Contrived Competition: Regulation and Deregulation in America [2nd printing 1996. Reprint 2014 ed.] 9780674436794, 9780674436800

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Contrived Competition

R I C H A R D H. K .

VIETOR

Contrived Competition REGULATION AND DEREGULATION IN AMERICA

THE B E L K N A P P R E S S CAMBRIDGE,

OF H A R V A R D U N I V E R S I T Y MASSACHUSETTS

LONDON,ENGLAND

PRESS

Copyright © 1994 by t h e President a n d Fellows of Harvard College All rights reserved Printed in t h e United States of America Second printing, 1996 First Harvard University Press paperback edition, 1996 Library of Congress Cataloging-in-Publication

Data

Vietor, Richard H. K„ 1 9 4 5 Contrived competition: regulation a n d deregulation in America / Richard H. K. Vietor. p. cm. Includes index. ISBN 0 - 6 7 4 - 1 6 9 6 2 - X (cloth) ISBN 0 - 6 7 4 - 1 6 9 6 3 - 8 (pbk.) 1. Trade regulation—United States—Case studies. 2. Deregulation—United States—Case studies. I. Title. HD3616.U46V53 1994 338.973—dc20 93-28975 CIP Pages 4 2 3 - 4 2 6 constitute a n extension of t h e copyright page.

Contents

1

The Experiment with Economic Regulation

1

2

American Airlines

23

3

El Paso Natural Gas

91

4

AT&T

167

5

BankAmerica

234

6

Regulation in Perspective

310

Tables Notes Acknowledgments Credits Index

333 361 421 423 427

Contrived Competition

CHAPTER

ONE

The Experiment with Economic Regulation We have always known that heedless self-interest was bad morals; we know now that it is bad economics. —Franklin D. Roosevelt, 1935

One of my Administration's major goals is to free the American people from the burden of over-regulation. —Jimmy Carter, 1977

Today American Airlines can offer service anywhere in the United States, at any price it chooses; it could not do that before 1979. AT&T is not the only vendor of long-distance telephone service; it was until 1978. Prices charged by El Paso Natural Gas are based on competition among suppliers; until 1978 they were set in Washington. And BankAmerica now serves depositors throughout the western United States; until the early 1980s it was restricted to California. Why is it that in these industries, and half a dozen others, competition and managerial discretion appear to make sense when for nearly half a century they did not? How were regulatory systems, so entrenched politically, suddenly subjected to thoroughgoing reform? And how have the companies themselves managed to adjust? These questions are particularly interesting because deregulation has confounded accepted ideas about politics, economics, and business. Before deregulation, observers of the political process generally believed that the mutual interests of bureaucrats, legislators, and regulated businesses were so strong that significant reform was unlikely, if not impossible. Economists, meanwhile, were so critical of regulation that many viewed its repeal as a panacea. If regulatory barriers and distortions were only removed, they thought, then competition would drive down prices

2

Contrived Competition

and restore efficiency to the markets. Finally, many business managers took regulation for granted and misunderstood its effects on corporate assets, human resources, and prices. For observers and participants alike, deregulation and its dramatic consequences provided some surprising and difficult lessons about the extent to which government intervention had distorted markets and shaped the structure and resources of business firms. The era of regulation, though rooted in earlier institutions and ideas, was largely framed by the Great Depression of the 1930s and the Great Stagflation of the 1970s. The recision of regulation across a dozen industries in the later period was no more a coincidence than the imposition of regulation was during the crisis of the Depression. In both periods, sudden economy-wide performance problems undermined political faith in the prevailing systems of economic management—competition in the first instance, regulation in the second.

The Failure of Competition The decade of the twenties was as prosperous and peaceful as any period in this century. After a sharp but brief recession in 1920 and 1921, the economy started expanding at a healthy pace. There was no inflation, and interest rates were low. Foreign trade grew steadily, enabling the federal government to run persistent budgetary surpluses. Investment in the infrastructure, amounting to 13 percent a year, led this growth. "It was a concentrated flowering of investment opportunities," said one economist nostalgically, "created by a series of new industries and new services." 1 Production and technological innovations stimulated by the war had pushed several such industries toward broader commercial feasibility. Seamless pipes, arc welding, and new types of compressors were making it possible for large pipelines to carry natural gas and petroleum hundreds of miles. Innovations in the generation and transmission of electric power were helping utilities keep up with an explosion in demand for new motors, appliances, and lighting systems. Telephonic innovations made long-distance telecommunications and nationwide interconnection commercially feasible. In transportation, mechanized warfare had stimulated tremendous advances in two new technological modes: trucking and airlines. Engine and tire technologies made possible trucks that were

The Experiment with Economic Regulation

3

large enough to compete with railroads in intercity freight. More powerful aircraft engines and wider airframes enabled companies to initiate and expand commercial passenger service. These were not merely new technologies but entirely new systems of infrastructure, overlaid on the older ones. In the transportation sector, automobiles, trucks, airplanes, and pipelines competed with the railroad and shipping foundation of the prewar era. Similarly, telephonic and radio communications superseded the base of telegraphic, mail, and newspaper communications that had predominated for nearly a century. In the energy sector, petroleum, natural gas, and electricity supplanted direct (and decentralized) reliance on coal and water for power. These new systems created a number of problems for public policy. To the extent that they supplemented existing systems, particularly railroads, telegraph, and coal, their rapid expansion amounted to a substantial increase in capacity by the end of the decade—indeed, led to excess capacity in the less competitive businesses. As it mounted, this excess led to more intense competition, declining prices, and weaker financial performance. The rapid growth and interstate expansion of these industries, meanwhile, encouraged the organization of holding companies to manage and coordinate these systems as they spread beyond local markets. Especially in the electric and natural gas sectors, and to a lesser extent in telephones and airlines, these holding companies became devices for skirting local regulations. To finance this expansion, the banking system also grew rapidly during the 1920s. Intrastate branching, investment trusts, mutual funds, and the integration of large commercial banks into securities underwriting and insurance enlarged the scale and complexity of the financial services industry. Until this time, most social control of economic activities had been vested in state and local government. Only in banking and railroads had federal authority mattered, and even there it had been limited by narrow statutes and even narrower judicial interpretations. 2 Over the course of the 1920s, state public service commissions became increasingly frustrated by the jurisdictional limits on their effectiveness. Out-of-state incorporation, holding companies structured as multilevel pyramids, complicated cost allocations, and transfer pricing frustrated even the most resolute efforts to regulate. By 1930, the regulatory gap between state control and interstate commerce had reached an impasse in judicial review. Federal legislation seemed the only remedy.

4

Contrived Competition

As new problems in other areas of interstate commerce emerged during the 1920s, Washington responded with voluntary and associational initiatives. The political consensus of the 1920s would sustain only limited and indirect forms of intervention. Under Herbert Hoover's leadership as commerce secretary from 1921 to 1928, problems in radio broadcasting and interstate electric sales, manufacturing and safety standards, airlines, energy, and the environment were addressed through studies, guidelines, and voluntary agreements developed jointly by trade associations and federal bureaucrats. This "corporatism," as Ellis Hawley and others have called it, was neither laissez-faire policy nor regulation. It evolved out of the mobilization experience of World War I, but without the force of law that national emergency had warranted. It was motivated by a desire for efficiency and coordination, but also by the realization that private institutions were fundamentally more effective than the public sector. 3 So long as the economy was growing and industry prospering, this voluntarist approach seemed adequate. But late in 1929 the economy of the United States collapsed. Gross national product (GNP) fell at an unprecedented rate ( - 8 . 6 % percent per year) for four years, and then limped along for another five. Investment ceased, especially in the infrastructure; prices on average dropped 25 percent. Dividends were suspended, bond payments delayed, and insolvencies by the thousands swept the very sectors that had driven the previous decade's impressive growth. 4 Worst of all, unemployment rose to 25 percent. The extent of the collapse becomes vividly apparent if we look at the average annual growth rates, given here in percent, for the years 1 9 2 1 - 1 9 3 8 (the figures for "utility construction" include rates for railroads, oil and gas pipelines, electric utilities, and the telephone and telegraph industry): 1921-1929

1929-1933

1929-1938

Real GNP

6.0

-8.6

0.5

Total construction

7.7

-25.0

-4.8

13.5

-33.0

-9.4

-1.0

-6.1

-1.6

Utility construction Inflation

From 1920 to 1929 manufacturing productivity grew an average of 5.5 percent each year and the federal budget showed an average annual surplus of $ 8 1 0 million. But from 1929 to 1937 productivity growth

The Experiment with Economic Regulation

5

slowed to 1.8 percent and the federal budget posted an average annual deficit of $2,206 million. The reasons for this catastrophe are difficult to understand even today; at the time, people were mystified, discouraged, and angry. 5 After a decade of prosperity and genuine optimism about the future, this apparent failure of free enterprise undermined people's faith in competition, in big business, and in public service liberalism. The Hoover presidency, between 1929 and 1933, was the critical gestation period for the nation's loss of faith, not just in competition but in limited supervisory government. Far from doing nothing, Hoover tried to mitigate the descent into depression. He instituted public relief and agricultural supports, negotiated with business leaders to stabilize prices and employment, and created the Reconstruction Finance Corporation. But n o n e of these programs could do enough, and their shortcomings seemed to confirm the need for a more direct form of government intervention. 6 The winter of 1932-1933 is usually recalled as a period of widespread despair. In the countryside, dispossessed farmers lived in camps as they migrated west and south in search of n e w lives. In the cities, the u n e m ployed milled about in the streets, burning trash in barrels to w a r m themselves. "No one," wrote one of Roosevelt's advisers, "can live and work in New York this winter without a profound sense of uneasiness." 7 The nation's businesses lay in ruins. Housing starts, which had exceeded 900,000 in 1925, stood at 93,000 by 1933. Industrial plants in steel, transport equipment, machinery, and chemicals were shuttered throughout the mid-Atlantic and midwestern regions. Steel output hit bottom in 1932, w h e n the nation's mills were operating at 15 percent of capacity. Automobile production fell to 100,000 cars per month, less than a fifth of its volume in 1929. 8 Small utilities, without adequate revenues or financial reserves to service their debt, went bankrupt all across the country. Struggling airlines and trucking companies simply collapsed. By 1933 m a n y interstate pipelines and nearly one hundred of the nation's railroads had fallen into receivership. Half of the nation's coal mines were closed, and in the oil fields hundreds of small producers and refiners were driven out of business by prices that fell to 10 cents a barrel. Agriculture was a disaster. Farm prices had fallen so sharply that millions of farmers could not afford to buy seed or fuel, m u c h less pay their mortgages. The result was a nightmare of foreclosures and distress auctions. 9 The collapse of the banking sector epitomized this crisis. Between 1929 and 1932, five thousand banks failed, along with hundreds of investment

6

Contrived Competition

trusts and insurance companies. As people stopped paying interest on mortgages and loans, the value of assets deteriorated. As people drew on their savings to meet everyday expenses, banks failed. Until 1932, these were mostly smaller banks and savings and loan associations that lacked large reserves. But as a widening circle of panic seized the nation's depositors, even big-city commercial banks began closing. Since there was no deposit insurance, thousands of people lost their life savings. Yet even as the failure rate accelerated, a lame-duck session of Congress that convened in December 1932 could accomplish nothing. The economy was in free fall, the government adrift. If Franklin Roosevelt had his own ideas about government's role in the economy, he kept them mostly to himself during the presidential campaign. Although he gave many speeches, they generally addressed broad needs rather than particular solutions. But Roosevelt did rely on advisers with all sorts of ideas about competition and regulation. One group, which the media dubbed the Brain Trust, advocated national planning. Rexford Tugwell, Raymond Moley, and Gardiner Means, all of whom worked on the campaign, shared ideas about government that built on the experience of mobilization and planning during World War I. Markets, they felt, no longer worked in most important industries. Huge corporations could avoid competition, exploit labor, and manipulate finances. "Control" of society's assets had come to be concentrated in the hands of an excessively small number of people: corporate executives in the private sector. Adolf Berle and Gardiner Means documented this development most effectively in their book The Modern Corporation and Private Property, published in 1932. 1 0 Yet because they valued the economies of scale and the complex technical systems afforded by modern industry, the Brain Trusters' solution was not the restoration of competition but national planning, administered by well-intentioned experts like themselves. "What we needed," wrote Tugwell, "was not more competition, but less." There was no point in going back: "We were at the present time a long way on the road to a system of monopolies. Ray, Adolf, and I had been insisting that we should allow it to evolve and should manage it publicly, rather than go back to a more primitive state where no social management existed. That primitive state was not only economically orthodox but was the political stock in trade of the progressives. It had, however, led us into terrible trouble, and persisting in it would not get us out." 11

The Experiment with Economic Regulation

7

Although Roosevelt always listened to this advice, and sometimes followed it, other approaches, often contradictory, also caught his attention. Collectivist agendas, as they evolved out of the 1920s, still held some appeal. Bernard Baruch, Gerard Swope, and Hugh Johnson were notable proponents of cooperative solutions to the problems of overproduction and falling prices. These men, especially Baruch, looked back to the World War I era for models—situations in which competition had produced only chaos but in which cooperation had appeared to produce results. The Depression, in their view, was caused by too m u c h competition, not too little. "Cut-throat and monopolistic price slashing," "chiseling," and "economic cannibalism" were n e w synonyms for competition. 12 The problem, according to Hugh Johnson, w h o would head the ill-fated National Recovery Administration, was too m u c h "eye-gouging, kneegroining and ear-chewing in business." 13 The notion that competition had failed was shared by descendants of Woodrow Wilson's "New Freedom" (the 1912 campaign slogan for promoting entrepreneurship and tough antitrust laws) but with exactly the opposite effect. Most prominent among this group were Justice Louis Brandeis, Felix Frankfurter, a law professor at Harvard and later a Supreme Court justice, and James Landis, a principal author of the Securities Act of 1933. These men, whose advice and philosophy also claimed a piece of Roosevelt's attention, attributed the problem to imperfect competition and monopoly power. For them, decentralization of business power, through antitrust enforcement, holding-company divestiture, and tough securities regulation, was the solution. 14 It was from this mélange that Roosevelt derived his program. Proponents of all of these approaches agreed on two things: that competition as practiced had failed, and that government needed to assume greater responsibility for economic performance. Immediately u p o n taking office, President Roosevelt began building on these ideas with his o w n commitment to action, and with a pragmatism that tolerated institutional experiments of almost every stripe. The story of FDR's Hundred Days is well known. After a resounding inaugural that promised relief to every economic sector and demanded the emergency powers of wartime, Congress and the administration threw together the early elements of the New Deal—a bailout for banking, agriculture, and manufacturing. The government, not markets, would restore the public's confidence.

