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banking and financial market


It also does not look as though community banks will disappear. When New York
State liberalized branching laws in 1962, there were fears that community banks
upstate would be driven from the market by the big New York City banks. Not only
did this not happen, but some of the big boys found that the small banks were able
to run rings around them in the local markets. Similarly, California, which has had
unrestricted statewide branching for a long time, continues to have a thriving number
of community banks.
Economists see some important benefits of bank consolidation and nationwide
banking. The elimination of geographic restrictions on banking will increase competition
and drive inefficient banks out of business, thus raising the efficiency of the
banking sector. The move to larger banking organizations also means that there will
be some increase in efficiency because they can take advantage of economies of scale
and scope. The increased diversification of banks’ loan portfolios may lower the probability
of a banking crisis in the future. In the 1980s and early 1990s, bank failures
were often concentrated in states with weak economies. For example, after the decline
in oil prices in 1986, all the major commercial banks in Texas, which had been very
profitable, now found themselves in trouble. At that time, banks in New England were
doing fine. However, when the 1990–1991 recession hit New England hard, New
England banks started failing. With nationwide banking, a bank could make loans in
both New England and Texas and would thus be less likely to fail, because when loans
go sour in one location, they would likely be doing well in the other. Thus nationwide
banking is seen as a major step toward creating a banking system that is less
prone to banking crises.
Two concerns remain about the effects of bank consolidation—that it may lead to
a reduction in lending to small businesses and that banks rushing to expand into new
geographic markets may take increased risks leading to bank failures. The jury is still
out on these concerns, but most economists see the benefits of bank consolidation
and nationwide banking as outweighing the costs.
Separation of the Banking and Other Financial Service Industries
Another important feature of the structure of the banking industry in the United
States until recently was the separation of the banking and other financial services
industries—such as securities, insurance, and real estate—mandated by the Glass-
Steagall Act of 1933. As pointed out earlier in the chapter, Glass-Steagall allowed
commercial banks to sell new offerings of government securities but prohibited them
from underwriting corporate securities or from engaging in brokerage activities. It
also prevented banks from engaging in insurance and real estate activities. In turn, it
prevented investment banks and insurance companies from engaging in commercial
banking activities and thus protected banks from competition.
Despite the Glass-Steagall prohibitions, the pursuit of profits and financial innovation
stimulated both banks and other financial institutions to bypass the intent of the
Glass-Steagall Act and encroach on each other’s traditional territory. Brokerage firms
engaged in the traditional banking business of issuing deposit instruments with the
development of money market mutual funds and cash management accounts. After
the Federal Reserve used a loophole in Section 20 of the Glass-Steagall Act in 1987 to
Erosion of
250 PART I I I Financial Institutions
allow bank holding companies to underwrite previously prohibited classes of securities,
banks began to enter this business. The loophole allowed affiliates of approved
commercial banks to engage in underwriting activities as long as the revenue didn’t
exceed a specified amount, which started at 10% but was raised to 25% of the affiliates’
total revenue. After the U.S. Supreme Court validated the Fed’s action in July
1988, the Federal Reserve allowed J.P. Morgan, a commercial bank holding company,
to underwrite corporate debt securities (in January 1989) and to underwrite stocks
(in September 1990), with the privilege extended to other

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