth, intentions, integrity and honesty.

The employee who has performed his labor faithfully and without fault for a period of five years in our service, and is looked upon by his fellow men as a law-abiding citizen, will be given an increase of ten cents per day in his pay.

The steady technological progress we have seen in this century seemed to have had little effect on many banks. Still relying on the old ways, these banks preferred to compete among themselves, and with other, nonfinancial institutions, by offering the customer a wide range of free services. In the 1920s, for instance, banks acted as railroad and theater ticket agents, made hotel reservations, maintained day nurseries for tired mothers, distributed seeds, and some even kept veterinarians on the payroll.

Things did not change much for a long time. Until quite recently, any time a bank wanted to run up its deposits, it offered toasters or blankets as premiums for opening a new account. A ten-dollar toaster hardly made up for the rip-off that was forced on consumers from 1965 to 1982; Regulation Q provided that the poor got 5.25 percent on their savings and the rich got 12 to 14 percent or more. The difference in dollars is not inconsiderable. In the first two years after Reg Q ended, banks paid an additional seventy billion dollars in interest on savings accounts at the new market rates. This consumer rip-off was just incredible and it went on for seventeen years, even though there are a lot more savers in this country than there are borrowers. Anyone with a sense of fair play would agree that the workingman should get the same market rate on his savings account that the rich man gets on his. But in cohoots with the government, the small banks and savings and loan institutions were happy to pay the lowest possible rate to savers. In turn, they lent money to local businesses, often at high rates that made competitive big-city banks green with envy. They bought government bonds with their surplus and they did very well indeed. They liked it that way and did not want things to change, and they succeeded at preserving the status quo long after the twin forces of inflation and technology reshaped the marketplace. Even now ignoring reality, banking continues to be hobbled in its ability to compete on equal terms with all comers as a result of rigid regulations, which suit the small banks and thrifts just fine.

The end result was predictable. Regulation Q, originally laid on at the behest of the savings and loan associations to give them an edge over banks, drove savings into market rate alternatives. Money market mutual funds grew to about four billion dollars in three years from the time the first one was founded, and then soared to over two hundred billion dollars in the next five years. To give you a time frame for that, Citibank was in business for more than one hundred years before its deposits reached the one-billion-dollar level.

It took a crisis to change that interest regulation because the small banks and S&Ls have about eight times more political clout than the big banks. In Cut Bluff, Montana, the president of the local bank, or S&L, is the finance chairman for the local congressman, and this is the situation all over the country -in fact, all over the world, wherever there is a multiparty political system.

If you sat up nights designing a system the consumer did not want, you would come up with something very close to today's American banking system. It wasn't intended that way. The Banking Act of 1933, commonly called the Glass-Steagall Act, provided the basic blueprint for American banking during the past fifty years. Its architects were Representative Henry Steagall, of Alabama, a member of the farm bloc, and Senator Carter Glass, a distinguished Virginian, onetime Secretary of the Treasury and the father of the Federal Reserve system. Both were fiscal conservatives and believers in competition. The senator, for example, once wrote:

There is entirely too much running to Washington by business, by agriculture and by labor. That way lies paternalism, with socialism just beyond. There are certain things necessary to be done, of course, which the people in their private capacities lack the power to do, and in such cases the public must operate through the government . . . and it is the proper function of government to prevent the erection of any unnatural barriers to the equality of opportunity.

The Glass-Steagall Act was never intended to separate or insulate certain industries from competition. Some of the restrictions it placed on banks did protect others from competition, but this result was an incidental side effect. Its primary purpose was to protect bank depositors and stimulate business in the wake of thousands of bank failures and the revelation of shocking, criminal conflicts of interest during the go-go boom of the late 1920s. Glass-Steagall was a response to widespread losses by depositors, who are not supposed to be risk-takers, and by shareholders, who are supposed to take risks but not the risk of dishonest management.

Consequently, the Banking Act of 1933 sought to restore the solvency and strength of banks and the confidence of depositors, and it had nothing whatsoever to do with the division of markets. That was set forth clearly in its title: "An Act to provide for the safer and more effective use of the assets of banks, to regulate interbank control, to prevent undue diversion of funds into speculative operations, and for other purposes.

This legislation went about accomplishing its purpose in an number of ways. It created the Federal Deposit Insurance Corporation. It banned payment of interest on checking accounts, with the apparent purpose of using the money thus saved to pay the insurance premiums of the FDIC. It placed limitations on loans to inside executives or affiliated companies. It increased reporting and examination requirements. It prohibited risking depositors' funds in underwriting corporate securities and in related activities. It dealt with other matters affecting banks-all with the objective of protecting their solvency and their depositors' and shareholders' funds.

Another cornerstone of bank regulation, the McFadden Act, was intended to preserve our illogical dual banking system, in which some banks are chartered by the federal government and others by the states. McFadden did this by limiting deposit-taking to one state, or even just one area of that state, at the discretion of the state's authorities. In practice, it became sort of a financial Mann Act, making it illegal and immoral to transport a deposit dollar over state borders.

Stocks and other segments of the securities industry were dealt with in a different framework when Congress enacted the federal securities laws in 1933 and in 1934.

The United States has a tradition of free enterprise and competition that is not only historic but also widely regarded as the foundation of our national strength and well-being. The concept is firmly rooted both in our tradition and in our body of law: the Sherman Act, the Clayton Act, the Federal Trade Commission Act, the Robinson-Patman Act, and hosts of state laws, all reaffirming the principle of competition. Banking is the only industry that is exempted from the Clayton and the Sherman acts by the fact that it's illegal to operate across state lines.

The American principle, which has been tested and proved, is that competition most efficiently produces the greatest well-being for the greatest number of people. It is confirmed by the strength of our economic performance domestically and in the world.

But instead of a free market, the U.S. is saddled with an outmoded, anticompetitive banking system that is the most fragmented in the world. There isn't a single bank in this country that has as much as 5 percent of a market. In fact, the largest single market share was 4.3 percent, which, incidentally, was held by the ill-fated Continental Illinois Bank in Chicago. I don't know of any other major industry that fragmented.

In addition, there are 340 foreign banking offices in the U.S., which hold more than 12 percent, or almost forty billion dollars, of all loans made in this country. In New York City alone, we have ninety-odd foreign banks and they have about 40 percent of our local business. Not surprisingly, the market share of the ten largest U.S. banks has not grown in the last nine years. I don't say that with any particular pride, but nine years ago the market share of the ten largest U.S. banks was 29.8 percent and at the end of 1981 it was 27.7 percent.

Globally, we have fallen behind too. Thirty years ago, forty-four U.S. banks ranked among the world's top one hundred, with 53 percent of those banks' global deposits. By 1981, only fourteen U.S. banks were among the top one hundred, and their share of deposits had declined to 15 percent. Only two American banks now remain among the world's top ten, in contrast to twenty years ago, when U.S. banks were numbers one through ten on the list. Another number that might interest you: there are now more Japanese banks in the top fifty financial institutions of the world than there are U.S. banks-sixteen versus seven.

I don't say any of these things to decry the growth of the foreign competition or the decline of the American share. Quite the contrary, I believe that welcoming all competition has been salutary for banking in general and the customer especially.