8

Contrived Competition

Beginning in this period with banking, and continuing over the next five years, the New Deal's regulatory regime took shape. Its principal legislative achievements were as follows: Banking and financial services Banking Act of 1933 Securities Act of 1933 Securities Exchange Act (1934) Banking Act of 1935 Telecommunications Communications Act of 1934 Transportation Emergency Railroad Transportation Act (1933) Air Mail Act of 1934 Motor Carrier Act (1935) Civil Aeronautics Act of 1938 Federal Maritime Act (1938) Oil, gas, and electric power Connally Hot Oil Act (1935) Public Utility Holding Company Act (1935) Natural Gas Act (1938) Retail and wholesale distribution Robinson-Patman Act (1936) Miller-Tydings Act (1937) Some of these initiatives, such as airline regulation, resulted from the desperate pleas of the industry itself. Others, including the Natural Gas Act, were passed despite the loud objections of industry. Some were conceived by experts and supported by broad reformist constituencies; the Banking Act and the Securities Act of 1933 are prime examples. Other legislation, although designed to support particular interests, also benefited from broad popular support; this was the case with the Robinson-Patman Act, which was intended to prevent chain stores from engaging in discount pricing. Some of the measures, including the Communications Act, were initiated by the administration itself. Others, such as

The Experiment with Economic Regulation

9

the Connally Hot Oil Act, originated with particular congressional interests but succeeded through Roosevelt's acquiescence or lack of interest. Although these sectoral measures differed significantly in statutory design, they had several things in common. They were designed to correct the perceived failings of competition, gave unprecedented authority to the federal government, and tried to solve problems for which existing economic theory had no effective answers, at least before Keynes. The Great Depression was the result of a macroeconomic failure, but as the economic historian Peter Temin has observed, "the New Deal represented an attempt to solve macroeconomic problems [insufficient aggregate demand, unemployment, and deflation] with microeconomic tools" [industry-specific regulation]. 15

The Era of Economic Regulation Taken together, the New Deal regulatory initiatives constituted a vast regime of microeconomic stabilization. From the late 1930s until the late 1960s, this system controlled price and entry competition in all of the nation's key infrastructural industries. The federal agencies created or strengthened by this legislation were vested with extraordinary powers to shape most aspects of market structure in these industries. High-quality, widely available service, secure contractual arrangements, and stable (often cross-subsidized) pricing were the principal objectives, and indeed accomplishments, of federal regulators. Like the decade of the 1920s, the period between 1939 and 1968 was an era of prosperity, with strong economic growth (gross national product increased 4.3 percent per year in real terms), low inflation (3.8 percent), and low interest rates (2.0 percent on average for three-month Treasury bills). Productivity improved steadily, and the federal budget oscillated between small surpluses and deficits. By most measures, regulation appeared to work well in this environment. The financial system quadrupled its assets. More than 40,000 financial institutions provided a wide range of services. Bank failures were virtually nonexistent. In the energy sector, an integrated national network of pipelines delivered petroleum and natural gas inexpensively to every major market. Oil and gas supplies were abundant, with prices stable and even declining a bit during the 1960s. Electric utilities likewise

10

Contrived Competition

succeeded in meeting unprecedented demand with steadily declining rates. In the airline business, the Civil Aeronautics Board limited entry and maintained an effective cartel of sixteen healthy carriers to serve the major intercity markets. Business travelers and affluent tourists could go almost anywhere, often nonstop; they were offered frequent departure times and the relative luxury of ample seats, meals, movies, comfortable lounges, and a guaranteed reservation. The trucking business also prospered in the absence of price and entry competition. Sixteen thousand trucking companies plied the nation's federally subsidized highway system, capturing more than three-fourths of the surface freight market, albeit at the expense of the railroads. And in telecommunications, the Bell System constructed and operated a nationwide telephone network that was the envy of the world. Standardization, centralized control of engineering and operations, and cross-subsidized pricing produced highquality service that reached nearly all areas of the country. And the earnings were sufficiently generous to support Bell Laboratories, the world's preeminent industrial research center. Of course, regulation of business was not the only aspect of the government's expanding role in economic affairs. By the 1960s, management of the macroeconomy and the remediation of social problems were increasingly viewed—at least by the political majority—as responsibilities of the federal government. The intellectual basis for government intervention in the macroeconomy was the revolutionary work of John Maynard Keynes. In The General Theory of Employment, Interest, and Money, published in 1936, Keynes provided a theoretical explanation of w h y market economies were not self-equilibrating and h o w government's fiscal policy could affect spending and investment. Although rejected by Roosevelt, Keynes's ideas were embraced by the American economics profession. Macroeconomics became the glamour field of study. In the decades after World War n, Keynesian economists came to believe that business cycles could be managed. If either inflation or unemployment got out of hand, federal spending and taxation could be adjusted to counteract it. In fact, even long-term growth was thought to be subject to this marvelous control. As Paul Samuelson put it, "whatever rate of capital formation the American people want to have, the American system can, by proper choice of fiscal and monetary program, contrive to do." 16 When John Kennedy took office in 1961, Keynesian economists had

The Experiment with Economic Regulation 11 their own student in the White House. Walter Heller and James Tobin were among the most prominent Keynesians w h o helped Kennedy set precise targets for a full-employment, noninflationary economy, growing at 4.5 percent. In 1963 they designed a major tax cut, despite a deficit in the federal budget, to extend the economy's growth for another five years. The tax cut, which Lyndon Johnson carried through in 1964, worked as predicted. Growth spurted, and the economy provided increased tax revenues without significant inflation. As a result, President Johnson could afford to propose a series of legislative initiatives that collectively would lead to a "Great Society," even while he financed the early stages of a war in Southeast Asia.

The Failure of Regulation But the political and intellectual confidence in government had reached its apex. Even as the Johnson administration rolled out its new antipoverty programs and instituted Medicare for the elderly, opposition to expansion of the Vietnam War cast a widening shadow over the administration's social and economic agenda. When economic growth slowed in 1967, the budget deficit more than doubled as tax revenues failed to match the 18 percent increase in outlays. By 1968 the budget gap had widened from $8 billion to $25 billion. Treasury borrowings helped push interest rates above the Federal Reserve's ceiling on savings accounts, giving rise to disintermediation (the circumvention of banks by lenders and borrowers). Worst of all, the inflation rate rose to 4 percent—its highest level since 1951, during the Korean War. With the government now mired in Vietnam, desperate to avoid a generalized tax increase, and openly fighting student protesters across the country, the United States entered a prolonged period of economic decline. Productivity, which had grown 3.3 percent annually since World War II, now slowed to 1.2 percent. Growth in GNP likewise stagnated, averaging just 1.9 percent over the next seven years. Inflation accelerated to unprecedented levels for peacetime, and nominal interest rates nearly tripled from their pre-1968 levels. Budget deficits, which had rarely exceeded $10 billion, now began widening, to reach $200 billion by 1983. Again, a brief tabulation gives a striking profile of the downturn.

12

Contrived Competition

The following percentages, taken from the Economic Report of the President for 1973 and 1991, show the changes in the country's basic economic conditions from 1938 to 1983: 1938-1968

1968-1975

1968-1983

Annual growth in real GNP

4.3

1.9

2.2

Inflation (GNP deflator)

3.8

6.8

7.0

Average interest rate on 3-month Treasury bills

2.0

5.9

7.4

From 1948 to 1968 growth in labor productivity averaged 3.3 percent per year and the average federal deficit was $3.1 billion. From 1 9 6 8 to 1983, however, labor productivity grew only 1.2 percent per year and the average annual deficit ballooned to $ 5 8 . 3 billion. Although certainly not as severe or as readily apparent at the time, this turnaround in the U.S. economy was as fundamental a structural change as the Great Depression. In neither period could the best conventional wisdom convincingly explain, much less remedy, the weak economic performance. Following the recommendations of his Keynesian advisers, President Nixon cut spending anu raised taxes. Although this produced a recession in 1970, it did nothing to alleviate inflation. In August 1971 the Nixon administration devalued the dollar, ending thirty years of fixed exchange rates, and imposed mandatory wage and price controls. Although the dollar was substantially devalued, fixed rates were never reestablished. This change in the international monetary regime had two important consequences. B y shifting to floating exchange-rate rates, the advanced countries had unknowingly begun the process of deregulating and eventually integrating their capital markets. And by decoupling the dollar from gold, U.S. inflation was transmitted abroad, giving Arab oil producers further incentive to raise prices sharply, as they did in 1973. The final blow to public confidence in government came in 1974. On top of an economy plagued by oil and gas shortages, inflation, and unemployment, the president of the United States was forced to resign his office to avoid impeachment arising from illegal campaign activities. By the time Gerald Ford, the House minority leader, took charge of the White House in the late summer of 1974, disillusionment with government was pervasive. The U.S. economy was once again slipping toward

The Experiment with Economic Regulation

13

recession, yet inflation was sapping real incomes and consumer purchasing power. The antipoverty programs, with built-in cost-of-living escalators, had degenerated into budgetary sinks with disappointing results. And economic regulation no longer delivered its historical results. Shortages of natural gas had caused widespread curtailments of service; petroleum products were in short supply, despite doubling and tripling in price; electric utilities suffered brownouts and blackouts in the summer heat, and then sought unprecedented rate hikes; commercial airlines were losing money despite higher fares; and several of the nation's largest railroads faced bankruptcy. In commercial banking, the failure rate jumped sharply in 1974, foretelling future problems, and the government brought an antitrust suit against the Bell System, the nation's greatest utility. In just six years, the downturn in economic performance had thoroughly undermined the public's faith in government—in macroeconomic demand management, in social engineering, and in economic regulation.17 A new consensus, that government itself was the problem, was emerging across the political spectrum.18 The intellectual foundations for this development were already in place. In the field of industrial organization, a growing body of microeconomic research was revealing the latent weaknesses of regulation. Beginning in the late 1950s, studies of railroads and airlines had pointed to the problems of price and entry controls. As early as 1962, in the utility sector, rate-of-return regulation was cited as the source of inefficient capital allocation. Later studies suggested that regulation induced excess capacity, caused higher-than-necessary costs, retarded innovation, and severely distorted patterns of supply and demand.19 By 1971 this intellectual critique of economic regulation had spread throughout the economics profession. Alfred Kahn, a microeconomist at Cornell University, published his two-volume masterpiece, The Economics of Regulation, which documented the failures of traditional regulation and advocated a new reliance on marginal-cost pricing.20 At the University of Chicago, where a school of free-market advocacy had begun to challenge the regulatory orthodoxy, George Stigler published "The Theory of Economic Regulation." This article provided a theoretical basis for the phenomenon of regulatory capture, in which regulation is manipulated by regulated firms so as to bring them unwarranted profits.21 These scholarly critiques of regulation penetrated the bureaucratic and legislative corridors of Washington through policy analysis produced at several think tanks, including the Hoover Institute, the Brookings Institution, and the

14

Contrived Competition

American Enterprise Institute, and through the appointment of regulatory economists to positions on the Council of Economic Advisors, the Department of Transportation, and various regulatory agencies. 22 Criticism also emerged from the consumer movement, of which Ralph Nader was a prime mover. In 1965 Nader published Unsafe at Any Speed, a journalistic attack on the automobile industry's safety record. Building on this success, Nader organized the Center for the Study of Responsive Law and deployed teams of committed young researchers, dubbed "Nader's Raiders," to investigate inept government regulation and big business. Their early studies, of air and water pollution control, the Federal Trade Commission, and the Interstate Commerce Commission, effectively publicized the failures of government regulation, especially the idea of regulatory capture. Later in the 1970s, w h e n reform legislation reached Congress, Nader's organizations, together with the Consumer Federation of America, Common Cause, and the Consumers' Union, provided the political mass needed to overcome opposition from industry. 23 Among politicians, however, serious interest in regulatory reform was not aroused until 1975. Although the Nixon administration undertook some administrative reforms to streamline the federal bureaucracy, it was not concerned with the economic effects of regulation or interested in pursuing major legislation. Neither was Gerald Ford initially, but the persistence of inflation eventually led his advisers to focus on government policies that might be contributing to the problem. After a few months, President Ford began speaking of regulatory reform as an end in itself, drawing a favorable parallel between competition in business and competition in sports. 24 At that very moment, Senator Edward Kennedy, a liberal Democrat f r o m Massachusetts, launched an attack on regulation from a very different ideological and political perspective. Kennedy, like Nader, was convinced that certain economic regulations hurt the interests of consumers, a constituency that the senator had cultivated for some time. As we will see in the next chapter, Kennedy organized hearings and cosponsored legislation that successfully put regulatory reform on the congressional agenda. During the presidential campaign of 1976, the old consensus that supported active government was nowhere in evidence. Both President Ford and his Democratic challenger, Jimmy Carter, campaigned against big government. Ford took a moderate, probusiness approach that was tra-

The Experiment with Economic Regulation

15

ditional for Republicans. "Government should foster rather than frustrate competition," said the president. "It should seek to insure maximum freedom for private enterprise." 25 But Carter, a small businessman from Plains, Georgia, who cultivated the image of a Washington outsider, attacked the culture of power that pervaded the capital. Once installed in the White House, Carter immediately endorsed airline deregulation, and signaled his commitment by appointing Alfred Kahn as chairman of the Civil Aeronautics Board. From there, Carter progressively embraced partial deregulation of gas prices, oil prices, electric power generation, trucking, railroads, telephone equipment, and banking. In fact, legislative reform of regulation occurred almost exclusively during the Carter years. Congress did nothing before 1977, and passed only three deregulatory laws after 1980: the Bus Regulatory Reform Act of 1982, the disastrous Garn-St. Germain Banking Act of 1982 (which contributed to the crisis in the savings and loan industry), and the Cable Television Act of 1984 (which Congress revoked in 1992). In view of Ronald Reagan's campaign rhetoric and the fervor of his advisers, this might seem surprising. Indeed, the Reagan team did have ambitious plans to attack regulations for environmental protection and nuclear power, consumer products, health and safety, agriculture, broadcasting, and financial services. Shortly after the election, David Stockman, whom Reagan appointed director of the Office of Management and Budget, called for a "major regulatory ventilation" to restore business confidence. 26 The president appointed George Bush to chair a task force on regulatory relief, froze all pending regulatory orders, and attacked regulatory budgets. He appointed aggressive deregulators to head the Council of Economic Advisors and half a dozen regulatory agencies. At first, these initiatives had some effect. Expenditures on regulation actually decreased by 3 percent (in real terms), and federal regulatory personnel shrank from 119,000 to 101,000. The budget for industry-specific regulation was reduced by more than a third, and there were sharp cuts in the enforcement budgets for the Environmental Protection Agency, the Occupational Safety and Health Administration, and the Consumer Product Safety Commission.27 But now, the consensus for regulatory reform, which had embraced the entire political spectrum in the late 1970s, began to disintegrate. In part, it was undermined by the very fact that the critique of economic inefficiency had expanded to a broad attack on the social regulations that protected consumers, workers, and the environment. 28 Most Democrats,

16

Contrived Competition

many moderate Republicans, and the majority of the public still supported these forms of government regulation. 29 There was, moreover, no real intellectual basis for revoking them. A devastating recession and expanding budget deficits in 1982 and 1983 eroded the administration's influence with Congress. Accusations of political corruption, involving the heads of the Environmental Protection Agency and the Department of the Interior, heightened the public's skepticism about deregulation and reinvigorated support for public advocacy groups. By 1984 the political momentum for deregulation was largely spent.

When people saw in the 1930s that competition had failed, a system of government regulatory controls, which left private property intact, was developed as a politically logical and constitutional solution. In the 1970s, when this system of regulation was blamed for economic stagnation, a new political consensus developed in support of competitive markets. Prior to the thirties, in the industries we will examine, the development of markets and industry structure was shaped primarily by technological and economic characteristics, by executive leadership and strategy, and by competition among firms. Government policy was a factor, but not the dominant one. During the era of regulation, from the late 1930s to the 1970s, government policy was the preeminent determinant of market development and structure. Then, in the 1980s, as a mixed regime of regulation with competition emerged, both public policy and business strategy shaped market outcomes. Figure 1, which depicts this historical evolution graphically, is a sort of aerial photograph of the regulatory terrain. It shows key changes in regulatory policy for the basic infrastructural industries over a span of seventy years. In the first period, lasting through the late 1920s, competition generally prevailed in transportation, energy, communications, and finance—sectors that were thought to be "affected with a public interest" and that together comprised one-fourth of the gross national product. Government intervention in some of these markets had been established decades earlier. Railroads and banks were supervised, relatively loosely, by federal authorities, while local utilities were regulated by state commissions. Still, management retained control of most strategic and many competitive decisions. If anything, competition during the booming 1920s was so intense in some sectors that it was subsequently deemed "excessive" and a prime cause of the Great Depression. In other sectors, corporate expansion and concentration were blamed.

