When the Massachusetts Bankers Association offered me the opportunity to appear on behalf of my firm to discuss the current state of the dual banking system, I readily accepted. The dual system seems to be under challenge today as never before. Corporate America seems to be favoring the Federal charter. The bluest of blue chips of corporate America have looked closely at charter alternatives. These premier companies have taken a keen interest in Federal thrift institutions over the last few years. Consider some of the names: Traveler's Group (which my firm represented on its recent successful application), John Hancock, Transamerica Corporation and Nationwide Insurance. And not just insurance companies have taken an interest. Such giants as GE Capital, Merrill Lynch & Co., Excel Communications Inc., the nation's fourth-largest long-distance phone company, and others have been applying for thrift charters. These are leaders in their fields choosing a Federal, not state, charter to do business. Federal-state considerations played an important role in their decision-making.

And let us pass from leaders in corporate America to our legislators in Washington. What have they been doing for the dual system? You will remember that in 1978 Congress approved the Federal charter option for mutual savings banks, thus promoting the dual system. The consumer lending laws of that era made allowance for state consumer protection schemes. You in Massachusetts are very familiar with the strength of these potent consumer forces in your Commonwealth.

For a time, the state systems were given their due. But the massive failures of the thrift and banking industries in the 1980's – most recently documented in an FDIC study, bankrupted both Federal deposit insurance funds. The call on the Federal Treasury that resulted changed Federal deference to the state system – perhaps irrevocably. In 1989, Congress finally owned up to the problems of thrift institutions and passed FIRREA. In 1991, Congress turned to the unfinished business of bank regulation with FDICIA. In a sweeping change for the dual banking system, Congress enacted provisions to the Federal Deposit Insurance Act that gave the FDIC veto power over new powers the states might care to give their institutions. Now hidden away in the FDIA are sections 24 and 28. These sections prohibit any state chartered bank or thrift from engaging as principal in any activity not permitted for a national bank or Federally chartered thrift. The rule is: if a Federally chartered bank or thrift may do it as principal, so may a state chartered institution. As for agency activities, for the present, these are left untouched.

What, then, do we see as we attempt to assess the current state of the dual system? We see giant, national and international firms opting for the Federal thrift charter to conduct banking business on a national basis. We see interesting new affiliations resulting: banking and insurance, banking and communications, banking and retail investment products. At the government level, we see the Federal government clamping down on the ability of state chartered institutions to innovate. When acting as principal, they must engage in activities Federal Regulators have approved for a national bank or Federal thrift. A Federal stamp is everywhere when it comes to the conduct of banking business.

This government trend is a return to the roots of the dual banking system as it was originally intended. The national bank charter was initially designed to oust the banking functions of state banks. I will pause for a moment to recount the story.

The national banking system was the idea of President Lincoln's Secretary of the Treasury, Salmon P. Chase, a persuasive Ohio lawyer. His belief was that to provide a uniform currency for the war effort, a uniform issuer of currency was necessary: a national bank. So he devised the national banking system, based upon a New York model. While a logical approach, this was a preposterous suggestion for the problems of war finance facing the Lincoln Administration in 1863. It would take years for such a system to establish itself. In fact, it was initially so unsuccessful in displacing state bank currency that Congress enacted a confiscatory tax on state banks to drive state banks out of the currency business. The Supreme Court later upheld the tax in 1869 in Veazie v. Fenno, with Chase himself sitting as Chief Justice, affirming his own system against a Maine chartered state bank. For a while national banks seemed to be winning the day, but eventually, toward the end of the century state banks had a resurgence.

The national banking system, then, was originally designed to displace the state system. The national bank now provides the standard of acceptable powers for state chartered banks as established by FDICIA in 1991. Any proposed variance by a state bank must receive special FDIC approval. To this extent, we have returned to the notion that a national system must replace a state system.

We can also see historical echoes in the current interest in the Federal thrift charter. You all know that a state thrift charter would do just as well from the standpoint of the unitary holding company law. This law permits a General Electric or a Travelers' Insurance to be affiliated with a savings institution whether chartered by the state or chartered by the Federal government. Bank holding company law would prohibit this affiliation, because of a "closely related to banking" requirement that Federal Reserve Chairman Alan Greenspan has recently defended. Why then a Federal charter if not required by the unitary holding company law? A Federal, as opposed to state, charter has been sought, because of the preemptive authority of Federal thrifts to conduct their business without regard to state law limitations. This special preemptive authority has a Constitutional foundation. It is special to Federal thrifts because of their unique legislative history and legislative authority.