My view, from day one, has been that instead of putting handcuffs on them, why not take the cuffs off us? I'm not afraid to compete anywhere or anytime on some kind of reasonable basis. But the competitive disadvantage for American banks has been great. A lot of the overseas banks are owned by the government, like the big French banks. They operate with thin ratios and capital bases that would put any American bank in bankruptcy. They price loans with such small markups over their own costs that their earnings are a joke.

Second, they have the support of their governments. I called around this world for over thirty-five years, and when I went abroad, a guy would say to me, "The American ambassador hasn't been to see me." And I'd reply, "Why should he?"

Then he told me that the German ambassador was just in and complained that the Deutsche bank got only a little business from him last year. Why wasn't the American ambassador out selling my bank?

The last place you go to get business for an American bank is the American embassy, because we have a sort of adversarial relationship with our government.

Another advantage foreign banks have is that they were not subject to the McFadden Act's geographic restraints, which limit U.S. banks to one state only. Consequently, forty-two foreign banks operate in three or more states. The British-owned Barclays Bank has a chain of commercial bank branches in California, and banks in New York, and a commercial bank in Chicago and another in Houston. That's legal for them, but an American bank couldn't do it. When a bank was failing in Philadelphia, Mellon Bank of Pittsburgh couldn't buy it but an Arab bank did. When a big bank was failing in New York, the California-based Bank of America couldn't buy it but it was all right to sell it to the Hong Kong and Shanghai Bank, hardly a small institution on the global scene. Sumitomo, Lloyds, Banco do Brasil, Mitsubishi, Dresdner, Credito Italiano, and the Bank of Tokyo, some of the world's largest banks, are among the forty-five foreign banks that own banks in California. In fact, seven of the eleven largest banks in California are foreign owned or -controlled. It's sort of ridiculous that they have geographic spread denied the natives.

This is not in any way to argue in favor of bigness. Big is a relative term. When I made my first airline loan, it was for a DC-3, which cost $125,000. I could have financed more DC-3s on the legal limit of Citibank then than I can finance 747s now at $85 million dollars apiece. It's a big world, and it requires big institutions to handle big problems. The factor more important than size is whether or not the system is competitive.

The word "competitive" runs through the financial services wonderland like the Mad Hatter because it seems to have a different meaning to everyone who uses it-and worse, often means different things at different times to the same people. It's what Humpty-Dumpty called a portmanteau word.

Competition, lauded as the foundation of America's strength and wealth, is a motherhood issue in theory but an abandoned child in practice. We keep looking for. it, but nobody seems to know whether we are supposed to encourage it or stamp it out. The poor banker usually finds himself like Alice asking the Cheshire Cat, "Would you tell me, please, which way I ought to go from here?" and confessing she doesn't much care where she wants to get. And the grinning cat replies, "Then it doesn't matter which way you go."

That's about where we are today: trying to identify where we want to go; where we want our country to go; and how to get there. That's not easy in wonderland. But I like to think, to extend the analogy, that we are not unlike Alice and her companion, knocking on a door in Wonderland. "There's no sort of use in knocking ..." the footman told Alice, "because I'm on the same side of the door as you are..... There might be some sense in your knocking if we had the door between us." One reason it is so hard to tell one side of the door from the other is that yesterday's image of the financial services business bears little relationship to today's reality. The old image is that banks are places to deposit money and get loans; that brokerage firms are places where securities are bought, sold, and distributed; that thrifts are places to maintain savings accounts and get mortgages.

Today, in financial services, you can't tell the players even with a scorecard, but that is not your fault.

Commercial banks take demand deposits and pay customers' checks drawn against them. So do credit unions, savings and loans, stockbroker cash management accounts, and money market mutual funds.

Commercial banks take time and savings deposits, and pay interest on them. So do brokers, money market funds, and all the savings and loan associations.

Commercial banks lend money secured by collateral. So do brokerage firms, leasing companies, factoring companies, captive finance companies, and aircraft engine manufacturers.

Commercial banks lend money to businesses without collateral. Businesses do too-they lend more than one hundred billion dollars to each other in the commercial paper market.

Commercial banks make personal loans and offer credit cards. So does everybody else, from finance companies to department store chains. In fact, bank-issued credit cards in the United States account for only about 15 percent of the credit card market.

Commercial banks deal in government paper. So do corporate treasurers, brokers, mutual funds, and the man in the street.

It's doubtful if there is any traditional banking service that somebody else is not also providing-and doing it nationwide.

That is what's happening in the real world. But in the Alice in Wonderland world of Glass-Steagall, McFadden, and protected special interests, banks still need ten messenger boys to send money across the street-one messenger boy for mortgages, another for stocks, another for installment loans, and so on, while money moves around the world at the speed of light and enters through the back door before the fastest messenger boy even steps into the street.

The reality is that the financial marketplace today is everywhere, anytime. A man in Texas takes his money out of a savings and loan and calls a toll-free telephone number in Arizona, and his money ends up in a money market fund in Boston-or anywhere else on the globe.

Financial transactions are now being performed in living rooms via cable TV or through a terminal in a corporate treasurer's office. In this kind of world, electrons have become money, credit, securities, or savings, and are more real than nineteenth-century banking palaces. The advent of electronic funds transfer and storage is as significant to the financial system today as was the substitution of paper money for gold or silver, and it has created just as big a revolution. That's what the commercial banks of America discovered when they woke up one morning and found they faced a serious competitive challenge from sources which they did not at one time regard as being in competition with banking at all. Almost every major company had a financial services division-department stores, telephone companies, broadcasting networks, engineering and construction firms, transportation operators, steelmakers, brokerage houses, and movie chains, to cite a few examples.

Sears Roebuck, for example, operates the largest savings and loan holding company in the world and its financial services operations alone earn over two hundred million dollars a year. Together with J. C. Penney and Marcor, Sears has consumer installment loans outstanding equal to roughly 12 percent of the total consumer installment debt held by all the commercial banks in the United States. Many of these nonbank corporations started with a captive finance subsidiary to enhance the sales efforts of the parent company. While this was the primary goal for most, some of these corporations have become highly venturesome and are now selling a vast array of financial products. Today, for example, the nation's three largest retailing chains offer everything from corporate venture capital investing and mortgage banking to consumer finance and insurance underwriting.

These retailers are an especially potent force in the consumer credit market. The credit program of Sears Roebuck alone is more sizable than either of the two national bank charge card systems. In fact, Sears with roughly twenty-five million credit cards accounted for 35 percent of the total amount owed on all U.S. bank credit cards. The success of Sears, of course, stems in no small measure from the fact that all you need anywhere in the U.S. is a shopping center and a showroom. Then you can have a mutual fund, an insurance desk, a tax expert, a travel agent, a leasing department, a real estate office, and a venture capital business right there among the refrigerators, tractors, and chain saws. American banks, which must get prior approval for every deep breath they take, are a long way from being able to compete with this "one-stop shop" concept.

In addition to the retailers, however, there are the major manufacturers of consumer durables like General Motors, Ford, and General Electric in the financial services market. These three manufacturers in combination with the three top retailers-Sears, Penney, and Marcor-hold over four times the national market share of the three largest banks in consumer credit.

Companies like ITT, Control Data, and Gulf & Western, for example, each received a third or more of their earnings from their financial operations. Borg Warner, Westinghouse, and dozens of other nonbank firms of considerable size are involved in some form of commercial finance, consumer finance, real estate, insurance, leasing, or investment services.