The Experiment with Economic Regulation

1

V V

Naturai gas

1

V

Petroleum

1

V

Telephone

1

V

Trucking

1

Airlines

Railroads

V 2 2

Banking

Securities brokerage Electric power

1 1920

2 2

V

3 • 4 V

3

2

3 2

2

V 1 1930

TT4 T

f?4 3^4

3

Phases of regulation

T4

3

2

1 Integrated competition 2 Economic regulation

„

3 V4

V

1 1940

4 T T4

3 V

vv V

V

3

V

1

•

2

V

17

1 1950

1 1960

1 1970

• 4 1 1980

Key government actions V = Imposed federal regulation T = Deregulation (or regulatory reform)

3 Breakdown 4 Reform

Figure 1. The era of economic regulation.

After the economy collapsed in the early 1930s, Congress and the Roosevelt administration created a vast system of regulation that repressed price competition, restricted entry, and vested government agencies with unprecedented authority to intervene in business affairs. As Figure 1 indicates, the legislative mandates for this new regime were effected in a concentrated burst of policy entrepreneurship. For the next three decades, this system flourished, shaping and defining all the major developments in these key industries. In the late 1960s, problems cropped up in each of these regulated sectors—shortages or surpluses, inefficiencies, inequities, or procedural gridlock in the regulatory process itself. The slowdown in productivity

>•

18

Contrived Competition

growth with ever higher inflation (a p h e n o m e n o n k n o w n as stagflation) aggravated these regulatory failings during the early 1970s. As political support for regulation faded, a wave of administrative and legislative reform swept through the regulated sectors, cresting during the Carter presidency in the late 1970s. W h e n it receded, it left most markets (other t h a n airlines and trucking) still partly regulated, but more competitive t h a n they had been in fifty years. As an aerial photograph, Figure 1 provides a useful orientation but nothing like the careful m a p we would need to find answers to our questions about deregulation. In order to do that, we need to look into the evolution of regulation in particular industries, comparing its impact on diverse economic characteristics, institutions, and individuals. For this purpose, I have chosen four industries, one in each of the major regulated sectors. In transportation, we will focus on commercial aviation. This industry, which originated in the 1920s, was a consumer retail business, with a number of interesting features: rapid technological change, mobile assets, special safety concerns, and a market segmented by thousands of pairs of cities. Commercial aviation barely survived until 1938, w h e n it came under the control of the Civil Aeronautics Board. For the next forty years, it was regulated as a virtual cartel. Congress deregulated the business in 1978, after a relatively brief political fight among the affected interests. Cutthroat competition broke out almost immediately, forcing incumbent carriers to make massive structural adjustments. Since deregulation in this industry was so quick and relatively complete (the regulatory agency was actually abolished), the airline case is especially valuable as a lens to magnify the consequences that occurred more slowly and less completely in most other industries. In the energy sector, we will look at the history of natural gas transportation by pipeline. This business, a straightforward commodity transport activity, became incredibly complex thanks to regulation. Interstate gas pipeline companies, which buy, transport, and resell natural gas to urban distributors and large industrial customers, were first regulated in 1938 by the Federal Power Commission. In 1954 the Supreme Court compounded this task by extending federal regulatory jurisdiction to the wellhead prices (that is, the prices paid by the pipelines) of thousands of gas producers. But the economic characteristics of gas pipelines were virtually the opposite of those of gas production, in terms of capital intensity, scale, and operating procedures: regulatory mechanisms that made sense for one activity often failed in the other. The contrast be-

The Experiment with Economic Regulation

19

tween natural gas and airlines is also interesting. The gas industry was organized in a complicated structure of political interests, while the airline sector was relatively simple. Thus, even after the gas crisis struck in 1969, it took Congress nearly a decade to work out a compromise for partial decontrol. With airlines, just three years of consideration produced complete decontrol. For telecommunications, we will be focusing on the telephone industry. Until the 1970s, telephony was generally thought to exhibit the characteristics of a natural monopoly. This industry was far less fragmented structurally than airlines or natural gas, even before federal regulation was imposed in 1934. American Telephone and Telegraph had consolidated control of more than 80 percent of local networks, and 100 percent of long-distance service. Under the Federal Communications Act of 1934, AT&T was protected from competitive entry in services and equipment until the late 1960s. In return, it provided high-quality service, allowing long-distance prices to subsidize local service and thus making it more widely available. Eventually, though, new technology in the hands of aggressive entrepreneurs forced changes in this regulatory system. AT&T's efforts to maintain its monopoly eventually precipitated an antitrust suit, settled by consent decree in 1982. The company agreed to divest all of its local telephone companies, retaining only long-distance networks and manufacturing. By the end of the 1980s additional regulatory reforms by the Federal Communications Commission had helped shape a more competitive, yet still thoroughly regulated, telecommunications industry. In financial services I chose to study commercial banking, for several reasons: its integrated, multiproduct structure prior to 1930s regulation, its unique regulatory status under the Banking Act of 1933, and its continuing importance to business development and monetary policy for the past half-century. Although banks were regulated before the 1930s, supervision by the Comptroller of the Currency and the Federal Reserve Board mostly pertained to interstate branching, reserve requirements, and accounting procedures. After several thousand banks failed in the early 1930s, Congress separated commercial banking (accepting deposits) from investment banking (underwriting corporate securities), strengthened branching restrictions, set interest rate ceilings, and provided deposit insurance. For three decades thereafter, the industry experienced stable growth, with no significant domestic or foreign competition and scarcely any failures. All of that began changing after inflation developed in the late 1960s,

20

Contrived Competition

pushing up market rates of interest. Banks were less and less able to compete for depositors or borrowers, as less regulated investment banks, foreign banks, and financial service firms attacked the more profitable segments of their business. With market share slipping and the failure rate rising sharply, the banking industry mobilized in support of regulatory reform. In 1980, and again in 1982, Congress enacted major changes in the law, providing some additional freedoms for commercial banks and especially for savings banks. But this partial deregulation did not solve the problem; in fact, it may have made it worse. By the end of the decade, the banking business was deep in crisis: the industry was divided in its interests, regulators were struggling to fix things, and Congress was contemplating further reforms. Although these four histories of industry regulation, taken together, would fill in most of the features of our aerial photograph, we still need one additional level of detail to understand the process. We need to see the impact of regulatory change on business firms. Affecting the firm's conduct is, after all, the goal of regulation. And when a firm is deregulated, or at least obtains regulatory relief, its strategic response can reshape the market and determine subsequent market performance. Since I wanted to understand the long-term effects of both regulation and deregulation, I chose four firms that began operating before the 1930s and that were still in business at the end of the 1980s. And I selected them from the largest firms in their industries, firms with complex organizations that had been thoroughly shaped by decades of regulation. Such dominant firms would not only highlight the problems caused by regulation but would also have the potential for adjusting successfully to competition. Finally, each of these firms was headed by colorful and talented executives who personified the critical role of leadership in business. Just prior to deregulation in 1978, American Airlines was the second biggest domestic carrier (after United) and had the worst performance, by several measures. Its adjustment to deregulation was quick, thorough, and brutally effective. El Paso Natural Gas was the largest, but among the least profitable, of pipeline companies before deregulation. After leading the industry in several quixotic adjustments to shortages in the 1970s, El Paso also led the industry through deregulation in the 1980s. In telecommunications, AT&T became the dominant force in the industry through Theodore Vail's deliberate strategy of universal service. Federal regulation then supported and sustained that dominance for more than four dec-

The Experiment with Economic Regulation 21 ades. In the years following deregulation and divestiture, AT&T has had to struggle to adjust, both to domestic competition and to globalization. BankAmerica, too, was shaped before the era of regulation, principally by its founder's extraordinary vision of universal banking. Under regulation, and some uniquely favorably regulatory circumstances, BankAmerica emerged as the nation's largest bank. After deregulation was initiated, it floundered, nearly failed, and then accomplished a most amazing turnaround. The stories of these firms over seven decades of regulatory flux offer high drama, as well as lessons in complex economics and politics. Yet the stories add up to more than narrative history. Together, they illustrate how regulation in the United States works as a political economic system. A great many academics have labored to construct and defend theoretical frameworks that explain regulation. Some economic theories claim that regulation serves the interests of regulated businesses. Historical models, for the most part, attribute government regulation to the efforts of wellintentioned reformers who try to serve the public interest by alleviating economic failures. Political models focus on interactions among interest groups, or on the interactions of individuals within the regulatory bureaucracies or the legislature. All of these explanatory approaches, which I will review more carefully in subsequent chapters, contribute to our understanding of regulation. But none of them, in my view, adequately explains the causes and consequences of regulation and deregulation broadly, in different industries at different times, and particularly the effects of regulatory changes on business firms. To do this, we need a broad and dynamic framework that will accommodate all four of our regulatory histories, from start to finish. At the heart of this framework, described in detail in Chapter 6, is the idea of market structuring. The regulatory relationship between business and government can best be viewed as indirect, acting most powerfully through markets and politics. In other words, government regulation shapes the structural characteristics of the market in which a firm does business. Such changes, in turn, create vested interests in protecting or changing the regulatory status quo, and these interests organize and compete analogously in the political arena. For the regulated firm, then, there are two related environments in which it must operate effectively: the market and the political arena, both of which are shaped by regulation. This framework applies equally from the regulator's perspective.

22

Contrived Competition

That is, the regulator must function in the same two environments—the political arena and the market—and must understand how regulation affects them, as well as the behavior of the regulated firm. Beginning with the history of airlines, and then in the stories of natural gas, telecommunications, and banking, we will see how government regulation shaped the collective behavior of firms, right down to their organizational resources and basic operations. We will see how the restoration of price and entry competition, after forty years of regulation, caused extreme competitive and managerial crises for the dominant companies in each industry. Finally, we will try to understand how top management in four companies struggled to adjust and to institute reforms so that their organizations could once again succeed in competitive markets.

CHAPTER

TWO

American Airlines There is need for reasonable competition, but there is a limit to reasonable competition and there is such a thing as wasteful competition. —C. R. Smith, 1947

Since the very start of commercial aviation, competition has seemed too intense for most participants in the industry. This was true in 1934, when C. R. Smith took over as president of the infant American Airways. It was true after World War II, when under Smith's leadership American became the nation's largest passenger carrier. And it was still true in 1974, when Smith returned as chairman of an American Airlines plagued by spiraling costs, excess capacity, and substantial operating losses. During this entire period, the federal government regulated airline competition. Only in retirement would Smith be able to assess the effects of real airline competition, deregulated by the government after 1978. Then he would see the awesome impact of deregulation on market structure and performance, and the successful strategic adjustment by his successors, Albert Casey and Robert Crandall, who would convert American into the largest and one of the most profitable of America's major carriers. Airline regulation and deregulation in the United States are unique experiences in several respects. From 1938 to 1978, the Civil Aeronautics Board attempted to manage competition in the airline industry through close control of entry and exit, route allocation, rates, and mergers. This form of "regulated competition," in which federal officials sought to shape markets and encourage certain aspects of competition, had mixed results. Despite extraordinary gains in productivity as a result of technological innovation, the industry's financial performance and efficiency eventually deteriorated to the point where economic regulation was abandoned. The Airline Deregulation Act of 1978 was the first major legislative recision of federal regulatory authority in peacetime. As such, it gave

24

Contrived Competition

momentum to the broader wave of regulatory reform in the energy, communications, and financial sectors. Deregulation has been more complete and has lasted longer in the domestic airline business than in any other U.S. industry. Moreover, no other country has yet allowed multifirm competition in airlines without imposing significant regulatory restraints on entry, route structure, or price. The contrast between regulation and deregulation is so sharp in the airline business that it provides a unique window for studying "business government relations" in the broadest sense: What causes governmental intervention in and withdrawal from markets? What are the effects of public policy on market structure and performance? And how do firms respond?

The Origins of Airline Regulation, 1925-1938 The airline business in the United States started as a dangerous, seat-of the-pants, heavily subsidized mail delivery service.1 Government virtually created the market. During the First World War, Congress set up an Aircraft Production Board to fund and supervise large-scale construction of military aircraft. At the end of the war, the U.S. Post Office inaugurated scheduled airmail service, with operations provided by army pilots. For several years, the industry limped along with a short supply of skilled pilots, few control systems, rudimentary airports, and an uncoordinated route structure. 2 Recognizing these weaknesses, the "industry" sought government help—asking for regulation of the airways and subsidies for commercial airmail service. In the early 1920s Herbert Hoover, then the dynamic secretary of commerce, cited aviation as "the only industry that favors having itself regulated by the government." 3 Congress was eventually moved to enact two measures that gave the aviation industry its real start: the Kelly Airmail Act of 1925 and the Air Commerce Act of 1926. The Airmail Act provided for contract airmail service, awarded by competitive bidding to private carriers, with government subsidies not to exceed four-fifths of airmail revenues. 4 The Air Commerce Act authorized the Department of Commerce to regulate air navigation and safety.5 The subsidies, amounting to $7 million a year by 1930, stimulated market demand and intense competition among suppliers; the Air Commerce Act provided for practical operations. Route mileage increased

American Airlines

25

tenfold, with more than a dozen carriers organized to provide scheduled regional service for mail and passengers. 6 The largest of these companies included Transcontinental Air, Western Air, American Airways, and United Airlines. The competitive bidding for subsidies, however, led to below-cost prices and thus to losses. This in turn hampered the maintenance of a stable airmail network, not to mention the development of passenger service. Frustrated by the industry's slow growth, Walter Brown, President Hoover's postmaster general, proposed legislation in 1930 that would give him authority over route certificates, mail rates based on route-miles (rather t h a n on actual volume), route extensions and consolidations, and discretionary contract awards, without competitive bidding. A bill written by postal lobbyists was passed by Congress in April 1930. This law, the McNary-Watres Act, incorporated most of Brown's objectives, except for the waiver of competitive bidding. 7 Brown wasted little time cashing this "blank check." 8 On May 19, 1930, he gathered the principal airmail carriers in his office in Washington. The postmaster general opened the meeting by noting that none of the "strictly passenger lines" was breaking even, and that without support from mail subsidies a nationwide network of commercial airlines was unlikely to develop. He t h e n asked these "pioneer" carriers if there was any way they could "agree among themselves as to the territory in which they shall have the paramount interest." 9 Brown planned to use administrative extensions to expand existing routes and redraw the national system. Several of the executives from these so-called pioneer carriers expressed approval for cooperative action rather t h a n for "competitive bidding [that] will result in wild promotions." A spokesman for American Airways observed that "there is a community of interest among the operators and the Department, and they are ready to cooperate and find out h o w to do it."10 After several days of discussion and some arm twisting by Brown, three n e w transcontinental routes were designated, and eventually awarded. A central route, through Denver and Salt Lake City, would be operated by the merged interests of Transcontinental Air and Western Air (which eventually became Trans World Airlines); the merger would be part of the deal. A southern route, f r o m Atlanta through New Orleans to Los Angeles, was assigned to American Airways. And United Airlines' northern route was expanded to r u n from New York, through Chicago, to San Francisco and Seattle. All the remaining mail routes were awarded to six