Federal thrifts were first suggested in the early stages of the Great Depression by representatives of the thrift industry in order to provide some uniformity in thrift practices. A dizzying array of savings and lending plans existed at the state level at that time. Legislation was finally enacted in 1933 after President Roosevelt took an interest, reading the legislation cover to cover himself and approving it. This brilliant politician is responsible for the name of the Federal thrift legislation, the "Home Owners' Loan Act." His principal interest was the Home Owners' Loan Corporation, a vehicle for refinancing thousands of defaulted home mortgage loans. The Federal charter was an afterthought for this legislation. Atlanta lawyer Horace Russell was responsible for drafting the legislation, and, like Chase, he based his Federal charter on a New York model, in this case the New York state savings bank. But unlike Chase's national banks, Federal thrifts were not designed to drive out state thrifts. They were to fill a need in communities where home financing institutions were lacking. They were also to provide a model for financial institutions by establishing the "best practices", a standard that is still in the legislation today. It is this "best practices" language, premised upon the Depression Era need to improve and strengthen savings and mortgage lending practices, that gives Federal thrifts a special claim to Federal preemptive effect under the Supremacy Clause of the United States Constitution.

Thus, large firms, seeking to establish a national presence without regard to restrictive state laws, are looking to the Federal, rather than the state charter, to do business. By choosing this alternative they obtain the benefits of preemption only dimly foreseen by President Roosevelt when he approved the legislation in April of 1933. Again we see a challenge to the dual system.

While the Federal government has been limiting the options of state institutions in order to protect the insurance funds, what has been happening to traditional banking markets? I need hardly attempt to address this audience on that subject. A downhill tumble began for the thrift industry in 1966 and has continued unabated since. It was in 1966, with deposit rate control in full flower, that the deposits at savings institutions became interest rate sensitive at a precipitous rate. The table below documents the transition. As can be seen, deposit rate regulation did little to prevent the public's desire for interest sensitive deposits. This was a calamity for an industry accustomed to stable, low rates of interest on deposits lent on fixed, long term mortgages:

In 1979, I left as Assistant to the Chairman of the FHLBB to join my present law firm. In 1980, I began representing a broker for deposit funds who correctly saw the immediate elimination of deposit interest rate ceilings on jumbo deposits as a market opportunity. For a time the firm, FAIC Securities, Inc., in Miami, Florida, was the largest of such deposit brokers in the country. It was eventually surpassed by similar efforts of Merrill Lynch & Co., now a savings and loan holding company. In 1980, when this chart ends, the Congress made the decision that the thrift industry should be more bank-like and began the era of deregulation with which you are all familiar.

Deposit composition was not only shifting, funds were leaving the banking system. Where were these funds going? According to a Federal Reserve Bank of San Francisco paper issued last spring, this era presaged an historic shift in household investment preferences. At the beginning of 1978, deposits constituted the largest single category of America's household financial assets, followed by trusts, pensions, and life insurance, stocks and bonds, and finally Money Market Mutual Funds. But between 1978 and 1996, household deposit growth slowed relative to the growth of stocks and bonds, and, by the first quarter of 1996, deposits and stocks and bonds had reversed their positions in the household asset ranking: stocks and bonds were first, accounting for 42.3% of household assets, while deposits placed third, accounting for only 16.9%. The change is illustrated in the table below.

You may wonder why insurance companies have taken an interest in banking institutions. You need only look at these charts to understand why. The chart dramatically shows the household shift away from deposits to stocks and bonds: a 56% drop in household deposits, a 49% increase in stock and bond holdings. Trusts, pension, and insurance have increased: a 16% increase over their 1978 level. By garnering both deposit and insurance business, insurance led unitary savings and loan holding companies might reach combined household assets of 55%!

We look again at the horizon: the entry of major financial related firms into banking ownership arrangements. The dominance of the Federal charter in a return to historical roots. Shrinking market share while households look to deposit alternatives. Is there any other good news? Unfortunately, yes. In the last two years, as the appendix documents, Federal regulators, the Comptroller and the OTS, have issued, in breathtaking scope, a host of enabling rulings for Federally chartered institutions. These rulings are a proxy for actual market place developments. They show what market innovators are seeking from the regulators.

Perhaps the most prominent are recent actions in the insurance area by the Comptroller. In 1995, the Supreme Court upheld the Comptroller's decision to permit a NationsBank's brokerage subsidiary to market variable rate annuities in the VALIC case. Such activities were deemed an "incidental power" of a national bank by the Court. In March of 1996 the Supreme Court spoke again in the Barnett Banks case, ruling that the Comptroller's determination that national banks may sell insurance in small towns, or "places of 5,000" as they are termed, preempts state law. In both cases we have the Comptroller being upheld when he expanded national bank's powers. Of the two, VALIC is the more significant, because it sets a general, incidental powers, standard for further expansion of national bank powers by the Comptroller.