National Steel owns the biggest coast-to-coast federal savings and loan in the country-First Nationwide Savings. Lowes, the theater chain, also sells insurance, provides installment credit and invests in real estate. Paramount, another movie maker, is part of the Gulf & Western conglomerate along with a bank and insurance, real estate, and mortgage companies. Texaco, best known as an oil company, formed Ful-Tex Euro services to broker time deposits, money market instruments, and foreign exchange. American Can bought Associated Madison, a billion-dollar-a-year insurance company that sells through mail order.

American Express, best known for its travel and entertainment card, also owns a cable television company, an insurance company, and a commercial bank overseas. Then it acquired Shearson Loeb Rhodes, the second-largest securities brokerage house on Wall Street. Bache, another large Wall Street house, was acquired by Prudential Insurance. Merrill Lynch, which led the Wall Street invasion into across-the-board financial services, in one way or another does everything a bank does by one name or another. Its Cash Management Account, a money market fund with check-writing privileges tied to a brokerage margin account and a high-limit credit card, set the pattern that other financial conglomerates quickly copied.

The attraction of financial services is simple. Willie Sutton, the famous bank robber, understood it clearly-that's where the money is. American consumers spend about $180 billion a year on retail financial services. An affluent household relies on an average of twenty financial vendors to purchase thirty-eight products. Less affluent families buy about twenty products from twelve sources.

U.S. banks face a considerable challenge from these competitors who are outside the banking industry. They are beating us at our own game simply because they enjoy competitive advantages on several fronts. First and foremost, there is ease of market entry-a privilege that a bank holding company does not enjoy. When both a nonbank company and a bank holding company seek to acquire a financial service operation, for example, it is to the seller's advantage to deal with the nonfinancial, and thus avoid wasting time and effort waiting around for federal approval.

When they take on a major acquisition that might violate antitrust laws, the burden of proof rests with the Justice Department and the Federal Trade Commission, which act only after the fact, if warranted. This relative freedom is in great contrast to the strict regulatory environment surrounding bank holding companies. Banks must obtain prior approval for most diversification, whether it is starting from scratch or through acquisition. In addition, the burden of proof lies with banks when it comes to showing how proposed action will serve the public benefit-a cloudy area at best, open to broad interpretation and conjecture.

Non-financials have a considerable competitive advantage too, in their freedom to design their capital structures, subject only to constraints imposed by financial markets. The capitalization of individual financial subsidiaries may be regulated by the various state authorities, but the parent company's capital decisions are seldom influenced by either state or federal regulators.

There is no such freedom for bank holding companies and their subsidiary banks. They must comply with the Federal Reserve standard of capital adequacy designed to protect banks from exaggerated-rather than reasonable-risks. To the extent that the Fed's standard differs from the standard considered appropriate by management, this standard may seriously restrict flexibility. Certainly, the Fed's static concept of capital adequacy, defined in ratio analysis terms, undermines the decision-making powers of management. It also ignores the changing competitive picture and the role of earnings.

We all know that risk-taking and profit-making in our society are as basic to banking as to any other business. Banks must offer services on a quality and price-competitive basis. They must acquire capital at least cost, on prevailing risk/reward terms, and they must employ this capital in the most productive, innovative, and responsible ways they can devise. Bankers must continually develop and train new people and reset internal controls to hold down costs. This task requires sophisticated management techniques and high levels of competence which no amount of regulation can guarantee.

Voltaire once remarked that "a multitude of laws in a country is like a great number of physicians, a sign of weakness and malady." Certainly, a multitude of laws and restrictions has not contributed to the health of the American banking system.

This isn't a conspiracy, because there's nothing unusual about such events. While non-banking competitors are free to do as they please, Congress regularly is beseeched to ban bankers from selling credit-related insurance or any number of other clearly financial-related activities, while allowing others to nibble away at bank markets.

While the public tries to get the best financial deal it can-- as it should-we have the sorry spectacle of bankers, insurance agents, securities dealers, and data-processing firms fighting each other in Washington and in the courts to protect their little monopolies.

Revenue bonds are a case in point. They barely existed in the 1930s, and in fact, the Glass-Steagall Act never mentioned them. Today, however, they account for more than 70 percent of all long-term funds raised by state and local governments. General obligation bonds, which banks are permitted to underwrite, typically sell at prices lower than revenue bonds, and the reason is obvious-more people are scrambling for the same business. When banks are kept out of the revenue bond market, the public is hurt because borrowing costs for local governments are higher, and those who aspire to keep them out are hurting the entire financial community.

Too many of us, unfortunately, practice doublethink. We defend free markets in public, but in our own offices and before government agencies we do our absolute best to create protected industries. This not only damages the fabric of the whole business community but inevitably leads to the loss of freedom. It may be obvious, but it needs repeating: protected markets are the exact opposite of free markets.

The philosophy of the divine right of kings died hundreds of years ago but not, it seems, the divine right of inherited markets. Some people still believe there's a "divine" dispensation that their markets are theirs-and no one else's-now and forevermore. It is an old dream that dies hard, yet no business person in a free society can control a market when the customers decide to go somewhere else. All the king's horses and all the king's men are helpless in the face of a better product.

Our commercial history is filled with examples of companies that failed to change with a changing world, and became tombstones in the corporate graveyard.

Investors in canal bonds in the nineteenth century who refused to invest in railroad bonds reflect the kind of vision I'm talking about. Besides saying the usual things-there're too many moving parts, I'll wait until all the technical problems are solved, it'll always be too expensive to catch on some came up with an answer they thought irrefutable. "Railroads rust," they said, "but what can happen to a canal?" The railroads showed them, then replayed the canal scenario themselves as buses, cars, and trucks whizzed down six-lane highways and jumbo jets flew overhead while railway tracks rusted and weeds clogged what was left of the few remaining canals.

It is fair to say that the financial services business is not immune from the ancient practice of running to the government for help, but I would point to the railroads and canals and remind the safe-market seekers that there is no social security for companies in the world marketplace, no seniority rights, no disability pensions. The public doesn't really care about the internecine problems of the financial services business, nor should it. The computer and the electronic revolution have created a new marketplace and the public wants the best return on its money that these technologies can now provide, which it is entitled to. Those who seek survival in wonderland will in time discover that all the Glasses, all the Steagalls, and all the McFaddens cannot lead them back through the mirror into yesterday.

Someone might reasonably ask how commercial banks have survived this long, if the threat over the last fifty years has been that bad. One answer is that many did not. In the 1920s there were about thirty thousand commercial banks; today there are about less than half that number.

Those that remain are steadily losing their share of market. In 1946, the banking industry had a 57 percent share of American financial assets; last year it had shrunk to about 37 percent-and it is still shrinking. Between the end of 1945 and 1960, certainly a time everyone remembers as highly prosperous, the assets of commercial banks rose by three fifths, while the assets of life insurance companies tripled, those of savings and loan associations multiplied by nine, and trusteed pension funds multiplied by fifteen.

The financial services industry is no exception to the realities of a free and open marketplace. It makes no sense to suppose that competitors would wither away under the challenge of comparably empowered banks. On the contrary, history supports the view that any industry kept in a segregated and protected market will lose its vigor but benefit from fresh competition. Separate but equal is an economic myth, as well as a social one.

