Robert T. Parry, president of the Federal Reserve Bank of San Francisco, has seen some of the largest bank mergers in history in his own backyard.

Confronted with yet another megadeal-the proposed merger of NationsBank Corp. and BankAmerica Corp.-Mr. Parry discussed his views of the consolidation trend with American Banker.

Following are excerpts from that conversation.

In a recent Economic Letter, you discuss changes in the financial services industry in terms of supply and demand. What do you mean by that?

I approach the changes in financial services from the perspective of an economist. That causes me to look at it in terms of important supply and demand factors that are causing the financial services industry to evolve.

On the demand side, greater wealth in the country, more sophisticated investors, and globalization, have increased the demand for financial service. If you went back 10 or 15 years ago, financial services played a much different role. These demand factors have been important.

But the developments on the supply side have been even more important. In the information age, there is just no question that when you strip away all the layers, financial services is an industry that deals with information and we now have much more sophisticated ways of processing information. It is just much more advanced than several years ago. We are much better able to incorporate the information we find.

There also have been tremendous innovations in finance. A lot of this goes back to innovations from the universities. The most famous is the work in the options area and following that the work in derivatives, which allow people to better assess, measure, and manage their risks.

So these demand and supply factors are putting the pressure on for change in the financial services industry. It has created pressure to enable institutions to be able to offer different types of instruments and pressure for the removal of geographic barriers to the provision of financial services.

When you look at the banking industry, this has been what it is all about. You have the mergers that are about consolidation, like NationsBank and Bank of America. You also get the convergence, which is the combining of financial services. That is seen by the proposed Citigroup.

You indicate that convergence may be a successful business strategy from a supply standpoint. What do you mean by that?

There are a lot of observers who believe there are similarities in financial services and it is really difficult to differentiate between mortgages, insurance, other loan products. Because there are a lot of similarities among financial products, there would be advantage, in addition to offering banking products, to offer an insurance product or a securities product.

The phrase "one-stop shopping" comes to mind. You could have joint marketing and distribution. That has an appeal to my analytical senses.

Another advantage of convergence and consolidation is the diversification it might bring. One thing illustrated by banking problems of the late 1980s and early 1990s is that those banks located in a single geographic area had a tremendously difficult time with their business. For instance, Southern California went through a very severe recession and Southern California community banks suffered very greatly.

But those banks in the 12th district who also had banks in states that were doing great economically seemed to suffer less. Geographic diversification is helpful to the business.

Product diversification may be helpful as well. The research is not as clear, but it seems to make sense that if you are in different businesses it can provide a measure of diversification that over the long run could be helpful.

You suggest that big banks may actually be more expensive to operate than midsize institutions. Why is that?

Economies of scale may indeed be a factor in mergers, but they probably only exist up to $10 billion or $25 billion of assets. I don't think I have seen a study saying economies of scale are all that compelling when you get above $25 billion of assets.

I'm not going to prejudge and say organization that are $300 billion or $500 billion are going to be inefficient. But it isn't clear that you are going to get tremendous cost savings. As a matter of fact, you could make the case that huge institutions actually have some cost disadvantages just because of the huge management challenges. It means the very large institutions will have to work even more diligently to be efficient.

What strategies are available to help small banks?

Small institutions will find the environment challenging, but they also will find a lot of opportunities. There will be opportunities for niche- type business. They will be able to provide a personal service that some of the large institutions may find very difficult to do. Most community banks I talk to say when there have been large mergers in their markets, there have been new opportunities.

There will be some significant challenges, too, because some of these economies of scale are real when it comes to back office costs. They have to be creative to get those costs to a level comparable to the larger institutions.

You said recently proposed megamergers such as Citigroup and the new BankAmerica make it more imperative than ever for Congress to enact financial reform. Why?

I have been enthusiastic for reform for a long time. We are seeing in the case for convergence that there is a blurring of the distinctions among the different types of financial institutions. But Congress has been well behind the times. Now we need to move in the direction of allowing different providers of financial services to offer a wide range of products.

If you look throughout the world, you see a move in the direction of the disappearance of the difference in these financial businesses. Unfortunately, the laws here in many instances don't reflect that. The Glass-Steagall Act is a good example. Most people, especially economists, don't think there is a good reason to have that law at this point.

You discuss the need to strike a balance between market forces and public policy imperatives, such as protecting the safety net. How do you strike such a balance?

You have to work at that. It is important that we do not jeopardize the safety net, that we make sure that these organizations are examined and regulated in a way that does not cause problems in our financial system. One of the things we ought to look at are ways to increase transparency and market discipline. The possibility of having safety-and-soundness problems is less if there is more information publicly available.

One of the proposals people have made is to change the deposit insurance system. I would hope we could make sure we restrict the amount of insurance to $100,000. To the extent one could do that, there are a number of proposals that create more market discipline because uninsured deposit holders would have more at risk.

Explain how the fight over operating subsidiaries and holding company subsidiaries is more than just a turf battle between the Office of the Comptroller of the Currency and the Federal Reserve Board.

As we move into this newer world with regard to financial services, we have to do it with some caution. Caution is necessary because of this issue of the safety net and our concerns about safety and soundness. We know this exists with regard to depository institutions. There are greater safety-net issues by putting activities in subsidiaries of the bank rather than subsidiaries of the holding company. There is an added measure of security that makes it worth putting it in the holding company.

If they are in subsidiaries of the bank, then if they have difficulties, it affects earnings of the depository institution. So the earnings and thus financial health of the depository institution are more secure if it is put in a subsidiary of the holding company.

You talk about some of the shortcomings in a "quasi-functional" regulatory approach in HR 10. What are these short-comings and what should be done to avoid them?

Functional regulation seems attractive. Why not have the insurance regulators regulate insurance? Why not have those in charge of banks regulate banks? But there is this evolving blurring of distinctions among financial instruments and activities. Who knows what the menu of financial activities will look like five or 10 years down the road. What may be appropriate in 1998 or 2000 may not look appropriate five, 10 or 15 years from now because the industry may evolve in ways we cannot foresee. I don't fault functional regulation. I just question the conclusion that this is the solution.

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