BANKING UNDER CHANGING RULES: THE FIFTH DISTRICT SINCE 1970 David L. Mengle Commercial banking has traditionally been one of lators. Specifically, Maryland, North Carolina, South the most tightly regulated industries in the United Carolina, and the District of Columbia allowed States. The controversies surrounding the First and statewide branching. At the other end of the spec- Second Banks of the United States, the National trum, West Virginia permitted neither branching nor Bank Act of 1864, the Federal Reserve System, and multibank holding companies. federal deposit insurance all attest to the concern Between the statewide branching states and West shown with banking throughout our history. Further, Virginia stood Virginia, which allowed a bank to desire to control concentration of economic power branch within its home city or county and within con- and to keep banking responsive to local interests led tiguous cities or counties. But the law was not quite to restrictions on branching and interstate operations so restrictive as it sounded because a 1962 amend- as well as, more recently, antitrust scrutiny of bank ment allowed a bank to expand in two other ways: mergers. First, it could merge with a bank anywhere in Despite the tradition of regulation, the 1980s have Virginia. Second, it could form a bank holding com- seen a call for at least partial deregulation of bank- pany which could in turn purchase banks anywhere ing. Deregulation is aimed neither at supervision of in the state. The law actually favored the bank bank soundness nor at consumer protection mea- holding company route over the merger route because sures, but rather at rules that constrain what banks a bank acquired by merger would generally lose its may sell, where they may sell it, and the interest rates branching privileges while a bank acquired by a bank they pay on their deposits. So far, the largest number holding company could still branch in its home area. of successful deregulatory efforts have loosened con- In practice, then, all Fifth District jurisdictions straints on where banks may do business. except West Virginia had liberal laws regarding ex- But banking deregulation did not begin in the pansion of banks within their borders. 1980s. In fact, the Fifth District provides a case study But full-service banking stopped at a state’s bound- of how banking laws and regulations have evolved aries. Whatever a state’s laws regarding expansion since 1970. For example, District commercial banks within the state, two federal laws kept a bank from have seen changes in bank holding company laws, expanding into another state: First, the McFadden in branching restrictions, and now in barriers to bank- Act of 1927 (as amended in 1933) prohibited national ing across state lines. And as the law has evolved, banks from branching outside their home states. so has the structure of banking in the District. Second, the Douglas Amendment to the Bank Holding Company Act of 19.56 forbade bank holding The Fifth District Regulatory companies to acquire banks in other states unless the Environment in 1970 acquiree’s state specifically permitted such acquisi- Banking, like other industries, must be responsive tion. And in 1970, no Fifth District state extended to both state and federal law. But banking’s com- the privilege to any other state’s bank holding petitive structure, unlike that of most other industries, companies. has been shaped to a large degree by laws that vary Bank Holding Company Laws ana’ Regulations An- among states. The most important state laws affect- other aspect of the 1970 legal environment was the ing banking structure in 1970 were branching re- impetus to growth of bank holding companies even strictions. Among the most important federal laws in states permitting statewide branching. For ex- were those governing bank holding companies. ample, a holding company could sell commercial Branching Laws In much of the Fifth District in paper and then pass the proceeds downstream to sub- 1970, banks could branch without restriction within sidiary banks. As interest rates rose in the late 1960s their states subject only to approval by their regu- and banks began to face problems raising funds under FEDERAL RESERVE BANK OF RICHMOND 3 Regulation Q interest rate constraints, the holding The amendments essentially closed the one-bank company route presented an appealing alternative. holding company loophole by subjecting almost all Further, until September 1970 funds raised by a bank holding companies to Federal Reserve regu- holding company and then passed downstream were lation. In addition, Congress gave the Board of not subject to reserve requirements. Governors authority to approve or deny nonbank- There were also differences in how federal law ing activities on a case-by-case basis subject to the treated different types of holding companies. requirement that activities be “so closely related to Specifically, the Bank Holding Company Act sub- banking. as to be a proper incident thereto” and jected companies owning