All of the foregoing seems clear and straightforward. But fifty years of revisionist interpretation by determined protectionists has so muddied the picture that only the works of Professor Dodgson come close to realistically portraying the situation in financial services: "Alice thought the whole thing very absurd, but they all looked so grave that she did not dare to laugh; . . . she simply bowed .. . looking as solemn as she could."

It gets, as Alice said, curiouser and curiouser.

In 1980, for instance, Congress passed the Depository Institutions Deregulation and Monetary Control Act. After the prima facie curiosity of juxtaposing the words "deregulation" and "control" in the title, the next step was putting the job of dismantling regulation in the hands of a committee of lifelong regulators. Not surprisingly, their first step toward eliminating regulation was to establish a slate of new regulations, adding to instead of reducing the problem.

They relaxed Reg Q reluctantly, fraction by fraction, fully intending to take until 1986, which the law set as a deadline, to finish the task. But the market forced their hand. Interest rates reached 20 percent in 1982, deposits at 5.25 hemorrhaged out of the S&Ls, and to save the thrift industry the regulators had to allow banks and the thrifts to compete equally with all comers.

That episode demonstrated anew a simple fact that is unfortunately little understood.

The reason that the banking system must be competitive is that it is a business. The fact is that bankers are in the business of managing risk. Pure and simple, that is the business of banking. As long as a bank keeps its risks within its risk-taking capabilities, it survives; and if it doesn't, it dies. So the critical factor is the ability of a bank to earn enough to absorb its losses. No bank with strong earnings ever got into trouble. Almost all banks that have failed had adequate capital but poor earnings. The market knows the difference between strength and weakness, and its judgment is swift and harsh, as witness the Continental Illinois episode.

Another basic fact about the banking business that is little understood is that on average 70 percent of a bank's profits go back into the business. This is just the opposite of the pay-out ratio in other industries, where the stockholders get 70 percent or more of the earnings in the form of dividends. It is those profits going back into the capital base of banks that give them the capacity to finance a growing national economy. A textbook could be filled on this relationship between bank profit and economic growth. But to the man on the street it can be summed up in one four-letter word. Jobs. Everyone, in that sense, has a vested interest in maintaining a healthy banking system, because the credit-extension and money-creation function of the commercial banking system is an integral part of the job-generating economic machine, which is one reason the banking industry is the most heavily regulated in the country. My quarrel is not with regulation, as such, but with the perversion of regulation to narrow ends, which works against the public interest. Whose market is being protected from whom is not a valid question, but we all should ask: What public principles should govern our society insofar as financial markets are concerned? How will the public be best served?

Surely, all can agree on broad public policy objectives, such as: Our national policy should be to promote maximum efficiency in the capital markets; to enable and encourage financial institutions to meet the rapidly changing demands of our economy; to foster public trust in financial institutions; to encourage widespread direct public ownership of American industry; to promote fair competition; to limit the economic and political power of any one sector; and to protect investors and depositors against improper practices.

In the real marketplace, the public couldn't care less about old-fashioned and artificial distinctions. They want the best deal they can get for whatever financial service they need, and J. C. Penny, wishing to survive, gives it to them. It is not my wish to restrict the ability of Prudential-Bache, or Shearson American Express, or any other competitor to provide quality customer services. My concern is that commercial banks are not free to compete on equal terms in the financial services marketplace out of a misguided fear that they would dominate it.

No one is worried that Sears Roebuck-with almost twenty-five million active credit card customers-will end retail merchandising competition. The facts of a fiercely competitive retail industry do not support that fear.

No one is afraid that Merrill Lynch-the largest brokerage house by far, with two million active customers and a branch office within twenty-five miles of three-fourths of the U.S. population-will gobble up its competitors and control everyone's financial assets.

Certainly, customers do not care who wins this obscure financial battle, because they are in the process of becoming somebody else's customers. In this age of consumerism, the public will go wherever goods and services are conveniently provided at a fair price. There is nothing wrong with this; that is what a market economy is all about. Banks cannot be sheltered from these market realities, but they are banned from participating fully and fairly in them. If banks cannot participate, they are finished as financial institutions. Those banks with no desire to become another tombstone in America's corporate graveyard may have to give up banking charters, if we want to survive into the twenty-first century.

The loss of traditional market share in the past points up an obvious truth: Whenever a business cannot or does not respond to the expressed demand of the public, a competitor moves in to fill the void. We all saw this happen when the truckers rose up to compete with the railroads, when the charter carriers made inroads into the markets of the scheduled airlines, and most recently, when cablevision began to menace television broadcasters.

What all this teaches is that competition is not a one-to-one proposition but rather a subtle evolutionary process. Those who look ahead will undoubtedly find many surprises down the road. Foresight, however, like the prophecies of Cassandra, is of little value if one lacks the flexibility to move out and meet each new challenge on an even footing.

There have been periods in our past-and not so very long ago-when political campaigners ritually looked to the time when the western farmer, the small-town businessman, and the small investor might have the same access to money and credit as a Hamilton or a Biddle or a Morgan. That time is now here. The technological conditions for fulfilling those promises exist.

Whatever the new shape of the future, one essential fact about money will not change. Gertrude Stein put it best, I think:

The money is always there, but the pockets change; it is not in the same pockets after a change; and that is all there is to say about money.

To understand what's going on in the banking business in the United States, which you should because it's your money, it is necessary to take a cue from a certain professor of mathematics at Oxford.

His name was Charles Lutwidge Dodgson and he was noted in academic circles of his time as the author of as well as for other abstruse mathematical works. He is far more widely known by his nom de plume, Lewis Carroll, and over many years millions have delighted in his better-known work, . Though he wrote to amuse a six-year-old girl, I sometimes think Professor Dodgson was really prophesying the shape of the U.S. banking system, which defies comprehension in rational terms.

Imagine, then, as you read this, that a white rabbit with pink eyes appears, pulls a watch from his waistcoat, and leads us all through the looking glass into a wonderland called the American banking system.

In Wonderland, you will recall, logic never seems to work quite the same way as it does in, say, Wisconsin, and things are never quite what they seem. So it is also in banking and the financial services markets. For example, it is an article of faith

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that American banks do not compete across state lines; that certain kinds of banks do not compete with other kinds; that stockbrokers do not offer banking services; that insurance companies do not sell stocks; or that retailers and steelmakers do none of those things. In banking wonderland, everything is neatly compartmentalized in theory, but actuality is another matter entirely.

It's as if the March Hare, or is it the Mad Hatter, is running around shouting, "No room! No room!" at the tea party when in fact there is clearly room for everybody. But, like Alice, Americans have "got so much in the way of expecting nothing but out-of-the-way things to happen, that it [seems] quite dull . . .for life to go on in the common way."

So no one is astonished to open the newspaper and discover that the major New York commercial banks are in head-on competition with the First Nationwide Savings, a thrift institution with 140 offices coast to coast, which the courts and the regulators assure us does not compete with commercial banks, and certainly not across state lines, except that it does but apparently hasn't yet been enlightened to that fact. To compound your confusion, I might point out that the organization I headed before retirement, technically a New York-based one-bank holding company, now operates savings and loan organizations in Florida, Illinois, and California. These have been blessed by the courts and regulators and are perfectly legal-illogical, perhaps, but legal.