26

Contrived Competition

other carriers; several dozen smaller firms never had a chance. 11 "There was no sense/' Brown later explained, "in taking the government's money and dishing it out to every little fellow that was flying around the m a p and was not going to do anything." Administrative integration and consolidation was the only way Brown "could think o f . . . to make the industry self-sustaining." 12 Some characteristics of the airmail business as it existed in 1932 are shown in Table 1, in the endmatter. With a government-sponsored cartel in place, the aviation business grew rapidly. Advances in aircraft technology, especially larger engines and multiengine aircraft, made passenger service commercially feasible. The principal carriers, organized as holding companies, grew by acquisition as well as route extension. As the economy fell into deep recession, small operators became easy targets for acquisition by large carriers that were organized, like utilities, as part of holding-company pyramids. Three aviation groups dwarfed all the others. General Motors (a holding company) acquired North American Aviation (a holding company), which owned Eastern Air, Western Air Express, Transcontinental Air Transport, and Douglas Aviation. United Aircraft and Transport (a holding company) owned United Airlines (a management company for airlines), National Air Transport, Pratt and Whitney, Boeing Airlines, Sikorsky, Stearman Aircraft, and half a dozen other companies. And Aviation Corporation (a holding company) owned American Airways (a holding company for several Canadian airlines, Embry-Riddle Aviation, Colonial Air Transport, and Texas Air Transport), and Universal Aviation (a holding company for Braniff Airlines, Continental Air, Robertson Aircraft—also k n o w n as the "Lindberg Line"—Northern Air, and others). 13 Embedded in this structure were most of today's major carriers, save Delta and Pan Am. The evolution of American Airlines epitomized the workings of this system. American's predecessor originated as a subsidiary of Aviation Corporation, a holding company formed in 1929 by the Fairchild Aircraft Company to raise funds for one of its o w n best customers, Embry-Riddle Aviation. Aviation Corporation immediately acquired several other airlines, including Colonial and the Universal group, which it reorganized as American Airways in 1930. During the next few years, Aviation Corporation acquired several more small lines, despite continuing, significant losses.14 In 1934, w h e n Brown's "spoils conference" came to light in a fullblown political scandal, the cartel and holding-company pyramids came crashing down. 1 5 President Roosevelt, responding to the allegations of

American Airlines 27 conspiracy, canceled all airmail contracts and ordered the U.S. Army to deliver the airmail.16 When the Army Air Corps proved unable to deliver the mail, emergency contracts were reissued to commercial carriers, and Congress hastily rewrote the Air Mail Act.17 The 1934 amendments (the Black-McKellar Act) curtailed the postmaster's authority, reimposed strict competitive bidding (for three-year contracts), and gave control of entry, through certificates of public convenience, to the Interstate Commerce Commission. The act's most distinctive feature, however, was punitive, in the best tradition of the Big Stick. Former contractors were prohibited from bidding on an airmail contract; no officer of a holding company could be connected to an airline with a mail contract; there would be no more interlocking directorships; and no airline with a mail contract could "engage in any other phase of the aviation industry"—especially aircraft manufacture. These measures destroyed the aviation trusts.18 From the ashes of this scandal, however, emerged an oligopolistic airline industry that lasted through the 1970s. Each of the major carriers was separated from its previous conglomerate, reincorporated, renamed, and given new executive officers: thus were born Trans World Airlines (TWA), United Airlines, Eastern Airlines, and American Airlines. By 1938 these "Big Four" held about 80 percent of the market (in revenue-passenger miles), somewhat less in route-miles. Seven other carriers— Northwest, Pennsylvania Central, Braniff, Western Air Express, Chicago and Southern, Mid-Continent, and National—shared the remaining 20 percent. In the case of American, a reorganized board appointed a young accountant named C. R. Smith as president. Smith had been a vocal advocate for developing passenger service into a profitable business. Although American generally lost money during the next few years, Smith at least succeeded in building American's passenger business to a position of industry dominance. Speed and safety were the keys to stimulating demand, but American Airlines' fleet of Condors, Fords, and DC-2s did not meet either criterion. In December 1934, after a particularly uncomfortable transcontinental trip, Smith placed a call to a favorite supplier, Donald Douglas in California, and asked him to expand the DC-2 so that it could carry twenty-one passengers (instead of fifteen to eighteen) and enough fuel to fly all night. When Douglas refused, on the grounds that Smith's request was technically and financially infeasible, Smith promised to buy twenty of the stretched version, sight unseen. After two hours

28

Contrived Competition

of haggling, Douglas agreed to try—a decision that assured his company's future, as well as American's. The Douglas Corporation's DC-3 would become one of the most famous aircraft in aviation history. 19 Despite some improvements in passenger service, the industry barely survived the 1930s. On top of the Depression, the Air Mail Act of 1934 proved unworkable. It was passed in haste, and contained m a n y "ambiguous" and "definitely contradictory" provisions. 20 Competitive bidding (for mail contracts), arranged to encourage entry by smaller firms, succeeded for firms like Delta and the reorganized versions of Braniff and Continental. But the process resulted in such absurdly low bids (a few mills, or tenths of a cent, per mile) that no carriers made money during the next several years. Business grew slowly; competitive bidding, subsidies, partial entry restrictions, and enforcement by three separate government agencies (Post Office, Commerce Department, and Aviation Administration) made no sense to anyone. Ironically, it was this mix of policies and economics that caused the "excess competition" which subsequently justified the need for economic regulation. Recognizing these shortcomings, Congress created a Federal Aviation Commission to review aviation broadly and make policy recommendations. The five-member panel, chaired by Clark Howell, did so thorough a job that its recommendations were substantially embodied in the Civil Aeronautics Act of 1938.21 The Aviation Commission urged the creation of an independent commission to regulate entry (through certification rather t h a n competitive bidding), m i n i m u m standards of service, and the financial performance of certified carriers. The commission cited four rationales: the award of direct governmental subsidies for serving a public purpose, the necessarily monopolistic character of some airline submarkets, avoidance of excess competition ("irresponsible campaigns of mutual destruction"), and prevention of concentration that might subvert public service. 22 Despite these recommendations, the Aviation Commission was not suggesting "an abandonment of competition." On the contrary, the "European model," built around national monopolies heavily subsidized and supervised by government, was deemed totally inappropriate. Air transport was "not a natural monopoly." The commission felt that "the present high quality of American air transport [was] due in large part to the competitive spirit"—not to direct, point-to-point competition but to alternative routes and a "spirit of emulation" in matters of speed, service, safety, and aircraft modernization: "There must be enough competition

American Airlines

29

to serve as a spur to the eager search for progress, but there must not be so much as to raise costs materially through the duplication of facilities. There must be no arbitrary denial of the right of entry of newcomers . . . [and] no policy of a permanent freezing of the present air transport map." 23 The commission was recommending a kind of regulated competition. The airline industry itself took the lead in lobbying for unified economic regulation by an independent commission. Under the 1934 act, potential entrants were willing to bid below costs to get a route, in the hopes of later renegotiating rates. Contract rates of less than a cent per mile were bid on routes where costs might justify 30 cents. Edgar Gorrell, president of the Air Transport Association, complained that without legislation "there is nothing to prevent the entire air carrier system from crashing to earth under the impact of cut-throat and destructive practices."24 None of the major airlines had made any money in the previous decade, and nearly half of the $120 million thus far invested in commercial aviation had been lost. "The industry," Gorrell testified, "has been reduced to the very rock bottom of its financial resources." 25 The industry supported the idea of a new commission, separate from the Interstate Commerce Commission, that would centralize all functions associated with commercial and civil aviation. 26 "The need for legislation," Gorrell explained, "springs not at all from a need to protect the public from exploitation, but rather from the need to assure to the industry itself opportunity for vigorous growth." 27 The Roosevelt administration supported airline regulation, but apparently preferred to have all transport regulation consolidated in one agency—either the Interstate Commerce Commission or a new cabinet department. 28 Not until 1938 did the president finally endorse legislation, introduced by Senator Pat McCarran and Representative Clarence Lea, which Congress passed as the Civil Aeronautics Act.29 The act created a Civil Aeronautics Authority (later redesignated a board) whose five members would be appointed by the president to serve six-year terms. 30 The centerpiece of the act was Title IV, "Air Carrier Economic Regulation." Under this title, the Civil Aeronautics Board received broad authority to (1) grant certificates of public convenience and necessity (entry, extension, and abandonment), (2) approve or amend tariffs, (3) set mail rates and award contracts, (4) control mergers and acquisitions, (5) authorize interfirm agreements, (6) control methods of competition, and (7) gather extensive operating and financial informa-

30

Contrived Competition

tion. The criteria for these extraordinary powers were specified in the Declaration of Policy: Sec. 2(c). The promotion of adequate, economical, and efficient service by air carriers at reasonable charges, without unjust discriminations, undue preferences or advantages, or unfair or destructive competitive practices; Sec. 2(d). Competition to the extent necessary to assure the sound development of an air-transportation system properly adapted to the needs of the foreign and domestic commerce of the United States.31

The regulatory concept expressed in these passages, combined with certification provisions modeled after the Motor Carrier Act of 1935, was clearly different from the public utility concept that had evolved from Munrt v. Illinois and was specified in both the Communications Act of 1934 and the Natural Gas Act of 1938. 32 Yet this was no simple "capture" of public policy by industry. Rather, it was a slightly muddled attempt to structure markets and guide competition toward an optimal mix of service, innovation, and economic growth.

Regulation-Defined Airline Markets The point of departure for airline regulation was a grandfather clause (Section 401e) in the act. Eighteen carriers offering regular mail and passenger service prior to May 1938 automatically received certificates for the routes they served. With this provision, the route structure established in 1934 and the market dominance of four carriers—American, United, TWA, and Eastern—were extended well beyond the war years.

Route Strengthening and the Issue of Competition During the 1940s, the Civil Aeronautics Board fostered rapid growth of the national airways (see Figure 2), but with no particular rationale other than "strengthening" the smaller trunk (that is, intercity) carriers.33 To do this, the board used route expansions, entry restrictions, and tight rein over mergers and acquisitions. For example, when American Airlines tried to acquire Mid-Continent Airlines in 1945, the board denied its application on the grounds that the takeover would be monopolistic and would not enhance route-structure efficiency.34 A few months later, though, adjudicating in an important route expansion, the board favored

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214

Contrived Competition

premises equipment; and they could not provide any other product or service, except exchange telecommunications and exchange access service, that was not a natural monopoly service actually regulated by tariff.152 In the aftermath of this divestiture, competitive forces and regulatory constraints clashed so fundamentally that even the most carefully construed transitional arrangements proved contentious and inefficient. Five sets of issues subsequently dominated the arena of domestic telecommunications policy: (1) access charges, (2) state price-and-service regulations, (3) enhanced services, (4) asymmetrical rate-of-return regulation of AT&T (but not of the other long-distance carriers), and (5) the court's MFJ restrictions. A sixth issue, that of asymmetrical deregulation of international competition, increasingly occupied trade officials, members of Congress concerned with competitiveness, and, eventually, AT&T management.

Access Charges Even before divestiture, the system of jurisdictional separations and division of revenues that subsidized universal service had been coming apart. Competition in the long-distance (inter-LATA) markets was handicapped by the "rough justice" of the 1978 tariff compromise. Bypass of local-exchange companies by large users had meanwhile begun to erode the revenue base of the public switched network. By requiring that access to the local exchange be nondiscriminatory and fairly priced, the Modified Final Judgment forced the Federal Communications Commission to devise a new system of pricing and cost recovery. Shortly after approving the ENFLA tariff in 1978, the commission had opened a wide-ranging investigation of the structure of the long-distance (MTS and WATS) market. 153 The discount arrangement, for the access fees paid by other (non-Bell) common carriers, was at best temporary. AT&T, despite its advantage of superior-quality access and its immense market power, was competing at a very significant cost/price disadvantage. Over the years, as Figure 29 indicated, the proportion of exchange-plant costs that were not traffic sensitive and that were allocated to the interstate jurisdiction had grown to 26 percent. This was 3.3 times the proportion of long-distance to local usage, and had created a system of prices that did not in any way reflect costs. In effect, one-fourth of the fixed costs of the local-exchange networks was recovered from the usage-sensitive toll charges for long-distance service.

Nathan Kingsbury

Operators on roller skates, Chicago, 1929

The inventors of the transistor, 1948: William Shockley (seated), John Bardeen (standing, left), and Walter Brattain

Servicing a 4-ESS (long-distance) switch, late 1970s

Charles Brown (left) and John deButts, 1978

William McGowan, of MCI Communications

William Baxter and Charles Brown announce the divestiture of AT&T, January 8, 1982

AT&T's headquarters, Basking Ridge, New Jersey

Robert Allen

AWT

215

To the extent that long-distance usage was priced far above marginal cost and that local-exchange service was priced far below, this system created an immense flow of subsidies between different customer groups, and thus significantly distorted the patterns of supply and demand. In general terms, business customers—especially the largest corporations, which accounted for the lion's share of long-distance usage—were subsidizing residential service; urban customers were subsidizing rural service; the East and West coasts were subsidizing the Midwest; and anyone who made more long-distance calls than average was subsidizing anyone who made fewer than average (this latter group was thought to include low-income users, minorities, the elderly, and the poor).154 By 1984, AT&T's access costs (both interstate and intrastate) were $15.5 billion, about 63 percent of its long-distance operating costs. This meant that AT&T was paying 15 cents out every 30 cents that it received per average minute of use. By contrast, MCI and the other new entrants were paying about 5 cents per minute for access. The Federal Communications Commission's search for an alternate cost-recovery and access-pricing mechanism lasted five years. The proceedings incorporated the views of virtually every interested party. No option was overlooked. At one extreme, all fixed costs of the local networks could be shifted to end-users, on a flat-rate (per-month) basis. At the other extreme, they could continue to be paid by long-distance carriers entirely on a per-use basis. Or there could be some mix of these two cost-recovery methods, in various proportions, phased in over time.155 The pace of the investigation quickened once the Modified Final Judgment had been issued, to comply with Judge Greene's deadline for equal access. In December 1982 the commission announced its Access Charge Plan, citing four objectives: greater economic efficiency, prevention of uneconomic bypass (bypass that exceeded AT&T's costs, but not its price), a less discriminatory pricing system suitable to competition, and preservation of universal service. The plan had three parts. First, every local subscriber would pay a flat monthly charge, initially $2 for residential customers and $6 for businesses. These charges would escalate to $6 or $8 over several years. Second, the long-distance companies would continue to pay access charges per minute of use. These charges would be gradually phased out as the customer charges were phased in, until 1990, when the carriers would pay only the traffic-sensitive costs of a long-distance connection. MCI and the other new carriers would still enjoy a discount

216

Contrived Competition Recovery of local fixed plant costs assigned to interstate service (in percent)

Universal service fund

Recovery from all long-distance carriers

Premium payments by AT&T

Access surcharge on special — long-distance service

60

—

40

1984

. Recovery from customers

1986

1987

1988

1989

Figure 34. Original version of the FCC's Access Charge Plan (1983).

