INDEPENDENCE ISSUE PAPER 16-87 Independence Institute 14142 Denver West Parkway #101 * Golden, CO 80401 + (303) 279-6536 December 21, 1987 INTERSTATE BANKING: HOW COLORADO WOULD BENEFIT By Jerome C, Darnell Professor of Finance University of Colorado Introduction The Colorado Legislature will soon be Confronted once again with the issue of whether or not to permit interstate bank- ing on either a reciprocal basis with contiguous states or a nationwide basis. This issue paper will examine the propo- sal_and look at how it might impact the ordinary citizen of Colorado. The debate should center on two questions: Would this change spur economic growth in the State, and perhaps in the Rocky Mountain region? Would an interstate banking net- work better serve the financial needs of the citizens of the state? Definition of Banking Terms Three types of banking structure are pre- valent in the U.S. today. Each of the three will be discussed below to afford better understanding of the controversy. Branch banking is a form of banking or- ganization in which a bank is permitted to conduct its business from more than one office. The branch offices are nor- mally engaged in offering the complete array of banking services that would be offered at the head office. In other words, there is a single bank, with one charter for doing business, with one board of directors, one president, and one set of by-laws. It is simply one organization with more than one place of doing business. Over the years there has IN BRIEF + Should Colorado permit bank owner- ship across state lines? When this proposal was defeated in the 1986 legislative session, — opponents were relieved at avoiding its "devastating impact on communi- ties" and its “danger to the economy fron concentration of the money supply in the hands of a few giant mega~banks." + But proponents warned of "a shift in the regional economic center from Denver to Phoenix or Salt Lake City." One leading banker i "We are already losing + Proposed again in the 1987 ses- sion, the measure was cheered as necessary to “protect Colorado's place as a financial hub" but booed by consumer advocates as holding few real benefits. It ‘once more failed to pass. The bill is given a good chance in 1988, however, and CU finance professor derome Darnell welcomes it in this issue paper. ‘Darnell says that a change in Col- orado law to permit interstate banking is overdue. Barriers can- not be erected around Colorado to inhibit the free flow of capital and retard innovation in banking practices, The benefits may not be dramatic, but the downside risk appears minimal. +The law probably would facilitate arrangement of larger loan pack- ages among affiliates of holding companies. Banks may be able to use the law change to import some capital from other states to assist our state's growth. ee | Note: The Independence Issue Papers are published for educational purposes only, and the authors speak for themselves. Nothing written here is to be construed as necessarily representing the views of the Independence Institute or as an attempt to influence any election or legislative action.been a steady trend among the states toward providing wider geographic opportuni- ties for branch banking within a single state's borders. Even though the movement toward wider area branch banking has only a handful of states left to encompass (Colorado included), branch banking across state lines is still taboo, As will be discussed shortly, none of the 40 states which have adopted some form of interstate banking legislation has gone so far as to permit entry into the state by buying existing banks and converting them into branch offices, or establishing branch offices from scratch (referred to in bankerese as de novo branching). ‘At the other extreme in banking structure is the organizational form known as unit banking. Under this system, a bank has only one location and all of its Business Teconducted at the single office. In a unit banking state, each bank is individually chartered either by the state government or the federal government (Comptroller of the Currency), and each bank has its own board of directors. All states, including Colorado, for a number of years have permitted of f- premise facilities which offer a limited array of banking services. The current Colorado law allows one facility per bank to be located within 3,000 feet of the head office, The primary distinction between a facility in Colorado and a branch office ina state that permits full-service branch banking is that the facility Cannot make loans, That may seem an unimportant distinction to the typical bank user, but within the banking fraternity it has enormous importance, Between the two extremes of branch banking and unit banking lies the hybrid form of holding company banking. This is an organizational form in which a corpor- ate entity owns two or more banks. The individual banks may have branch offices, if branching is permitted, or they may be unit banks. Each bank owned by the holding company is individually chartered and has its own board of directors, al- though the same officers and directors may be common to some or all of the affil- jated banks within the holding company umbrella. Historical Perspectives Leading to Interstate Banking Holding company banking first emerged in the non-branching Northwest Central states in the late 19th century. The motivation behind the early development of the bank holding company systems was two-fold. First, the chartering of a corpora- tion under the general incorporation laws of the state for the purpose of owning two or more unit banks was an easy way to skirt the branch banking ban at the state level. Second, in the early days it was also a convenient vehicle for combining non-banking susidiaries with banking activities. It didn't take enterprising bankers long to discover that the holding company arrangement could also be used to cross state lines. It was a useful mechanism for circumventing in-state branch banking restrictions with a substitute form of branching that was perfectly legal. It also afforded the opportunity to develop interstate semi-branching systems, which had always been prohibited since the demise of the Second Bank of the United States in 1836. Furthermore, a bank holding company could combine all sorts of non-banking business ventures with the business of banking.Congress finally awakened to the fact that its restrictions on interstate banking and the linking of non-banking businesses with banking were being flouted. The result was the passage of the Bank Holding Company Act of 1956. This was the first attempt by Congress to assert control over this substitute form of branch banking. The act had numerous provisions, but the ones of most concern for this discussion were the following: 1, The act defined a bank holding company as a corporate entity (no mention of individuals loosely affiliated or partnerships) owning 25 percent or more of the voting stock of two or more banks.2 2. Once so designated, a bank holding company would have to submit to super~ vision and regulation by the Federal Reserve Board of Governors in Washington. 3. The holding company would have to dispose of existing non-banking activities that were not “closely related" to banking.3 In the future such activities could be added to the holding company system only after meeting certain tests. 4. Perhaps the most important provision of the Bank Holding Company Act was the so-called Douglas Anendment, sponsored by a senator from the strong unit banking state of Illinois. This provision prohibited further inter- state expansion by existing bank holding companies and for those that might develop in the future. The amendment stated that, before a bank holding company could expand across state lines, the state targeted for entry would have to have a law on its books that specifically permitted out-of- state entry. In other words, no more junping across state Times and buying banks there just because the state's law was silent on the matter. The Douglas Amendment was the first time Congress had ever passed such a banking restriction that said you must have prior permission to carry out an act. The typical rule has been that an act is legal as long as there is no specific prohibition against it. With the Douglas Amendment, Congress passed the ball to the states to let them decide whether the entry of an out-of-state holding company would be in the state's best interest. What happened to the interstate multibank holding companies already in existence in 1956? They were "grandfathered" in -- allowed to keep their positions intact. But those that were in existence could not expand further in any of the non-home office states of operation. Therefore, an institution such as First Interstate Bancorp, headquartered in Los Angeles and formerly known as Western Bancorp, could retain all of its banks in 11 Western states, including three in Colorado, where it had operations prior to the passage of the 1956 law.4 No sooner had the 1956 Act been passed than some 16 states, predominantly unit banking states, quickly passed laws to prohibit the formation of multibank holding companies within their borders. These laws were passed with the intent of preserving the unit banking integrity that had always persisted within the various states. However, Colorado was not one of the states to pass such a law in the wake of the 1956 Act.