If you asked me to explain this, since I am not an Oxford mathematician I would have to say, as Alice did to the Caterpillar, "I'm afraid I can't put it more clearly, for I can't understand it myself to begin with."

It can be described, however, and the place to begin is at the beginning.

Our banking system is a part of our frontier heritage. Whenever the wagon trains stopped to water the horses, a couple of guys dropped out and opened a bank. That is why the United States today has more than 14,000 banks, 3,800 savings and loan associations, 430 mutual savings banks, and 21,000 credit unions. Unlike Canada, Great Britain, and

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most other nations, where fewer than a dozen large banks operate nationwide, we have a grand total of 41,591 depository institutions that will take your money for safekeeping, pay you a rent called interest for the use of your money, and then lend it to a third party-if possible, at a rate sufficiently higher than the rent to cover their costs of operation and, if managed properly, make a profit to finance their future growth.

Most of these depository institutions are small. Ninety-five percent of the more than fourteen thousand commercial banks in the United States have fewer than two hundred employees and assets of less than three million dollars, which is a small number in the banking business. Many still reflect a nineteenth-century image in their buildings and style of operations, as well as in their thinking. Outside they look like fortresses; inside they are public palaces. Lavish interiors give customers something to admire while waiting in endless lines as tellers cash checks, take deposits, and record all transactions by hand, despite the popularity of automated teller machines which give faster, more efficient service. Too many banks are still rooted in the nineteenth century, when bankers, who would not tolerate sloppy penmanship, proudly boasted that their account books were works of art and employees worked long hours and had to adhere to strict moral standards. The following set of rules, found in Citibank's archives, was typical of nineteenth-century banking:

The office will open at 7 A.M. and close at 8 P.M. daily except on the Sabbath. Each employee is expected to spend the Sabbath attending church.

Each clerk will bring in a bucket of water and a scuttle of coal for the day.

Make your pens carefully. Whittle the nibs to suit your taste.

Men employees will be given an evening off each week for courting purposes, or two evenings if they regularly go to church.

Any employee who smokes Spanish cigars, uses liquor in any form, gets shaved at a barber shop, or frequents pool or public halls, will give us good reason to suspect his worth, intentions, integrity and honesty.

The employee who has performed his labor faithfully and without fault for a period of five years in our service, and is looked upon by his fellow men as a law-abiding citizen, will be given an increase of ten cents per day in his pay.

The steady technological progress we have seen in this century seemed to have had little effect on many banks. Still relying on the old ways, these banks preferred to compete among themselves, and with other, nonfinancial institutions, by offering the customer a wide range of free services. In the 1920s, for instance, banks acted as railroad and theater ticket agents, made hotel reservations, maintained day nurseries for tired mothers, distributed seeds, and some even kept veterinarians on the payroll.

Things did not change much for a long time. Until quite recently, any time a bank wanted to run up its deposits, it offered toasters or blankets as premiums for opening a new account. A ten-dollar toaster hardly made up for the rip-off that was forced on consumers from 1965 to 1982; Regulation Q provided that the poor got 5.25 percent on their savings and the rich got 12 to 14 percent or more. The difference in dollars is not inconsiderable. In the first two years after Reg Q ended, banks paid an additional seventy billion dollars in interest on savings accounts at the new market rates. This consumer rip-off was just incredible and it went on for seventeen years, even though there are a lot more savers in this country than there are borrowers. Anyone with a sense of fair play would agree that the workingman should get the same market rate on his savings account that the rich man gets on his. But in cohoots with the government, the small banks and savings and loan institutions

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were happy to pay the lowest possible rate to savers. In turn, they lent money to local businesses, often at high rates that made competitive big-city banks green with envy. They bought government bonds with their surplus and they did very well indeed. They liked it that way and did not want things to change, and they succeeded at preserving the status quo long after the twin forces of inflation and technology reshaped the marketplace. Even now ignoring reality, banking continues to be hobbled in its ability to compete on equal terms with all comers as a result of rigid regulations, which suit the small banks and thrifts just fine.

The end result was predictable. Regulation Q, originally laid on at the behest of the savings and loan associations to give them an edge over banks, drove savings into market rate alternatives. Money market mutual funds grew to about four billion dollars in three years from the time the first one was founded, and then soared to over two hundred billion dollars in the next five years. To give you a time frame for that, Citibank was in business for more than one hundred years before its deposits reached the one-billion-dollar level.

It took a crisis to change that interest regulation because the small banks and S&Ls have about eight times more political clout than the big banks. In Cut Bluff, Montana, the president of the local bank, or S&L, is the finance chairman for the local congressman, and this is the situation all over the country -in fact, all over the world, wherever there is a multiparty political system.

If you sat up nights designing a system the consumer did not want, you would come up with something very close to today's American banking system. It wasn't intended that way. The Banking Act of 1933, commonly called the Glass-Steagall Act, provided the basic blueprint for American banking during the past fifty years. Its architects were Representative Henry Steagall, of Alabama, a member of the farm bloc, and Senator Carter Glass, a distinguished Virginian, onetime Secretary of the Treasury and the father of the Federal Reserve

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system. Both were fiscal conservatives and believers in competition. The senator, for example, once wrote:

There is entirely too much running to Washington by business, by agriculture and by labor. That way lies paternalism, with socialism just beyond. There are certain things necessary to be done, of course, which the people in their private capacities lack the power to do, and in such cases the public must operate through the government . . . and it is the proper function of government to prevent the erection of any unnatural barriers to the equality of opportunity.

The Glass-Steagall Act was never intended to separate or insulate certain industries from competition. Some of the restrictions it placed on banks did protect others from competition, but this result was an incidental side effect. Its primary purpose was to protect bank depositors and stimulate business in the wake of thousands of bank failures and the revelation of shocking, criminal conflicts of interest during the go-go boom of the late 1920s. Glass-Steagall was a response to widespread losses by depositors, who are not supposed to be risk-takers, and by shareholders, who are supposed to take risks but not the risk of dishonest management.

Consequently, the Banking Act of 1933 sought to restore the solvency and strength of banks and the confidence of depositors, and it had nothing whatsoever to do with the division of markets. That was set forth clearly in its title: "An Act to provide for the safer and more effective use of the assets of banks, to regulate interbank control, to prevent undue diversion of funds into speculative operations, and for other purposes.

This legislation went about accomplishing its purpose in an number of ways. It created the Federal Deposit Insurance Corporation. It banned payment of interest on checking accounts, with the apparent purpose of using the money thus saved to pay the insurance premiums of the FDIC. It placed

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limitations on loans to inside executives or affiliated companies. It increased reporting and examination requirements. It prohibited risking depositors' funds in underwriting corporate securities and in related activities. It dealt with other matters affecting banks-all with the objective of protecting their solvency and their depositors' and shareholders' funds.

Another cornerstone of bank regulation, the McFadden Act, was intended to preserve our illogical dual banking system, in which some banks are chartered by the federal government and others by the states. McFadden did this by limiting deposit-taking to one state, or even just one area of that state, at the discretion of the state's authorities. In practice, it became sort of a financial Mann Act, making it illegal and immoral to transport a deposit dollar over state borders.

Stocks and other segments of the securities industry were dealt with in a different framework when Congress enacted the federal securities laws in 1933 and in 1934.