(35 percent), which was lower than the rate charged AT&T, but this would be phased out over thirty months as they received equal-quality access from the local-exchange companies. The third part of the plan provided for a "universal service fund"—an explicit contribution from long-distance revenues that would subsidize local phone companies with unusually high fixed costs.156 These proposed rates are shown in Figure 34. By realigning costs, forcing "cost causers" to pay, and reducing the competitive handicap on which MCI and the other new long-distance carriers depended, the Access Charge Plan sparked a heated political battle that lasted throughout 1983. To some congressmen, it appeared that the Federal Communications Commission was preempting the policymaking prerogatives of Congress. Representatives Timothy Wirth and John Dingell (chairman of the Senate Commerce Committee) tried to block the plan, on a jurisdictional basis if nothing else. State regulators, moreover, felt that the commission was interfering in local pricing (for example, by imposing a $2 per month charge for local access), so they, too, opposed it on jurisdictional as well as substantive grounds.157 Congress conducted joint hearings in which consumer activists, state utilities regulators, organized labor, small business, and the new long-distance companies bitterly contested the plan.158 The Reagan administration lay low, leaving only large corporate users, the commission, AT&T, and

AT&T 217 the emerging Bell operating companies to support the plan. And since AT&T and the Bell companies were preoccupied with the immense problems of divestiture, their political effectiveness was negligible. The fight came to a head in October 1983, when AT&T and the seven new Bell companies filed tariffs for access under the new system. The plan's opponents claimed that proposed reductions in long-distance rates did not fully reflect AT&T's reduction in (access) costs, and that the difference amounted to a "Great Phone Robbery."159 MCI and the other new competitors added to this pressure with a letter to the chairman of the Federal Communications Commission, Mark Fowler. In this so-called Eight-Carrier Letter, they claimed that any immediate reduction in their discount, and its phasing out over thirty months, would be financially ruinous. Their collective earnings for 1984 would plunge from estimated profits of $484 million to losses of more than $500 million.160 Together, these allegations gave political momentum to Wirth's legislation, which passed the House by a voice vote. This bill, the Universal Telephone Service Preservation Act, would have prevented the commission from shifting the fixed costs of local service back to local customers. It would also have established mandatory "lifeline" rates (minimum bill) for the poor and elderly, and would have required large users that bypassed the public network to contribute nonetheless to local telephone service.161 When thirty senators cosigned a letter to the Federal Communications Commission urging reconsideration and delay (until after elections), Fowler realized that the Access Charge Plan was politically dead—at least in its original form. He immediately postponed the customer charge until 1985, agreed to a cap of $4, and raised the access discount for AT&T's competitors to its previous level of 55 percent (see Figure 35).162 Between 1985 and 1987, the commission made some limited progress with its efforts to reform access-cost recovery. The business-line charge did take effect on schedule, and in mid-1985 a charge of $1 per month was imposed on residential customers. This was raised to $2 in 1986, and then (in small increments) to $3.50 by 1989. As a result of these charges, long-distance rates to all customers were reduced by an average of more than 30 percent.

State Regulation Divestiture, combined with federal regulatory changes, created innumerable problems for state regulators. In 1983 and 1984, public service commissions everywhere had to arrange new reporting systems for the

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1984

1985

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Figure 35. Revised version of the FCC's Access Charge Plan (1984).

regional Bell holding companies and conduct rate cases requested by their operating subsidiaries, which wanted to raise rates to levels that would reflect accelerated depreciation schedules. Before these issues were resolved, state regulators had to begin considering requests for rate deaveraging and measured service, intrastate access charges, new service offerings, bypass and competition in the markets for intrastate long-distance service, and even for local-exchange services. By July 1986, according to a survey conducted by the U.S. Department of Commerce, regulatory change was well under way but diverged widely in substance and process from state to state. In Virginia, for example, inter-LATA competition was not only allowed but deregulated in 1984. In Utah, in contrast, competition in inter-LATA tolls was explicitly prohibited. The Nebraska legislature enacted a law to deregulate intraLATA service (terminating rate-of-return regulation) but prohibited competition until 1989. Louise McCarren, chair of the Vermont Public Service Board, proposed a "social contract" whereby New England Telephone would commit to residential-rate stability in return for competitive flexibility in business-service markets. In Illinois, the Commerce Commission unbundled access from intrastate toll service, adopting a flat-rate subscriber-line charge capped at $5.52. Idaho, however, explicitly prohib-

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ited such a charge. In all, thirty-six states (out of thirty-eight having more than one LATA) had permitted inter-LATA competition; fourteen states had permitted intra-LATA toll competition. Pricing flexibility in toll services was introduced in twenty-eight states; and in local-exchange services, in thirty-five states. Six states had implemented access (subscriberline) charges, and fifteen states had approved limited systems for eliminating tariffs on "competitive" services.163 The patterns of deregulation, no less than those of regulation itself, were intricate indeed.

Enhanced Services The Federal Communications Commission had scarcely ruled in Computer Inquiry II w h e n divestiture released AT&T from the terms of the 1956 consent decree. For the Justice Department, the imposition of separate subsidiaries on AT&T made less sense after divestiture. For AT&T, it imposed a serious organizational handicap in its efforts to sell integrated services competitively. Digitization of long-distance and local-exchange networks, making possible an array of new services and equipment, was fast dissolving the distinction between basic and enhanced services faster than the commission could implement its rules. 164 The commission undertook a Third Computer Inquiry, and announced its decision in June 1986. It concluded that with bypass technologies proliferating and competition increasingly robust, the threat of cross-subsidy was reduced. It ruled that structural safeguards could be replaced by "nonstructural" safeguards, of which the most important was the implementation of "open-network architecture." Access to local and long-distance networks would be opened to any potential user; tariffs would be set for competitive services and products would be fully unbundled at prices approximating incremental costs.165

Asymmetrical Regulation Even after divestiture, the new AT&T remained fully regulated by the Federal Communications Commission with respect to rates, rate of return, services, and facilities. Of course, it still had tremendous market power in the long-distance business, and had better-quality access to most local exchanges until late 1986. Yet none of the other long-distance carriers with which AT&T competed, such as MCI and Sprint, were regulated as common carriers. 166 They could enter and exit markets freely

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and selectively, build facilities and change prices without the commission's prior approval, and offer n e w services on short notice. Until 1986, the other long-distance companies remained adamantly opposed to even the most gradual regulatory relief for AT&T.167 They claimed that AT&T had deep pockets for advertising, a huge reserve of goodwill with customers, bargaining power with the local operating companies, and overwhelming market presence. MCI suggested that deregulation would be appropriate sometime in the mid-1990s, after AT&T's market share had fallen to 40 percent. 168 Sprint went so far as to admit that AT&T's unit costs, without its access-charge disadvantage, were 20 to 30 percent below its own. Were AT&T deregulated, according to Sprint, its competitors would never earn their cost of capital and more t h a n likely would be driven from the market. 169 By mid-1986, however, equal access had been implemented and the other carriers' artificial cost advantage over AT&T was virtually gone. Since the Federal Communications Commission would not allow AT&T, as a public utility, to raise its rate of return above 12.2 percent, AT&T was forced to keep lowering rates as customer access charges were implemented. This put immense price pressure on MCI and the others, destroying their only real competitive advantage. Early in 1987, MCI announced losses of $448 million and—what is supremely ironic—called for the immediate deregulation of AT&T. Bert Roberts, Jr., MCI's president, urged the commission to "redirect its resources to regulate the true monopolies in this industry—the local telephone companies." 170 But as AT&T's access-cost handicap had dissipated, revealing its immense economies of scale and scope, competition in the interexchange market began to appear somewhat less tenable. Political opposition to deregulation resurfaced, especially in the House of Representatives. The regional Bell companies, meanwhile, began flexing their political muscles—with alternative access plans that would benefit themselves and with pleas for relief f r o m the consent decree. 171 AT&T, n o w wary of the political crossfire, chose not to press the issue. The commission's investigation of deregulation simply faded into oblivion.

Restrictions Imposed by the Modified Final Judgment Increasingly, the court's competitive restraints on the regional Bell companies came to occupy Washington. At the time of the divestiture, Judge Harold Greene had ordered that the Modified Final Judgment be re-

AT&T 221 viewed by the Justice Department every three years, to ensure its continuing relevance to the state of technology and competition. In the meantime, all of the regional Bells had been clamoring for waivers so that they could enter unregulated lines of business, including international operations, cellular mobile phones, electronic publishing, computer retailing, real estate, financial services, and so on. The Justice Department commissioned Dr. Peter Huber, an engineer, lawyer, and former professor at the Massachusetts Institute of Technology, to study the telecommunications industry and recommend changes, if appropriate, in the Modified Final Judgment. In January 1987 Huber submitted his report, recommending that the Bells be freed from restrictions on manufacturing equipment and allowed to provide enhanced services. He based the recommendations, in part, on the striking view that the emerging architecture of the network warranted (oligopolistic) competition by vertically integrated firms.172 The Justice Department took Huber's advice, and then some, apparently rejecting its own previous stance and the theory underlying its case for divestiture. In February 1987 it recommended abandoning the MFJ restrictions on equipment manufacturing, information services, and entry into inter-LATA, long-distance markets, except for service originating or terminating in an operating company's own local-exchange territory.173 Three hundred parties submitted more than 6,000 pages of testimony, trying unsuccessfully to affect Judge Greene's decision.

Regulated Competition Regulatory changes since 1980, and especially divestiture, had indeed made most segments of the domestic telecommunications market more competitive. But government regulation still defined an underlying three-part segmentation of the market: local (intra-LATA) service, longdistance (inter-LATA) service, and equipment (central-office equipment and customer-premises equipment). Information services, except for a few value-added networks available to business subscribers, had yet to take off in the United States.174 Local (intra-LATA) service. These markets, reshaped by the Modified Final Judgment, were still relatively uncompetitive. Although partial substitutes had developed (local-area networks, cellular mobile telephones, and direct connection to inter-LATA networks), they had yet to make a

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significant dollar impact. 175 Incursions by AT&T into intra-LATA markets concerned t h e local-exchange carriers b u t w e r e n o t yet a reality. Few states w o u l d allow t h e m , a n d AT&T h a d generally chosen n o t to attempt any. Each of t h e seven regional Bell companies controlled f r o m 11 to 15 percent of all local-access lines; GTE controlled a n o t h e r 10 percent; and all other independents, 7 percent. Voice communication w a s still t h e d o m i n a n t product, a l t h o u g h data transmission was growing faster. Residential service still generally consisted of flat-rate local service (with options such as "call waiting") and intra-LATA toll calling. Pricing h a d m o v e d s o m e w h a t closer to costs, although tolls still subsidized local service. For businesses, local-exchange companies offered private lines, PBX trunklines, intra-LATA WATS, highspeed switching for large packages of data, and "Centrex." Centrex was a family of switched services provided to large customers by a n exchange carrier's central-office switch. A m o n g these services w e r e messaging, information access, d o c u m e n t distribution, conferencing, graphics, a n d records m a n a g e m e n t . Centrex competed directly w i t h t h e functions of a PBX, w h i c h business customers o f t e n purchased a n d installed o n their premises. The upgrading of e x c h a n g e switches to digital technology, combined w i t h a n e w c o m m o n signaling system, m a d e Centrex t h e strategic centerpiece for most of the local-exchange carriers competing in t h e business services market. 1 7 6 Access to telephone users, provided by local carriers to long-distance inter-LATA carriers, h a d become a n important segment of this market. Two kinds of access—switched and special—were n o w subject to tariffs u n d e r t h e Federal Communications Commission. Switched access was billed o n a minutes-of-use basis; special access, such as a private line, was billed o n a flat-rate basis. Access charges, w h i c h still h a d little to do w i t h costs, contributed as m u c h as a third of the exchange carriers' r e v e n u e s and a n e v e n larger portion of earnings. Although AT&T's portion of these charges h a d decreased since 1984, as customer-line charges increased, such charges still provided about $20 billion in 1987. 177 Long distance (inter-LATA) service. Transmission of voice, data, facsimile, a n d video signals across LATA boundaries constituted the second m a j o r m a r k e t segment for telecommunications. By 1987, t h r e e types of firms w e r e competing in t h e inter-LATA market: six carriers w i t h their o w n facilities, 554 resellers of leased lines (with about 10 percent m a r k e t share), a n d nine "value-added networks" for distributing electronic data. AT&T still dominated this market, accounting for about 70 percent ($20

AT&T 223 billion) of its revenues; MCI (with revenues of $3.6 billion) and Sprint (with revenues of $2 billion) shared 11 percent. All three major carriers offered a range of voice, data, and wideband services, through switched public networks and private-line facilities. The remainder of the market was served by regional carriers and resellers.178 Equipment. The market for telecommunications equipment comprised two distinct parts: the central-office segment and the end-user segment. In the central-office segment, telephone companies themselves bought switches (with software and service), transmission equipment, media (cable and wire), and, increasingly, network operating systems. In 1988 the domestic market for these products was estimated to be about $20 billion; the world market, about $50 billion.179 As a result of scale economies and very high research and development costs, the central-office market, particularly for switches, was the most concentrated; there were only a dozen manufacturers worldwide. Three of these—AT&T Network Systems, Northern Telecom, and GTE—dominated the U.S. market, although Ericsson (a Swedish firm) and Siemens (of Germany) had a growing number of sales contracts among the regional Bell companies. The world market remained fragmented, however, with each major country dominated by one or two domestic suppliers. The markets for transmission equipment, fiber, cable, and wire were somewhat less concentrated. In the United States, AT&T was still the dominant vendor, with just under 50 percent market share.180 In the area of customer-premises equipment, PBXs and other terminal hardware (telephones, keysets, cellular phones, modems, and integrated voice-and-data terminals) accounted for an estimated $13 billion in manufacturers' shipments, of which $6 billion was attributable to the U.S. market. Although many firms competed in these markets, less than a dozen accounted for 90 percent of all sales. In the United States, AT&T and Northern Telecom shared market leadership with several Japanese firms.181

A Strategy for Regulated Competition For AT&T, this increasingly competitive yet asymmetrically regulated market structure posed daunting strategic problems. In its core long-distance business, MCI and Sprint were only supervised by the Federal Communications Commission, not regulated on a rate-of-return basis. They could pick and choose the market segments they wished to enter,

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offer n e w services with little notice, and price competitively. But AT&T was still obliged to serve all customers, to file elaborate tariffs whenever it offered a n e w service, and to average rates across broad customer segments. Its rate of return, moreover, was capped. In the market for business products and services, AT&T was especially hampered by the separate-subsidiary requirement of Computer Inquiry II. AT&T Communications, the long-distance arm of the company, had to operate with virtually no ties (much less sales coordination) with AT&T Technologies, which provided terminal equipment. Equipment such as PBXs and computers could not be offered jointly with telecommunications services. Any economies of multiproduct scope had to be forgone, in the n a m e of antitrust policy.182 This meant that two or even three AT&T sales teams would separately visit major customers, sometimes selling competing products. These conditions contributed to the substantial losses that AT&T reported for its computer business, and they eliminated any advantage in customer-premises equipment that AT&T might have realized from its vertical integration. In central-office equipment, AT&T Network Systems faced several challenges: meet the technical requirements of equal access (mandated by the court); catch up with Northern Telecom's lead in digital central-office switches; satisfy the demands for n e w features and functions f r o m its n o w fragmented and independent customers, the regional Bell companies; and establish a sales presence in major foreign markets, w h e r e technological incompatibility, state monopolies, and indigenous equipm e n t suppliers posed daunting barriers to entry. It was the artificiality of regulation that made AT&T's business relationships so complicated. For example, AT&T paid about $20 billion annually for access to local exchanges—by far its biggest cost. For the regional Bell companies, these access charges provided nearly one-third of their revenues and thus took some pressure off their local rates. Yet since the price of access was set by regulation and had little to do with actual costs, its level was intensely politicized. Not only did this put AT&T in direct political conflict with its largest suppliers, the regional Bells, but it gave AT&T a powerful incentive to bypass switched access altogether. "Bypass"—a dirty word in some regulatory circles—usually referred to direct connections between business customers and long-distance companies, thereby enabling customers to avoid local exchanges and the payment of access charges. By placing n e w switching centers closer to customers and locating the intelligent communications functions in its