more than one bank to that the anticipated benefits, such as convenience, regulation by the Federal Reserve but made no pro- competition, and efficiency, outweigh anticipated visions for companies owning only one bank. One- costs such as conflicts of interest and increased bank holding companies were consequently subject concentration. to fewer restrictions on activities and product offer- The initial effect of the new legislation was diver- ings than were multibank holding companies. Thus sification of bank holding companies into new finan- there was incentive to attempt to initiate new finan- cial activities. During the early 1970s for example, cial services in a holding company subsidiary rather the Board approved such nonbanking activities as than apply for permission from regulators to conduct mortgage banking, factoring, leasing, financial data the activity within the bank and risk legal challenge processing, and credit life insurance underwriting. from those threatened by the competition. But in the mid-1970s two sets of events may have It became increasingly apparent in the late 1960s helped slow the entry of bank holding companies into that Congress would bow to the Federal Reserve’s new activities: First, the failures of two New York urgings that the one-bank holding company loophole banks, Franklin National and Security National, be closed. Still, the number of one-bank holding com- pointed to the problems faced by banks attempting panies more than doubled between May 1968 and to expand without sufficient regard for their capital December 1970. Evidently, many banks felt com- base. Second, during the recession of the mid-1970s pelled to switch to the holding company form in many banks experienced problems with their asset hopes they would be “grandfathered” under any new portfolios. In particular, some banks that advised real restrictions. estate investment trusts (REITs) committed exten- Thus the structure of Fifth District banking in 1970 sive resources to keeping certain REITs afloat. While reflected two main aspects of the laws in place at the bank holding companies were ostensibly under no time: First, multibank holding companies dominated obligation to support the REITs, the record does in Virginia where they constituted a means of ex- show that bank earnings suffered as a result of the panding throughout the state. But because they were support they did provide. regulated by the Federal Reserve, their ability to Consequently, the Board shifted to a “go slow” expand into new financial fields was limited. Second, policy toward diversification into new activities. But one-bank holding companies were important in despite the announced policy of slowing entry into Maryland, the District of Columbia, and the nonbanking activities, there was no reversal of the Carolinas. Apparently, banks with statewide branch- movement toward the bank holding company ing privileges were in a position to choose an organization form. Of the one hundred largest bank- organization form on the basis of product rather than ing organizations in the United States, the number geographical diversification. not affiliated with a bank holding company declined from twenty-eight in 1970 to three in 1975, two in Changes after 1970 1980, and none by the end of 1981. The years following 1970 were a period of rapid Statewide Branching The next significant changes growth for Fifth District banking. While the number affecting bank expansion in the Fifth District involved of banks did not necessarily increase in all states, the liberalization of branching laws in two states. The number of branches did. Banking services therefore first occurred in Virginia in 1978 when the legislature became more widely available. As one would expect, extended branching privileges (still limited to con- the growth occurred during a period of change in the tiguous jurisdictions) to acquired banks. Under the regulatory environment. amended law, a bank could acquire another bank, Bank Holding Company Act Amendments The first turn it into a branch, and still establish branches in significant change came in December 1970 when the area of the new branch. In practice, then, Virginia Congress amended the Bank Holding Company Act. had adopted statewide branching even though 4 ECONOMIC REVIEW, MARCH/APRIL 1989 (until 1986) the letter of the law limited branching most of the Southeast. Another law, passed in 1986, to contiguous areas. By 1979, four of the five largest allows entry of bank holding companies agreeing to Virginia bank holding companies had consolidated provide loans and lines of credit, jobs, and branches their subsidiaries as branches under one bank. And for specified economic development projects and by 1987 there were 112 fewer banks but 3 16 more areas. Finally, a law passed by West Virginia in 1986 branches operating in Virginia than there had been allows reciprocal entry by bank holding companies a decade earlier. from anywhere in the nation subject to the restric- The other liberalization occurred in West Virginia.