Neither the Comptroller nor the Office of Thrift Supervision have been idle in expanding powers or content with examination of insurance issues. The appendix shows selected regulatory actions – proposed regulations and interpretive letters – of both these agencies over the last two years. Over 70 items are listed, about 3 a month during the period covered. The list is thought provoking. Internet, electronic banking, and prepaid telephone card sales are given broad approval. Trust powers are expanded and modernized. The automatic loan machine has appeared as a new way to originate loans based upon electronic credit scoring – an interpretation I was able to secure for a West Coast client. The OTS has eased the way for credit unions to become Federal thrifts – allowing direct conversion to Federal thrift status. Federal thrifts may engage in third party real estate brokerage – a decision unthinkable at the time of the original deregulation activity in the early 1980's. Both agencies have streamlined their regulatory procedures in order to ease regulatory compliance burdens. Banks may leverage their investments in operations – they may invest in payroll services vendors; they may offer access to the Internet by non-customers as part of their electronic banking services. Sale of credit life insurance is expanded. Personal property leasing powers of national banks is streamlined and modernized.

A new diversification vehicle has developed: the "operating subsidiary." These entities are more than the alter egos of banks, they may also, to some unspecified extent, implement the "incidental powers" approved by the Supreme Court in VALIC. Federal banks and thrifts may also directly invest in certain companies, such as software companies.

This list deserves your careful attention. In each of the items listed, behind the regulation or interpretive letter, is a nationally chartered bank or thrift or group of firms planning to undertake the activities in question and seeking regulatory approval. For example, the recent spate of insurance company applications for Federal trust powers was anticipated by several trust powers opinions issued by the OTS in 1996. These opinions are documented in the list provided to you.

It may be difficult for Massachusetts to observe all this Federal thunder, when it played so important a role in the development of American banking. Boston was a major banking center from the outset, along with New York, Philadelphia and Baltimore, because of the importance of Boston as a port for foreign trade – with the possible exception of tea. In Massachusetts was developed the Suffolk Plan, a 19th Century prototype of the clearing house association, that disciplined bank note issue and fostered the holding of reserves by banks. We do not forget Ron Hazleton of Worcester Country Savings Bank, whose NOW Account in 1972 ignited the wave of restructuring that followed. We may ask, with the now pervasive Federal oversight, would the FDIC have permitted the NOW account in 1972? I think not. Such a product was too destabilizing; it caused an earthquake in banking legislation. It took eight years for NOW accounts to become lawful nationally.

What then is the role of the dual system for the future? Indeed, can it have any role? One unanticipated result of preparing the appendix for this presentation was realization of its sheer bulk. State regulators do not have the 200 or so professionals available to the Federal regulators who produce this volume of regulation and interpretation. Several conclusions suggest themselves:

1. The dramatic shift in the dual system wrought by FIRREA and FDICIA requires reexamination. Protection of the insurance funds does not necessarily require an application to Washington every time a new power is sought by state institutions. The balance of state and Federal powers needs review and some degree of restoration.
2. Protection of the deposit insurance funds does not require a presumption that only Federal charter powers may be safely and soundly implemented. State financial institutions are subject to very substantial Federal oversight through reporting and examination not present a decade ago. Management of state chartered institutions should be permitted to innovate. They know they will be held accountable for results.
3. For companies doing business on a national scale, the Federal charter is an obvious choice. It is not the only choice, however. Just as a national bank may establish insurance operations in a small town and then export its insurance powers to other locations, so state chartered banks and thrifts should be able to export their powers to other state locations. This is a radical notion, but there is some law on this subject. It is a kind of preemption, but it is state preemption, not Federal preemption. The Constitutional foundation is different, based upon the full faith and credit clause of the constitution. The clause has been interpreted to mean that each state will respect the laws of the other. This area will develop as state chartered institutions seek to export state granted banking powers to other states in which they do business. Riegle-Neal's interstate branching authority will assure that this issue is raised.

The state regulation of banking has been an essential leavening for the nation's development of banking over many years of the Republic. Protection of our deposit insurance funds should not mean that we stifle the state innovation that has given us such important products as the NOW account and the variable rate mortgage. State institutions and state regulators should promote well managed innovation, whether permitted for Federally chartered entities or not. They should also push the envelope by encouraging their state chartered institutions to establish these new powers in their sister states, testing the limitations of our Constitutional system and the deference that each state must show to the laws of another.

The history of American banking is the history of the exploitation of banking markets. In the Twenty - First Century, this should not be the sole province of Federally chartered banks.

Prepared for the Massachusetts Bankers Association
Chief Executive Officer Conference