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o w n long-distance network, AT&T could reduce switched access, earn additional revenues for enhanced services, and even divert intra-LATA toll traffic from the regional Bells. Though alternate access networks using satellites or fiber optic cable had been organized by entrepreneurs in several cities, AT&T generally chose not to use t h e m (except where customers insisted). 183 Since bypass diverted revenues from local companies, it upset the same state regulators on whose goodwill AT&T depended for reasonably priced intrastate access. Furthermore, by giving the appearance of prospective intra-LATA competition with the regional Bells, it even ran the risk of undermining the restrictions imposed by the Modified Final Judgment. And of course it irritated the Bell companies no end. 184 This was particularly important because the regional Bells were also AT&T's largest customers for switching equipment. The type of centraloffice digital switch which they bought from AT&T (a switch k n o w n as the 5ESS) provided the advanced Centrex services that competed with the PBXs being sold directly to AT&T's business customers. Not surprisingly, the Bell companies worried that the service enhancements offered by AT&T for Centrex might lag behind the services it made available through PBXs. The local companies retaliated either by shifting orders to AT&T's competitors, such as Northern Telecom, or by urging state regulators to allow lower trunkline rates for Centrex connections t h a n for PBXs. Overshadowing all of these day-to-day frictions was the issue of structural restrictions in the Modified Final Judgment. 1 8 5 No sooner were the regional Bells divested t h a n they began petitioning the court for waivers to expand their services. By 1987, w h e n the court had agreed to review the judgment's restrictions, most of the regional companies had formulated strategies to expand beyond the limits of plain old local access and transport. The very prospect of relief from the restrictions created a relationship, as the regional Bells and AT&T became potential competitors. Charles Brown, AT&T's chairman, bore the responsibility for managing these difficult transitional problems while preparing AT&T for a more competitive environment in the future. Toward this end, Brown sought to restore AT&T's public and commercial image, to pursue deregulation, and to develop capabilities in the emerging global markets for integrated information services. Yet because of the restrictions imposed by Computer Inquiry II and because of rate-of-return regulation on services, it made

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sense initially to leave responsibility for net income and most decisionmaking authority within the separate lines of business. Since several of the business units had conflicting objectives, it would be difficult, if not impossible, to coordinate t h e m from the outset. Thus, for long-distance services, the critical tasks beginning in 1984 were to increase long-distance revenues, reduce costs, and prevent a precipitous loss of market share. Had the Federal Communications Commission's original Access Charge Plan gone into effect, this agenda would have been m u c h less difficult. Access costs would have been shifted to subscribers, and rates would have been equalized sooner among long-distance competitors. But w h e n the plan collapsed, AT&T was faced with far higher costs t h a n it anticipated and with deep discounting by MCI and Sprint, as they vied to sign up subscribers in the one-time balloting process that was part of the Modified Final Judgment. On the revenue side, AT&T adopted a vigorous advertising campaign (featuring actor Cliff Robertson) in an effort to achieve brand recognition as a long-distance company and win customers based on premium-quality service. This initiative, enhanced by credit card promotions, volume discounts (offered under the "Pro-America" program), and subscriber inertia, was quite successful. 186 Over the next thirty months, as customers made their choices, AT&T retained about 84 percent market share. 187 Besides regular long-distance service, AT&T's service offerings included WATS lines (toll-free outbound), 800 Service (toll-free inbound), private voice and data channels, PBX trunk circuits, and software-defined networks (SDNs). With the implementation of a n e w signaling system in 1988, AT&T began offering Integrated Services Digital Network (ISDN)— multiple voice, data, and signaling channels over a single circuit. AT&T also received about $3 billion from international services, through bilateral arrangements with major foreign carriers. In 1986 and 1987, however, both MCI and Sprint had begun to contest most of these segments. On the cost side, as we've already seen, AT&T's access tariffs posed a major problem. Few states were willing to lower the intrastate access charges that helped subsidize local service. AT&T, therefore, faced losses on intrastate service amounting to several h u n d r e d million dollars for 1984. It hastily created a state regulatory department, n a m e d External Affairs, and began filing petitions to lower intrastate access tariffs (and challenging underpriced Centrex, as well). Meanwhile, it moved quickly in Washington to win lower access tariffs for interstate service. By convincing the Federal Communications Commission that the regional Bells were overcharging for access, AT&T w o n a $ 1 billion reduction in access

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costs that saved its 1984 earnings from disaster. In return, AT&T could lower long-distance prices by about 5 percent, giving the commission's chairman, Mark Fowler, his first visible public benefit from "deregulation." By focusing on access to reduce costs, AT&T was able to avoid cutbacks in modernization, which were critical for its competitiveness in long-distance service, and to postpone major personnel reductions until after the nationwide shock of divestiture had dissipated. In the subsequent months, AT&T rebuilt a coalition that successfully lobbied Congress to support the progressive imposition of customer access charges. As these gradually rose to $3.50 per month, AT&T repeatedly lowered prices, stimulating demand for long-distance services while restoring its public image. AT&T Technologies, meanwhile, focused on selling PBXs and computers to end-users. Direct competition in these two areas was intense. In personal computers, AT&T sustained losses amounting to about $750 million over two years (1984 and 1985). 188 And PBXs were competing indirectly with Centrex service. AT&T salespeople were constantly pressing External Affairs to intervene in state tariff proceedings to win lower rates for PBX trunklines. Network Systems was trying to sell central-office switches, primarily to the regional Bells, which accounted for about 75 percent of the firm's sales. These newly independent companies were rapidly converting their outmoded analog networks to digital systems, so that they, too, could cut costs, offer n e w services, and become more competitive. 189 As they demanded software enhancements and greater control of features, Network Systems struggled to maintain an air of autonomy from the rest of AT&T, to gain its customers' trust. Within AT&T, the cross-currents between access pricing, asymmetrical regulation, bypass, PBXs, Centrex, and competitive international entry in the equipment sector made the transition from divestiture barely m a n ageable. After two years, AT&T had stabilized earnings and survived the organizational trauma of divestiture, but had yet to set a clear, strategic course for the future. Then, in the spring of 1986, James Olson succeeded Charles Brown as chairman of the company. Olson had spent forty-three years with AT&T, rising from a supervisor of operator services to vicechairman. Although he was personally close to Brown and represented continuity more t h a n change, it would be Olson's task to refocus AT&T on the basis of a durable, longer-term strategy. Olson gathered his twenty-seven top executives for a management

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retreat at New Seabury, Massachusetts, in September 1986. The agenda was clear: to articulate strategic goals and obtain a commitment to cost cutting and reorganization. The meeting produced a statement that set forth three broad goals: defend the core business (long-distance services and network equipment sales), establish a position in "data networking," and become a global force. A new organization, made possible by the Federal Communications Commission's recent decision to end structural separations, was also announced. Network services, equipment, and computers were now combined in a new "End-User Organization," comprising four business units plus External Affairs. Randy Tobias, then the president of AT&T Communications, was appointed vice-chairman to head that organization. AT&T Technology Systems (which manufactured computers), AT&T Network Systems, and Bell Laboratories were maintained as separate units. AT&T International was converted to a staff organization, and its international sales activities were returned to the various lines of business. Federal regulation, law, and public affairs remained separate staff entities, reporting to the Office of the Chairman. The rationale behind these changes was cost control. In 1986 AT&T announced a force reduction of 30,000 people and wrote off $3.2 billion for asset revaluation and facilities resizing. These efforts, together with continuing network modernization, yielded a 10.8 percent reduction of costs in 1987. This was enough to cheer Wall Street in the short run, but it was only a start if AT&T was to become competitive, whether with foreign equipment manufacturers or its domestic service rivals. In the policy arena, AT&T faced two issues of strategic importance: review of the MFJ restrictions, and "price caps"—a new alternative to rate-of-return regulation. AT&T's political effectiveness on these issues was vital to its future earnings. Review of the Modified Final Judgment. The Justice Department's recommendation that the court lift two of its restrictions on the regional Bells, and even ease the inter-LATA ban, startled AT&T. Suddenly, it realized that the consent decree, and the very premise for divestiture, was not written in stone. Now AT&T examined the competitive consequences of allowing regional Bells to compete in information services, equipment, and long-distance (inter-LATA) services; its conclusions were alarming. All of the regional-exchange companies wanted to be more than "dial tone" companies, and were especially eager to provide one-stop shopping for major business customers. Toward these ends, they would certainly offer information services and use their existing intra-LATA toll networks

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to enter the inter-LATA market, possibly forming interregional joint ventures or acquiring other long-distance carriers. Several of the Bells would likely form alliances or joint ventures with equipment suppliers, especially in software and private-label terminal equipment. Based on this analysis, and on a conviction that preserving the Modified Final Judgment was "fair," AT&T aggressively and effectively opposed any change in the inter-LATA or equipment manufacturing restrictions. It marshaled compelling data on the continuing lack of competition in the intra-LATA market, and made powerful arguments against allowing the "bottleneck" facilities into otherwise competitive long-distance and equipment markets. It put together an impressive array of expert witnesses, made presentations to Congress, and supported other groups and vendors w h o also opposed relief. 190 Aware, however, of the damage being done to its Bell relations, AT&T agreed to support removal of the court's restriction on nontelecommunications businesses, and hedged its position on information services. It suggested that a streamlined waiver process, or supervision by the Federal Communications Commission, be applied to the Bell companies' requests to offer information services. Judge Harold Greene announced his decision in September 1987. Flatly rejecting the Justice Department's recommendations, he retained all three of the principal restrictions indefinitely. Yet despite this victory, AT&T learned an important lesson; no matter h o w rational or fair, the MFJ restrictions were ephemeral, as m u c h subject to political pressure as any other policy. Going forward, therefore, AT&T would adopt a different way of thinking about its competitive relationships with the regional Bells. Though relief might be granted in the coming years, AT&T would at least extract concessions in exchange for its support—on access, price caps, and structural safeguards. Meanwhile, AT&T would seek to develop competitive advantages that could endure even if the restrictions were lifted. Price Caps. In December 1986, Dennis Patrick, a member of the Federal Communications Commission (and previously an assistant director of personnel at the White House), suggested in a speech to the Communications Bar that the British form of price caps regulation might be suitable in the case of AT&T. The basic idea was to regulate price directly, rather t h a n earnings, in order to avoid the inefficiencies of rate-of-return regulation and to create competitive incentives for cost reduction and revenue enhancement. By tying prices to productivity gains, sellers and buyers

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could split the benefits of effective competition. Even if AT&T was not efficient, the results would be no worse than those under rate-of-return regulation. And if price caps were simpler administratively, there could be significant savings in the cost of regulation. Since deregulation had lost political m o m e n t u m , price caps appeared to be the next best thing. As Dennis Patrick optimistically put it, "Deregulation is not an all-or-nothing proposition." 191 In February 1987, President Reagan designated Patrick as the next chairman of the Federal Communications Commission. The public debate over price caps began five months later, w h e n the commission issued a notice of proposed rulemaking. The proposal, already far more complicated t h a n the initial concept, entailed price floors and caps for different services, elaborate determinations of starting points, adjustment factors, productivity measurements, and agreement on a "social contract" for splitting the benefits. To broaden the base of political support, the notice suggested that once price caps had been implemented for AT&T, they might be extended to local-exchange carriers. 192 This idea, though, m a y have generated as m u c h opposition as support. The regional Bells supported the concept but demanded equal treatment, along with AT&T. The prospect of removing rate-of-return regulation from local monopolists, m u c h less f r o m the b e h e m o t h AT&T, was too m u c h for consumers and their advocates. Over the next twenty months, Patrick's initiative caused a major political fight, reminiscent of the battle over the Access Charge Plan four years earlier. Once again, the Consumer Federation led the opposition; most state regulators and some large users opposed the idea. 193 And again, Representative J o h n Dingell, still chairm a n of the House Commerce Committee, made himself the linchpin of political negotiation. For its part, AT&T grudgingly went along with the plan. After stating a preference for deregulation, AT&T opined that "at best, properly-designed caps for AT&T would be superfluous 'safety nets' that allow the interexchange market to function competitively . . . At worst, price caps, if designed improperly, could substitute one costly and inefficient set of regulatory controls for another . . . If the Commission implements price cap regulation, it should thus do so as a transition to the regulatory oversight approach." 194 But in order to win congressional support, Patrick was forced to add all sorts of complicated mechanisms and procedures that added up to a n e w regulatory system which in no w a y resembled a transition to deregulation. The final plan, approved in March 1989, created a pricing

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baseline tied to a productivity index. Adjusted for inflation, AT&T would have to reduce prices each year by a productivity factor of 2.5 percent, plus a "consumer dividend" of 0.5 percent. AT&T's services were grouped into three categories, or "baskets": residential toll, 800 Service, and all other business services. AT&T could not increase or decrease prices for any of the services by more than 5 percent per year. If it did increase the price of one service, it would have to lower another in the same basket by a corresponding percent. 195 The floor was designed to assuage congressional concern over predatory pricing—despite fierce competition in the inter-LATA market and a further decline in AT&T's share, to 68 percent. 196 While contesting these regulatory issues at home, AT&T was learning through painful experience that Asian and European regulatory systems were at least as complicated, and posed awesome barriers to entry. In Japan, AT&T had tried to sell switches directly to the Japanese phone company Nippon Telephone and Telegraph, but lost out to Northern Telecom, the only foreign firm allowed into that segment. Subsequently, it did sell some transmission equipment to Nippon Telephone and Telegraph and was allowed to offer a n electronic mail service as part of a multifirm syndicate. In East Asia, AT&T formed a venture with the Korean company Lucky Goldstar, an arrangement that eventually yielded significant central-office sales in Korea, as well as some Asian exports. In Europe, AT&T also chose to work through alliances and joint ventures—with N. G. Phillips, the giant consumer electronics firm based in the Netherlands, and with Olivetti, the Italian computer and office equipm e n t company. 197 Both alliances were formed on the eve of divestiture. The Phillips-AT&T venture would produce and sell central-office equipment, including AT&T's flagship product, the 5ESS switch. Although this organization developed a significant manufacturing and research presence in Europe, its sales were disappointing and limited mostly to the Netherlands, Belgium, and the United Kingdom. In 1989 AT&T bought out Phillips and reorganized its activities under the name Network Systems International. Still, the key markets of France and Germany remained largely impenetrable. 198 In the spring of 1989, AT&T negotiated a n alliance with Italtel, the Italian telephone company. Since Italtel was planning to spend $20-$30 billion to modernize its antiquated network, the negotiations had been intensely contested by Siemens, Ericsson, and Alcatel (of France), and AT&T's victory was deemed a major step in its globalization. 199 Robert Allen, w h o had succeeded Olson as chairman of AT&T after Olson's

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unexpected death in 1988, personally campaigned for the deal in Washington and Rome. So, reportedly, did President Reagan, President-elect George Bush, and Carlo de Benedetti, the prominent chairman of Olivetti. 200 AT&T acquired 20 percent of Italtel, while its parent, Stet, received 20 percent of Network Systems International. Together, AT&T and Italtel would offer a full and complementary line of digital switches and related equipment, and reportedly had plans to enter Spain, Portugal, and Greece. 201 With the n e w price caps regulation in place and the global strategy back on track, Robert Allen chose to reorganize AT&T yet again. In March 1989 Allen announced a more decentralized organization, to cut costs and "strengthen customer relationships." The plan designated nineteen semiautonomous business units and twenty-four divisions. The latter were support or sales organizations that were required, by contract, to sell their services internally to the business units. The business units, representing each major AT&T product line, were given supposedly firm responsibilities for meeting net-income levels. Drastic though this was, Allen cautioned that "if employees focus solely on the organizational changes, they are missing the point." The point was to help "our people get closer to their customers." 202 Surely, this was a n e w AT&T.