The United States has a tradition of free enterprise and competition that is not only historic but also widely regarded as the foundation of our national strength and well-being. The concept is firmly rooted both in our tradition and in our body of law: the Sherman Act, the Clayton Act, the Federal Trade Commission Act, the Robinson-Patman Act, and hosts of state laws, all reaffirming the principle of competition. Banking is the only industry that is exempted from the Clayton and the Sherman acts by the fact that it's illegal to operate across state lines.

The American principle, which has been tested and proved, is that competition most efficiently produces the greatest well-being for the greatest number of people. It is confirmed by the strength of our economic performance domestically and in the world.

But instead of a free market, the U.S. is saddled with an outmoded, anticompetitive banking system that is the most fragmented in the world. There isn't a single bank in this country that has as much as 5 percent of a market. In fact, the largest single market share was 4.3 percent, which, incidentally,

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was held by the ill-fated Continental Illinois Bank in Chicago. I don't know of any other major industry that fragmented.

In addition, there are 340 foreign banking offices in the U.S., which hold more than 12 percent, or almost forty billion dollars, of all loans made in this country. In New York City alone, we have ninety-odd foreign banks and they have about 40 percent of our local business. Not surprisingly, the market share of the ten largest U.S. banks has not grown in the last nine years. I don't say that with any particular pride, but nine years ago the market share of the ten largest U.S. banks was 29.8 percent and at the end of 1981 it was 27.7 percent.

Globally, we have fallen behind too. Thirty years ago, forty-four U.S. banks ranked among the world's top one hundred, with 53 percent of those banks' global deposits. By 1981, only fourteen U.S. banks were among the top one hundred, and their share of deposits had declined to 15 percent. Only two American banks now remain among the world's top ten, in contrast to twenty years ago, when U.S. banks were numbers one through ten on the list. Another number that might interest you: there are now more Japanese banks in the top fifty financial institutions of the world than there are U.S. banks-sixteen versus seven.

I don't say any of these things to decry the growth of the foreign competition or the decline of the American share. Quite the contrary, I believe that welcoming all competition has been salutary for banking in general and the customer especially.

My view, from day one, has been that instead of putting handcuffs on them, why not take the cuffs off us? I'm not afraid to compete anywhere or anytime on some kind of reasonable basis. But the competitive disadvantage for American banks has been great. A lot of the overseas banks are owned by the government, like the big French banks. They operate with thin ratios and capital bases that would put any American bank in bankruptcy. They price loans with such small markups over their own costs that their earnings are a joke.

Second, they have the support of their governments. I called around this world for over thirty-five years, and when I went abroad, a guy would say to me, "The American ambassador hasn't been to see me." And I'd reply, "Why should he?"

Then he told me that the German ambassador was just in and complained that the Deutsche bank got only a little business from him last year. Why wasn't the American ambassador out selling my bank?

The last place you go to get business for an American bank is the American embassy, because we have a sort of adversarial relationship with our government.

Another advantage foreign banks have is that they were not subject to the McFadden Act's geographic restraints, which limit U.S. banks to one state only. Consequently, forty-two foreign banks operate in three or more states. The British-owned Barclays Bank has a chain of commercial bank branches in California, and banks in New York, and a commercial bank in Chicago and another in Houston. That's legal for them, but an American bank couldn't do it. When a bank was failing in Philadelphia, Mellon Bank of Pittsburgh couldn't buy it but an Arab bank did. When a big bank was failing in New York, the California-based Bank of America couldn't buy it but it was all right to sell it to the Hong Kong and Shanghai Bank, hardly a small institution on the global scene. Sumitomo, Lloyds, Banco do Brasil, Mitsubishi, Dresdner, Credito Italiano, and the Bank of Tokyo, some of the world's largest banks, are among the forty-five foreign banks that own banks in California. In fact, seven of the eleven largest banks in California are foreign owned or -controlled. It's sort of ridiculous that they have geographic spread denied the natives.

This is not in any way to argue in favor of bigness. Big is a relative term. When I made my first airline loan, it was for a DC-3, which cost $125,000. I could have financed more DC-3s on the legal limit of Citibank then than I can finance 747s now at $85 million dollars apiece. It's a big world, and

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it requires big institutions to handle big problems. The factor more important than size is whether or not the system is competitive.

The word "competitive" runs through the financial services wonderland like the Mad Hatter because it seems to have a different meaning to everyone who uses it-and worse, often means different things at different times to the same people. It's what Humpty-Dumpty called a portmanteau word.

Competition, lauded as the foundation of America's strength and wealth, is a motherhood issue in theory but an abandoned child in practice. We keep looking for. it, but nobody seems to know whether we are supposed to encourage it or stamp it out. The poor banker usually finds himself like Alice asking the Cheshire Cat, "Would you tell me, please, which way I ought to go from here?" and confessing she doesn't much care where she wants to get. And the grinning cat replies, "Then it doesn't matter which way you go."

That's about where we are today: trying to identify where we want to go; where we want our country to go; and how to get there. That's not easy in wonderland. But I like to think, to extend the analogy, that we are not unlike Alice and her companion, knocking on a door in Wonderland. "There's no sort of use in knocking ..." the footman told Alice, "because I'm on the same side of the door as you are..... There might be some sense in your knocking if we had the door between us." One reason it is so hard to tell one side of the door from the other is that yesterday's image of the financial services business bears little relationship to today's reality. The old image is that banks are places to deposit money and get loans; that brokerage firms are places where securities are bought, sold, and distributed; that thrifts are places to maintain savings accounts and get mortgages.

Today, in financial services, you can't tell the players even with a scorecard, but that is not your fault.

Commercial banks take demand deposits and pay customers' checks drawn against them. So do credit unions, savings

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and loans, stockbroker cash management accounts, and money market mutual funds.

Commercial banks take time and savings deposits, and pay interest on them. So do brokers, money market funds, and all the savings and loan associations.

Commercial banks lend money secured by collateral. So do brokerage firms, leasing companies, factoring companies, captive finance companies, and aircraft engine manufacturers.

Commercial banks lend money to businesses without collateral. Businesses do too-they lend more than one hundred billion dollars to each other in the commercial paper market.

Commercial banks make personal loans and offer credit cards. So does everybody else, from finance companies to department store chains. In fact, bank-issued credit cards in the United States account for only about 15 percent of the credit card market.

Commercial banks deal in government paper. So do corporate treasurers, brokers, mutual funds, and the man in the street.

It's doubtful if there is any traditional banking service that somebody else is not also providing-and doing it nationwide.

That is what's happening in the real world. But in the world of Glass-Steagall, McFadden, and protected special interests, banks still need ten messenger boys to send money across the street-one messenger boy for mortgages, another for stocks, another for installment loans, and so on, while money moves around the world at the speed of light and enters through the back door before the fastest messenger boy even steps into the street.

The reality is that the financial marketplace today is everywhere, anytime. A man in Texas takes his money out of a savings and loan and calls a toll-free telephone number in Arizona, and his money ends up in a money market fund in Boston-or anywhere else on the globe.

Financial transactions are now being performed in living rooms via cable TV or through a terminal in a corporate treasurer's office. In this kind of world, electrons have become

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money, credit, securities, or savings, and are more real than nineteenth-century banking palaces. The advent of electronic funds transfer and storage is as significant to the financial system today as was the substitution of paper money for gold or silver, and it has created just as big a revolution. That's what the commercial banks of America discovered when they woke up one morning and found they faced a serious competitive challenge from sources which they did not at one time regard as being in competition with banking at all. Almost every major company had a financial services division-department stores, telephone companies, broadcasting networks, engineering and construction firms, transportation operators, steelmakers, brokerage houses, and movie chains, to cite a few examples.

Sears Roebuck, for example, operates the largest savings and loan holding company in the world and its financial services operations alone earn over two hundred million dollars a year. Together with J. C. Penney and Marcor, Sears has consumer installment loans outstanding equal to roughly 12 percent of the total consumer installment debt held by all the commercial banks in the United States. Many of these nonbank corporations started with a captive finance subsidiary to enhance the sales efforts of the parent company. While this was the primary goal for most, some of these corporations have become highly venturesome and are now selling a vast array of financial products. Today, for example, the nation's three largest retailing chains offer everything from corporate venture capital investing and mortgage banking to consumer finance and insurance underwriting.

These retailers are an especially potent force in the consumer credit market. The credit program of Sears Roebuck alone is more sizable than either of the two national bank charge card systems. In fact, Sears with roughly twenty-five million credit cards accounted for 35 percent of the total amount owed on all U.S. bank credit cards. The success of Sears, of course, stems in no small measure from the fact that all you need anywhere in the U.S. is a shopping center and a

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showroom. Then you can have a mutual fund, an insurance desk, a tax expert, a travel agent, a leasing department, a real estate office, and a venture capital business right there among the refrigerators, tractors, and chain saws. American banks, which must get prior approval for every deep breath they take, are a long way from being able to compete with this "one-stop shop" concept.

In addition to the retailers, however, there are the major manufacturers of consumer durables like General Motors, Ford, and General Electric in the financial services market. These three manufacturers in combination with the three top retailers-Sears, Penney, and Marcor-hold over four times the national market share of the largest banks in consumer credit.

Companies like ITT, Control Data, and Gulf & Western, for example, each received a third or more of their earnings from their financial operations. Borg Warner, Westinghouse, and dozens of other nonbank firms of considerable size are involved in some form of commercial finance, consumer finance, real estate, insurance, leasing, or investment services.

National Steel owns the biggest coast-to-coast federal savings and loan in the country-First Nationwide Savings. Lowes, the theater chain, also sells insurance, provides installment credit and invests in real estate. Paramount, another movie maker, is part of the Gulf & Western conglomerate along with a bank and insurance, real estate, and mortgage companies. Texaco, best known as an oil company, formed Ful-Tex Euro services to broker time deposits, money market instruments, and foreign exchange. American Can bought Associated Madison, a billion-dollar-a-year insurance company that sells through mail order.

American Express, best known for its travel and entertainment card, also owns a cable television company, an insurance company, and a commercial bank overseas. Then it acquired Shearson Loeb Rhodes, the second-largest securities brokerage house on Wall Street. Bache, another large Wall Street house, was acquired by Prudential Insurance. Merrill Lynch,

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which led the Wall Street invasion into across-the-board financial services, in one way or another does everything a bank does by one name or another. Its Cash Management Account, a money market fund with check-writing privileges tied to a brokerage margin account and a high-limit credit card, set the pattern that other financial conglomerates quickly copied.

The attraction of financial services is simple. Willie Sutton, the famous bank robber, understood it clearly-that's where the money is. American consumers spend about $180 billion a year on retail financial services. An affluent household relies on an average of twenty financial vendors to purchase thirty-eight products. Less affluent families buy about twenty products from twelve sources.

U.S. banks face a considerable challenge from these competitors who are outside the banking industry. They are beating us at our own game simply because they enjoy competitive advantages on several fronts. First and foremost, there is ease of market entry-a privilege that a bank holding company does not enjoy. When both a nonbank company and a bank holding company seek to acquire a financial service operation, for example, it is to the seller's advantage to deal with the nonfinancial, and thus avoid wasting time and effort waiting around for federal approval.

When they take on a major acquisition that might violate antitrust laws, the burden of proof rests with the Justice Department and the Federal Trade Commission, which act only after the fact, if warranted. This relative freedom is in great contrast to the strict regulatory environment surrounding bank holding companies. Banks must obtain prior approval for most diversification, whether it is starting from scratch or through acquisition. In addition, the burden of proof lies with banks when it comes to showing how proposed action will serve the public benefit-a cloudy area at best, open to broad interpretation and conjecture.

Non-financials have a considerable competitive advantage too, in their freedom to design their capital structures, subject only to constraints imposed by financial markets. The capitalization

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of individual financial subsidiaries may be regulated by the various state authorities, but the parent company's capital decisions are seldom influenced by either state or federal regulators.

There is no such freedom for bank holding companies and their subsidiary banks. They must comply with the Federal Reserve standard of capital adequacy designed to protect banks from exaggerated-rather than reasonable-risks. To the extent that the Fed's standard differs from the standard considered appropriate by management, this standard may seriously restrict flexibility. Certainly, the Fed's static concept of capital adequacy, defined in ratio analysis terms, undermines the decision-making powers of management. It also ignores the changing competitive picture and the role of earnings.

We all know that risk-taking and profit-making in our society are as basic to banking as to any other business. Banks must offer services on a quality and price-competitive basis. They must acquire capital at least cost, on prevailing risk/reward terms, and they must employ this capital in the most productive, innovative, and responsible ways they can devise. Bankers must continually develop and train new people and reset internal controls to hold down costs. This task requires sophisticated management techniques and high levels of competence which no amount of regulation can guarantee.

Voltaire once remarked that "a multitude of laws in a country is like a great number of physicians, a sign of weakness and malady." Certainly, a multitude of laws and restrictions has not contributed to the health of the American banking system.

This isn't a conspiracy, because there's nothing unusual about such events. While non-banking competitors are free to do as they please, Congress regularly is beseeched to ban bankers from selling credit-related insurance or any number of other clearly financial-related activities, while allowing others to nibble away at bank markets.

While the public tries to get the best financial deal it can--

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as it should-we have the sorry spectacle of bankers, insurance agents, securities dealers, and data-processing firms fighting each other in Washington and in the courts to protect their little monopolies.

Revenue bonds are a case in point. They barely existed in the 1930s, and in fact, the Glass-Steagall Act never mentioned them. Today, however, they account for more than 70 percent of all long-term funds raised by state and local governments. General obligation bonds, which banks are permitted to underwrite, typically sell at prices lower than revenue bonds, and the reason is obvious-more people are scrambling for the same business. When banks are kept out of the revenue bond market, the public is hurt because borrowing costs for local governments are higher, and those who aspire to keep them out are hurting the entire financial community.

Too many of us, unfortunately, practice doublethink. We defend free markets in public, but in our own offices and before government agencies we do our absolute best to create protected industries. This not only damages the fabric of the whole business community but inevitably leads to the loss of freedom. It may be obvious, but it needs repeating: protected markets are the exact opposite of free markets.

The philosophy of the divine right of kings died hundreds of years ago but not, it seems, the divine right of inherited markets. Some people still believe there's a "divine" dispensation that their markets are theirs-and no one else's-now and forevermore. It is an old dream that dies hard, yet no business person in a free society can control a market when the customers decide to go somewhere else. All the king's horses and all the king's men are helpless in the face of a better product.

Our commercial history is filled with examples of companies that failed to change with a changing world, and became tombstones in the corporate graveyard.