The Dynamics of Regulation In this chapter, as in the preceding ones, I have tried to understand the process of regulation, from inception to partial recision, as a series of institutional arrangements designed politically to "structure" the industry's markets. For more t h a n a h u n d r e d years, the market structure of telecommunications has been defined by the interaction of technology, strategy, and public policy. Above all, this has been a dynamic relationship. Technology, f r o m the earliest years of telephony, was the source of competitive advantage. The technical characteristics of a rudimentary network set the Bell System on a course of horizontal integration, vertical integration, and end-to-end voice service. Strategy, as early Bell managers used it, was a means for extending their competitive edge, beyond their first-mover advantage, into a period in which entry barriers were low and competition was intense. But end-to-end integration, by itself, was not enough.

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Theodore Vail was the first of several Bell chief executives who chose regulation over competition as the best means for organizing the network and controlling the growth of the telecommunications business. This choice, in my opinion, worked stunningly well. By comparison to any other national network, there is no question that this American system worked best—measured by penetration, technical quality, or price. But of course, this regulatory system and artificial market structure were designed for a technical regime rooted in analog electronics. By the mid-1970s the digital revolution, triggered by AT&T's own invention of the transistor, was radically changing the product and operating economics of the telecommunications business. And as these economics changed, the existing regulation became less and less appropriate. Typically, regulators entrenched in the structures of interest group political networks and bureaucratic organizations were unable to adopt regulation effectively, in any sort of reasonable time frame. Policy reform unfolded haphazardly over a period of more than two decades. This, of course, is a fundamental flaw of any economic regulation. In 1982, when Charles Brown finally abandoned integration and monopoly, he could see only the tip of the digital iceberg. Moreover, he naively thought competition would come quickly—a quid pro quo for divestiture. But Brown's legacy, and that of the federal government, was to be not competition but regulated competition. As we saw in the case of natural gas, this mixed regime, in which regulators sought to emulate or even synthesize competitive markets, entailed significant political and economic inefficiency—at least in its early stages. After a decade of regulated competition and continued digitization, the U.S. telecommunications system was still in a state of flux. Whereas other nations, including Japan, France, and Germany, had moved quickly to promote digital networks, state and federal regulators in the United States were still preoccupied with regulatory form and process. Even as AT&T continued to rebuild and extend its position in computing and cellular telephony, its home market remained fragmented and its global competitiveness was hampered by regulatory systems.203 In the next chapter, we will explore the emergence of regulated competition in banking, where the initial costs appeared even more likely to outweigh any benefits and where the continuation of fragmentary policies also limits the competitiveness of U.S. firms.

CHAPTER

FIVE

BankAmerica Restrictions against interstate banking and branching . . . are not rooted in economics; they are embedded in the concrete of politics. —Tom Clausen, 1979

My bias is to be on the offensive, on the positive side of the equation . . . We have no intention of pulling in our strategic planning horizons. —Sam Armacost, 1981

For most of this century, government has played an immense role in U.S. financial markets, as lender, borrower, intermediary, and regulator. But the government's role as regulator, all but eliminating competition in price, product, and geographic scope, appears now to have been an anomaly, an emergency alternative to the mechanisms of more integrated and competitive markets. By the end of the 1980s, these controls had been largely superseded by the forces of economic and technological change. For commercial banks in particular, a new and asymmetrical form of supervised competition replaced a comfortable era of risk-free stability. Although still closely regulated, both banks and thrifts (that is, savings and loan associations) were exposed to price and product competition from similar institutions, from nonbank financial firms, from foreign banks with relatively protected home markets, from substitute financial products, and from disintermediation (the practice of avoiding banks when saving or borrowing) by large customers. BankAmerica is an institution whose historical rise to preeminence exemplifies in microcosm the ebb and flow of regulation and competition. Its relatively late founding, early growth, and diversification occurred in an era of "free banking," when entrepreneurship could flourish. BankAmerica experienced phenomenal growth after World War n in an unusually prosperous economic environment, thoroughly shielded from competition by the elaborate New Deal structure of banking regulation.

BankAmerica 235 But in the early 1980s, its late exposure to risk and competition, with little prior preparation, nearly caused its demise. "Since BankAmerica had benefited more from regulation than anybody else," as one executive observed, "it was going to get hurt more than anybody else from deregulation." 1 In this chapter, we will explore one of the more complicated of U.S. regulatory regimes—a system of multiple overlapping bureaucracies that controlled the activities of thousands of individual financial firms. This system was established in the early 1930s, amid the complete collapse of the U.S. banking system, and it functioned effectively until the late 1960s. During these three decades, elaborate economic regulations shaped and defined most aspects of financial markets and the enterprises that operated within them. The fragmentation of the industry's structure and the segmentation of its market made this system unique among Western economies. Between 1968 and 1982, this system experienced a variety of pressures that forced regulators, and eventually Congress, to allow a greater degree of competition and integration. Changing macroeconomic conditions and political values, new data-processing technologies, entrepreneurship, new ideas about regulation, and regulatory failure all contributed. The process, however, was gradual and piecemeal; innovation and entrepreneurship far outpaced political accommodation. The tension between competitive forces and administrative control was almost palpable. As gaps between market conditions and prevailing regulation widened, interest rate ceilings were grudgingly withdrawn, product innovations were haltingly approved, and geographic boundaries were breached by technological innovations, organizational loopholes, and, eventually, the need for bailouts. Business conduct, like regulatory policy, was both a response to and an influence on this process of market and political change. Firms adapted strategy and organizational structure to the unraveling of competition controls. As they did so, their initiatives forced further changes in public policy and market structure. BankAmerica illustrates this process in detail; we will see how it used the holding-company organizational form, new product policy, and strategic acquisitions in financial services, brokerage, and failing banks. After 1982, political support for banking deregulation lost some of its momentum. The Reagan administration focused increasingly on macroeconomic problems, while Congress devoted its attention to the ever more frequent bank failures and political criticism of lax supervision. By 1984,

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deregulation had given way to reregulation and the closing of competitive loopholes. For the BankAmerica Corporation, resurgent competition, macroeconomic decline, and tighter supervision combined to cause big problems. In the 1980s, for the first time in decades, profits and then assets declined. Efforts at strategic redirection and corporate restructuring pushed in the right direction, but were too little and too late. By 1986 the bank stood at the brink of collapse, with losses of nearly $1 billion. Only after radical surgery would a new bank emerge—somewhat smaller, more focused, and better suited to the political and economic context of the 1990s.

Free Banking and Integrated Finance, 1837-1932 The era of free banking began in 1837, when the charter of the Second Bank of the United States expired; it ended in 1933, when Congress passed the Banking (Glass-Steagall) Act. Both dates mark times of national controversy over corporate power, monopoly, and special privilege. The label "free banking" is something of a misnomer, for it suggests an absence of regulation. But during this period of nearly one hundred years, state governments did regulate state-chartered banks, in matters of safety and soundness. And with the passage of the National Banking Acts of 1863 and 1864, the federal government, through the Office of the Comptroller of the Currency, also became involved in the regulation of nationally chartered banks. Yet this dual supervisory system was not designed to eliminate competition. Instead, the critical factor in both was free entry. Here the State of New York led the way with its "Free Banking Act" in 1838, setting minimal terms for chartering. As other states followed New York's lead, the number of state-chartered banks jumped from 713 to 1,466 by 1863.2 Prices (interest rates) were effectively set by supply and demand (though usury laws fixed ceilings on loan-interest rates); product portfolios were largely discretionary (though invariably under attack); and industry structure, with the important exception of branching, was constrained.

Financial Services Markets Basically, the National Banking Act of 1863 was an attempt to create institutional buyers for government securities issued to finance the Civil

BankAmerica 237 War. Its terms authorized nationally chartered banks to issue notes, backed by Treasury bonds, and a tax was imposed on state bank notes. With these incentives, more than a thousand state banks switched charters during the next few years. For these national banks, the act also set reserve requirements, prohibited stock trading, and created a comptroller of the currency to supervise chartering and perform examinations. Since they operated under fewer restrictions, state-chartered banks continued to attract new entrants by devising such innovations as the demand deposit (that is, the checking account). 3 One of the comptroller's first rulings (1864) restricted branch banking by nationally chartered banks. In the mid-nineteenth century, this rule made little difference; most states maintained a similar prohibition, urban areas were small, and electronic communications (between offices) did not yet exist. But by 1900, this rule had become restrictive. Since several states had allowed limited branching in metropolitan areas, state-chartered banks enjoyed another advantage over national banks. In effect, the comptroller's ban constrained the growth of national banks, distorted their natural structure, and caused more defections from national banking.4 Under these conditions, the number and variety of deposit-taking institutions increased rapidly. Since commercial and private bankers initially focused on wholesale corporate finance, there were attractive opportunities for mutual banks (cooperatively owned savings banks), savings and loan associations, or S&Ls (associations to promote home ownership), and, eventually, credit unions (nonbank savings institutions operated by companies for their employees) to serve niches in the retail market for small-business owners, farmers, urban wage earners, and residential mortgage holders. By World War I, more than 25,000 commercial banks, 6,000 S&Ls, and 600 mutual savings banks were operating in the United States.5 During the same period, private (investment) banks, insurance companies, and trust companies (banks that invest customers' funds) were left even freer to grow and compete. About 250 unincorporated investment banking houses, located primarily in New York, Boston, and Philadelphia, already dominated the business of underwriting, distributing, and brokering corporate issues of longterm debt and equity. The most prominent of these firms (such as Morgan; Kidder Peabody; Kuhn, Loeb; Halsey, Stuart) had grown prosperous during the second half of the nineteenth century by serving the financial needs of railroads, utilities, state and local governments, foreign governments, international traders, and, eventually, manufacturers. Until

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the early 1900s, investment banking focused on large institutional customers, with close, relatively private relationships between bankers and their clients.6 But with the emergence of individual investors, large securities issues, and trading in secondary markets, private investment banking became a matter of the larger public interest. 7 The life insurance and property liability insurance industries also developed rather haphazardly during the nineteenth century, since they were largely free from regulation. After the 1850s, several progressive states created insurance commissioners to license and supervise (at least minimally) industry practices. The system of independent agents that developed led to intense price competition, frequent insolvencies, and attempted cartels.8 Public dissatisfaction over this sort of performance eventually captured the attention of progressive "muckrackers." 9 Trust companies, such as Guaranty, Bankers Trust, and some 300 other firms, combined the functions of commercial banking, investment banking, insurance, and more; they managed estates, cared for property, and made investments. "These wide powers," noted one observer, "attract customers." By 1900, trust companies (organized under general incorporation laws) controlled about $1 billion in deposits—equal to the sum held by state-chartered commercial banks and to two-fifths of the deposits of national banks.10 Their ability to provide this "department store" style of financial service, without any regulation, resulted in a fivefold increase in the number of such firms by 1 9 1 0 . " By the turn of the century, privately owned firms in all these financial service sectors controlled very large capital holdings and competed intensely in a relatively unrestricted environment. Since other people's money was at stake, however, political scrutiny and legislative intervention seemed inevitable. Investigation and regulation became the order of the day; reform was in the air. First came insurance reform. During the summer of 1905, an investigation by the New York State legislature revealed serious improprieties, mismanagement, and influence peddling in the life insurance industry. Charles Evans Hughes drew national attention, as he interrogated and then shamed industry leaders. New York and several other states responded with legislation that gave insurance commissioners additional responsibilities.12 A few years later, similar investigations of fire insurance in New York resulted in a law to permit price fixing, purportedly to protect insurance companies from "excess competition." 13 In banking, the comptroller sounded an alarm in 1902. 1 4 Concerned by

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the increasing involvement of national banks in securities sales, he ruled that corporate bonds must be limited to 10 percent of a bank's capital.15 In 1907, after a severe financial panic had rocked the U.S. economy, a national monetary commission recommended creation of a central bank, to manage the currency and maintain liquidity. Public pressure for reform intensified in 1912, as a result of the House Banking Committee's revelations about the "money trust." This committee, chaired by Representative Arsene Pujo, examined the financial power and interlocking directorships among investment bankers. 16 It found that commercial banks, such as National City Bank and the First National Bank of New York, were risking conflict of interest by underwriting and selling corporate securities. The Pujo committee urged that banks be prohibited from dealing in securities. 17 President Woodrow Wilson likewise called for a new system that would vest control in the government, "so that the banks may be instruments, not the masters, of business and of individual enterprise and initiative." 18 In 1913 Congress passed the Federal Reserve Act, which established twelve regional reserve banks and a governing board in Washington and required all nationally chartered banks to become members. State-chartered banks and trusts could also join the system, without giving up their affiliated securities activities. The reserve banks would loan capital to member banks at an interest rate ("discount rate") set by the Federal Reserve Board; member banks' commercial and agricultural loans would serve as collateral. The Federal Reserve Board originally consisted of five presidential appointees plus the comptroller of the currency and the secretary of the Treasury; it was primarily responsible for maintaining liquidity in the banking system. 19 These mid-course corrections did little to restrain expansion of financial markets. World War I accelerated the pace of growth by creating a vast n e w pool of government securities and by stimulating personal savings, thus expanding the market for corporate equities. The total number of commercial banks (and branches) increased rapidly until 1922, but shrank thereafter as a result of consolidations and suspensions; the number of S&Ls approached 12,000, trust companies increased to 1,500, and life insurance companies expanded to more than 400. Assets grew threefold between World War I and the Depression (see Table 24 in the endmatter) ,20 The volume of bond issues in the securities sector more than doubled during the 1920s, to almost $65 billion. 21 The number of issues listed on

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Contrived Competition

the New York Stock Exchange surpassed a thousand, as hundreds of independent brokers and dealers participated in a booming over-thecounter market. The portion of personal wealth in the form of securities reached 75 percent by 1932 (from 23 percent in 1908). This burst of growth in the securities markets, combined with the intense competition among financial services vendors, stimulated increased innovation and integration. Commercial banks expanded through branching and by forming securities affiliates; investment trusts syndicated shares in the huge n e w debt market; and securities brokers increasingly accommodated their customers' frenzied demands by selling stock "on margin" (paying only part of the price, using previously purchased stocks as collateral). Prior to World War I, branch banking had been encouraged in some states as a means of getting bank services out to local markets. Under a 1918 statute designed to deter defections from the Federal Reserve System, even national banks had been allowed to acquire branch bank systems. 22 And in 1922, the comptroller ruled that "tellers' windows" (limited-service branches) were permissible for national banks. But thereafter, as the n u m b e r of viable unit banks (that is, banks with no branches) receded from its peak of 30,000, local political resistance to branching stiffened. The issue of branch banking was extensively debated in the banking industry, in state governments, and in Congress. In 1923 Henry Dawes, the comptroller of the currency, drafted antibranching legislation which Representative Louis McFadden of Pennsylvania introduced in 1924. In its original form, the McFadden bill prohibited state banks from keeping even intracity branches if they joined the Federal Reserve system. And, no state member bank could establish any extracity branches. That same year, the U.S. Supreme Court upheld the states' authority to prevent branching by national banks. 23 After a three-year political fight, Congress enacted the McFadden Act of 1927—a compromise that saved, but limited, branch banking. According to Representative McFadden, this bill was designed to slow defections from the national banking system. On the one hand, the measure put national banks on an equal footing with state banks; where state laws allowed, intracity branching would be open to all. On the other hand, the McFadden Act curtailed any n e w branching outside the city of a bank's head office. State banks benefited disproportionately f r o m this provision, since their existing networks of intercity branches were grand-