Investors in canal bonds in the nineteenth century who refused to invest in railroad bonds reflect the kind of vision I'm talking about. Besides saying the usual things-there're too many moving parts, I'll wait until all the technical problems

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are solved, it'll always be too expensive to catch on some came up with an answer they thought irrefutable. "Railroads rust," they said, "but what can happen to a canal?" The railroads showed them, then replayed the canal scenario themselves as buses, cars, and trucks whizzed down six-lane highways and jumbo jets flew overhead while railway tracks rusted and weeds clogged what was left of the few remaining canals.

It is fair to say that the financial services business is not immune from the ancient practice of running to the government for help, but I would point to the railroads and canals and remind the safe-market seekers that there is no social security for companies in the world marketplace, no seniority rights, no disability pensions. The public doesn't really care about the internecine problems of the financial services business, nor should it. The computer and the electronic revolution have created a new marketplace and the public wants the best return on its money that these technologies can now provide, which it is entitled to. Those who seek survival in wonderland will in time discover that all the Glasses, all the Steagalls, and all the McFaddens cannot lead them back through the mirror into yesterday.

Someone might reasonably ask how commercial banks have survived this long, if the threat over the last fifty years has been that bad. One answer is that many did not. In the 1920s there were about thirty thousand commercial banks; today there are about less than half that number.

Those that remain are steadily losing their share of market. In 1946, the banking industry had a 57 percent share of American financial assets; last year it had shrunk to about 37 percent-and it is still shrinking. Between the end of 1945 and 1960, certainly a time everyone remembers as highly prosperous, the assets of commercial banks rose by three fifths, while the assets of life insurance companies tripled, those of savings and loan associations multiplied by nine, and trusteed pension funds multiplied by fifteen.

The financial services industry is no exception to the realities of a free and open marketplace. It makes no sense to

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suppose that competitors would wither away under the challenge of comparably empowered banks. On the contrary, history supports the view that any industry kept in a segregated and protected market will lose its vigor but benefit from fresh competition. Separate but equal is an economic myth, as well as a social one.

All of the foregoing seems clear and straightforward. But fifty years of revisionist interpretation by determined protectionists has so muddied the picture that only the works of Professor Dodgson come close to realistically portraying the situation in financial services: "Alice thought the whole thing very absurd, but they all looked so grave that she did not dare to laugh; . . . she simply bowed .. . looking as solemn as she could."

It gets, as Alice said, curiouser and curiouser.

In 1980, for instance, Congress passed the Depository Institutions Deregulation and Monetary Control Act. After the prima facie curiosity of juxtaposing the words "deregulation" and "control" in the title, the next step was putting the job of dismantling regulation in the hands of a committee of lifelong regulators. Not surprisingly, their first step toward eliminating regulation was to establish a slate of new regulations, adding to instead of reducing the problem.

They relaxed Reg Q reluctantly, fraction by fraction, fully intending to take until 1986, which the law set as a deadline, to finish the task. But the market forced their hand. Interest rates reached 20 percent in 1982, deposits at 5.25 hemorrhaged out of the S&Ls, and to save the thrift industry the regulators had to allow banks and the thrifts to compete equally with all comers.

That episode demonstrated anew a simple fact that is unfortunately little understood.

The reason that the banking system must be competitive is that it is a . The fact is that bankers are in the business of managing risk. Pure and simple, that is the business of banking. As long as a bank keeps its risks within its risk-taking capabilities, it survives; and if it doesn't, it dies. So the critical

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factor is the ability of a bank to earn enough to absorb its losses. No bank with strong earnings ever got into trouble. Almost all banks that have failed had adequate capital but poor earnings. The market knows the difference between strength and weakness, and its judgment is swift and harsh, as witness the Continental Illinois episode.

Another basic fact about the banking business that is little understood is that on average 70 percent of a bank's profits go back into the business. This is just the opposite of the pay-out ratio in other industries, where the stockholders get 70 percent or more of the earnings in the form of dividends. It is those profits going back into the capital base of banks that give them the capacity to finance a growing national economy. A textbook could be filled on this relationship between bank profit and economic growth. But to the man on the street it can be summed up in one four-letter word. Jobs. Everyone, in that sense, has a vested interest in maintaining a healthy banking system, because the credit-extension and money-creation function of the commercial banking system is an integral part of the job-generating economic machine, which is one reason the banking industry is the most heavily regulated in the country. My quarrel is not with regulation, as such, but with the perversion of regulation to narrow ends, which works against the public interest. Whose market is being protected from whom is not a valid question, but we all should ask: What public principles should govern our society insofar as financial markets are concerned? How will the public be best served?

Surely, all can agree on broad public policy objectives, such as: Our national policy should be to promote maximum efficiency in the capital markets; to enable and encourage financial institutions to meet the rapidly changing demands of our economy; to foster public trust in financial institutions; to encourage widespread direct public ownership of American industry; to promote fair competition; to limit the economic and political power of any one sector; and to protect investors and depositors against improper practices.

In the real marketplace, the public couldn't care less about old-fashioned and artificial distinctions. They want the best deal they can get for whatever financial service they need, and J. C. Penny, wishing to survive, gives it to them. It is not my wish to restrict the ability of Prudential-Bache, or Shearson American Express, or any other competitor to provide quality customer services. My concern is that commercial banks are not free to compete terms in the financial services marketplace out of a misguided fear that they would dominate it.

No one is worried that Sears Roebuck-with almost twenty-five million active credit card customers-will end retail merchandising competition. The facts of a fiercely competitive retail industry do not support that fear.

No one is afraid that Merrill Lynch-the largest brokerage house by far, with two million active customers and a branch office within twenty-five miles of three-fourths of the U.S. population-will gobble up its competitors and control everyone's financial assets.

Certainly, customers do not care who wins this obscure financial battle, because they are in the process of becoming somebody else's customers. In this age of consumerism, the public will go wherever goods and services are conveniently provided at a fair price. There is nothing wrong with this; that is what a market economy is all about. Banks cannot be sheltered from these market realities, but they are banned from participating fully and fairly in them. If banks cannot participate, they are finished as financial institutions. Those banks with no desire to become another tombstone in America's corporate graveyard may have to give up banking charters, if we want to survive into the twenty-first century.

The loss of traditional market share in the past points up an obvious truth: Whenever a business cannot or does not respond to the expressed demand of the public, a competitor moves in to fill the void. We all saw this happen when the truckers rose up to compete with the railroads, when the charter carriers made inroads into the markets of the scheduled

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airlines, and most recently, when cablevision began to menace television broadcasters.

What all this teaches is that competition is not a one-to-one proposition but rather a subtle evolutionary process. Those who look ahead will undoubtedly find many surprises down the road. Foresight, however, like the prophecies of Cassandra, is of little value if one lacks the flexibility to move out and meet each new challenge on an even footing.

There have been periods in our past-and not so very long ago-when political campaigners ritually looked to the time when the western farmer, the small-town businessman, and the small investor might have the same access to money and credit as a Hamilton or a Biddle or a Morgan. That time is now here. The technological conditions for fulfilling those promises exist.

Whatever the new shape of the future, one essential fact about money will not change. Gertrude Stein put it best, I think:

The money is always there, but the pockets change; it is not in the same pockets after a change; and that is all there is to say about money.