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fathered. The act, as McFadden candidly acknowledged, was "an antibranch banking bill."24 Even as they made efforts to expand geographically, banks attempted to expand their product lines into securities. The First Securities Company, incorporated in 1908 by the First National Bank of New York, was the first important securities affiliate of a commercial bank. But commercial bankers did not fully realize either the market's potential or their o w n competitive advantage in bundling financial services, until after their wartime experience handling treasury bonds. By 1922, sixty-two commercial banks were engaged in investment banking and had opened branches in cities across the country. This proliferation brought forth another blunt warning from the comptroller that these institutions were dangerous vehicles, vulnerable to scheming and speculation; his warning went unheeded. 2 5 By 1927, bank affiliates were originating 13 percent of n e w debt issues and participating in 7 percent. 26 The McFadden Act, written to prevent defections from national banking, confirmed the legality of securities affiliates (a matter left unclear in section 5136 of the Federal Reserve Act). Although Senator Carter Glass adamantly opposed it and complained that "there is nothing in the national banking act that permits it," Congress approved the security affiliate provision with relatively little debate. 27 After passage of the act, "department store banking" really took off.28 By 1931, 285 national bank affiliates and n u m e r o u s state banks were engaged in investment banking. More remarkably, banks increased their share of originations to more t h a n 40 percent, and their share of participations to 61 percent. 29 From 1931 to 1933, the Investment Bankers Association of America elected presidents drawn from the securities affiliates of commercial banks; private investment banks were nearly left in the dust. 30 Investment trusts were another innovation of this period. These n e w organizations, of which there were just a handful in 1920, issued shares to individual investors and reinvested the funds in a portfolio of securities. Investors in these trusts presumably benefited from the trust m a n ager's expertise and risk spreading. Some of these companies were organized by professional managers and trustees; others, increasingly, were set up by investment banks and by the securities affiliates of commercial banks, to take advantage of underwritings and to provide a broader bundle of services to customers. Between 1921 and 1929, more t h a n 700 investment trusts were organized, with total holdings of $7 billion. The rate of growth and potential risk for banking affiliates were noted by

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some critics prior to 1929, but nothing was done. "When the crash came," as Vincent Carosso has written, "investment trusts went down with 'a deadening thud.'"31 The economic freedom of commercial and investment banking went down with them.

Giannini's Bank When Franklin Roosevelt declared a bank holiday in March 1933, the Bank of America was the fourth largest bank in the United States—just twenty-nine years after its founding. Although it looked like a moneycenter bank because of the size of its assets, the resemblance ended there. This bank was created "to serve the little fellow," and it did. Its founder, a second-generation Italian-American, championed nationwide branch banking and supported Roosevelt. Amadeo Peter Giannini grew up in the North Beach section of San Francisco. His family had moved there in 1882 from San Jose, because his father had decided to convert his haulage business for agricultural produce into commission sales and wholesale distribution. This business met with modest success in the booming economy of northern California, especially so after young A. P. Giannini took it over. And it exposed Giannini to the dozens of small agricultural communities up and down the California coast, where farmers invariably had credit needs but could find no one to fulfill them.32 In 1902 Giannini joined the board of a neighborhood S&L that took deposits and provided credit for home builders and merchants. From the start, Giannini chafed at the conservative lending and growth policies of the bank; it "warehoused deposits," lent only to the financially secure, and hesitated to expand beyond the Italian community of North Beach. In 1904, after a heated meeting in which the board rejected his expansionist pleadings, Giannini resigned in a huff and established his own bank: the Bank of Italy, chartered as a state bank. He raised capital by selling stock door to door, believing as he did in wide distribution of ownership. Deposits were also solicited door to door, and loans as small as $25 were made to working people who had good reasons to borrow. Giannini's bank grew rapidly, receiving a tremendous boost from the reconstruction after the San Francisco earthquake of 1906, and from Giannini's heroic civic efforts in the quake's aftermath.33 The Bank of Italy acquired its first branch, a failing bank in San Jose, in 1909—-just three months after the California Bank Act was passed. The act, a reform initiative prompted by failures during the panic of 1907,

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allowed branching with the permission of the state's superintendent of banking, based on a finding of "public need and convenience." Four years later, Giannini acquired a toehold in Los Angeles; after that, he never looked back. He expanded into Oakland, then to suburban Redwood City, and in 1916 to rural Santa Clara. He moved almost always by acquisition, and generally with the eager support of the target bank's management. Before long, the Bank of Italy's aggressive expansion caught the attention of unit bankers, w h o were not at all supportive, and of regulators, who questioned Giannini's ability to digest and integrate so many firms. Branching within the home-base city was generally accepted and emulated by others. But statewide branching came under attack, especially from the banking interests of Los Angeles. In 1919 a new superintendent of banking for California, who truly believed branching to be unsound, tried to halt Giannini's growth. It took Giannini two years to convince him that a branch system could provide financial soundness that no unit bank could achieve. Yet no sooner was this roadblock removed than the Federal Reserve Board intervened to check the Bank of Italy's rapid growth and to force the bank's forty-one branches to keep more careful and integrated records. Neither private nor public opposition deterred A. P. Giannini from his vision of statewide branch banking. Opponents of all stripes were w o n over, circumvented, or simply defeated. In the boom years of the 1920s, the Bank of Italy grew even faster than California; oil, agriculture, entertainment, and housing spurred loan growth to more than $1 billion by 1929. Deposits expanded sixfold, reaching nearly $900 million, and the number of branches grew to 292. 34 Giannini and his bank were first drawn into the national political arena in the mid-1920s, as branch banking became a national issue. In its original form, the McFadden bill directly threatened the Bank of Italy and, more significantly, Giannini's strategic vision of nationwide banking. Giannini and his lobbyists worked through the new comptroller, Joseph Mcintosh, and through Senator Carter Glass to defeat the key restrictive provision in the McFadden bill. To help win the comptroller's support and persuade the Federal Reserve Board, Giannini held out the prospect of switching to a national bank charter if he could consolidate his various bank holdings—many of which were acquired and retained as separate entities to skirt opposition within California. Consolidation, however, would be impossible if the McFadden Act went through without change." After the branching interests blocked the original McFadden bill, it was

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reintroduced in 1926. This time, it lacked the provision that would prevent statewide branch systems from acquiring Federal Reserve membership with national charters. 36 Giannini was delighted and immediately went on a buying spree, to grandfather as many branches as possible before the law took effect. But then the antibranching forces gained momentum and blocked passage for another session. When the act finally passed, in the spring of 1927, the Bank of Italy was surely the largest beneficiary. No other bank came close to having so large a system, or so deep a deposit base. The ink was scarcely dry on the McFadden Act before A. P. Giannini devised his next strategic move: the establishment of a nationwide bank. He moved quickly, implementing most of the key steps during 1928 and 1929. First, he converted the Bank of Italy to a national charter, thus ensuring Federal Reserve membership. Next, he consolidated his bank holdings in California under two corporate umbrellas—the Bank of Italy and a state-chartered subsidiary, the Bank of America. The latter was a commercial bank with headquarters in San Francisco. Giannini had acquired it to comply with provisions of the McFadden Act. During the summer of 1928, Giannini went to New York and bought a well-regarded medium-sized bank, also named the Bank of America.37 Through a New York-chartered holding company, Bancitaly, Giannini already owned two other banks in New York, which he now merged with Bank of America. J. R Morgan, whose powerful bank dominated New York's financial markets, acquiesced in this move; in exchange, one of his people was appointed to head the New York bank. In September, Giannini created a holding company named Transamerica Corporation, chartered in the state of Delaware. The stock of Transamerica (capitalized at $250 million) was exchanged for stock in Bancitaly and the Bank of Italy in less than a month. Transamerica, then, controlled the Bank of Italy, the California Bank of America, the New York Bank of America, and some miscellaneous insurance and commercial interests. In September 1929, Giannini announced the endplay to employees and stockholders: the Bank of Italy would be renamed the Bank of America. In name and ownership, it would be a nationwide bank. The Morgan people had not anticipated Giannini's real ambition; when they did, there was little they could do about it.38 Giannini's third political initiative came amid the crisis that soon enveloped the nation's banking system. Like other banks, the Bank of America suffered from panic withdrawals (particularly in the East), from

BankAmerica 245 a collapse in its market value, and from the political backlash that developed in 1932-1933. But the Bank of America was strong enough to survive the crisis, mostly thanks to its immense branch system and its loyal depositors in California. Rather than fleeing from the prospect of reform, Giannini embraced it and the politics of its leading proponents: Senator Carter Glass and President-elect Franklin Roosevelt. Giannini endorsed legislation introduced by Senator Glass in 1932. He supported the Reconstruction Finance Corporation, and in turn enjoyed the support of Jesse Jones, its chairman. He also backed the candidacy of Franklin Roosevelt, as well as the president's subsequent decision to declare a nationwide bank holiday. The power he thus acquired enabled him to influence the debates over the Banking Act of 1933 and its amendments in 1935. "No other banking group," wrote the bank's chief lobbyist, "gains from this act as many advantages as does Transamerica."39

The Era of Regulation Regulatory Stabilization, 1933-1945 By 1933 the American financial community had been totally discredited. In the four years following the stock market crash in October 1929, more than 9,000 banks, an estimated 2,000 investment and brokerage firms, and hundreds of investment trusts and insurance companies had failed (see Figure 36).40 To prevent a total collapse of the banking system, President Franklin Roosevelt had declared a national bank holiday on March sixth.41 In congressional hearings later that same year, one executive after another from the nation's largest banks and investment houses admitted to practices ranging from negligent to outrageous. Those revelations, according to the New York Times, shocked the "moral sense of the nation."42 Subsequent analyses of the banking crisis have implicated several factors and exonerated others. Peter Temin attributed the collapse to a decline in the value of banks' investments, tied to the downturn in the real economy.43 Milton Friedman and Anna Schwartz also looked at this argument, but they concluded instead that "a contagion of fear among depositors in the fall of 1930"—in other words, a panic—was the proximate cause, later exacerbated by the Federal Reserve Board's inept monetary policies.44 Conversely, branching was certainly not the problem. As Eugene

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5

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I M

: M

I »

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1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 • i Number of banks

!•

I Percent failed

F i g u r e 36. Bank suspensions, 1921-1933.

White has argued, regulation of branching so narrowed the deposit base and concentrated risk that the industry's structure could not withstand the weight of these other factors. 45 Comparative data from Canada, and indeed the case history of BankAmerica, seem to corroborate this. Recent studies of security affiliates of commercial banks also suggest that despite widespread improprieties, large integrated banks rarely failed; in fact, securities affiliates might have reduced the probability of failure. 46 Lacking these relatively dispassionate studies, however, Congress and the public put most of the blame for financial collapse on greed and bad judgment induced by excessive competition and integrated finance. Even members of the financial community, n o w in desperate straits, were fed up with competition. Apparently, it had not worked. The failures it caused, in both substance and confidence, engendered a stream of legislation: the Federal Home Loan Bank Act of 1932, the Banking Act of 1933, the Securities Act of 1933, the Securities Exchange Act of 1934, the Federal Credit Union Act of 1934, the Banking Act of 1935, the Maloney Act of 1938, and the Investment Company Act of 1940. Each act, by itself, was the product of intense political contention and maneuvering among diverse banking and securities interests, bureaucracies, and legislative coalitions. Taken together, these laws restruc-

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tured the financial system, established a maze of n e w operating standards, segmented asset and liability markets by type and territory, fixed prices, and guaranteed risk. Stability was the overriding legislative objective; noncompetitive and inefficient markets were the result. Nonbank, depository institutions—primarily savings and loan associations and mutual savings banks—were the hardest hit and the first to respond. The United States Building and Loan League began lobbying intensely in 1931. By 1932, it had succeeded in getting Congress to enact a bill, drafted by league officials, that created the Federal Home Loan Bank Board (FHLBB). The responsibilities of this board were similar to those of the Federal Reserve Board—to provide liquidity to the S&Ls through funds borrowed in the capital markets. 47 During the next couple of years, Congress authorized the Home Loan Bank Board to charter and supervise federal S&Ls, and it established the Federal Savings and Loan Insurance Corporation to provide deposit insurance. At the same time, Congress created a parallel system for federal credit unions. The centerpiece of legislative reform, and thus of national policy, was the Banking Act of 1933 (and its sequel in 1935). This law, often called the Glass-Steagall Act, revised branching restrictions, created federal deposit insurance, imposed interest rate ceilings on deposits, authorized the Federal Reserve Board to adjust reserve requirements, and decoupled commercial banking from investment banking. Special interests within the financial community contested each of these changes, and n o n e was passed without controversy. The drive for banking reform had been initiated several years earlier by Carter Glass, Republican chairman of the Senate Banking Committee's subcommittee to review national banking. Glass, w h o was one of the original sponsors of the Federal Reserve Act of 1913, was deeply disturbed by the recurrence of financial panic. He firmly believed that although the Federal Reserve System was well designed, it had failed to manage monetary policy aggressively. Moreover, the industry's structure and conduct—"unsound" affiliations and "evil practices"—appeared to Senator Glass to have caused the n u m e r o u s bank failures and the stock market's collapse. 48 In reaching these conclusions, Glass and his subcommittee relied heavily on the expert advice of H. Parker Willis, a professor of finance at Columbia University. The purpose of commercial banking, according to Willis, was short-term lending for real business investments. In the prevailing economic orthodoxy of this "real bills doctrine," longer-term

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financial credit would fuel inflation by creating more money than real economic activity. Thus, any involvement of bank affiliates in bondfunded debt seemed theoretically unsound. In its early deliberations during 1931, the Glass committee first considered a program that would have severely regulated securities affiliates of commercial banks. But committee members received so many letters from citizens who were "outraged" by the injustices of the affiliate system that they opted for the complete separation of commercial and investment banking. 49 Later, the Pecora hearings in 1933 (named for Ferdinand Pecora, counsel to the Senate Banking Committee) made separation a political necessity; even bankers accepted it as inevitable.50 Winthrop Aldrich, president of Chase National Bank, summed up the banks' newfound sense of responsibility: "Many of the abuses in the banking situation had arisen from failure to discern that commercial banking and investment banking are two fields of activity essentially different in nature . . . The commercial bank's credit function is very definitely governed by its responsibility to meet its deposit liabilities on demand. It must not seek excessive profits by taking undue credit risks and it cannot wisely tie up its funds in long-term credits however safe they may be."51 In its final form, the Banking Act prohibited commercial banks that were members of the Federal Reserve System from underwriting, purchasing, or selling corporate securities on their own account. Banks could not be affiliated, or have interlocking directorships, with securities firms or investment trusts. Conversely, securities firms were prohibited from accepting deposits that were subject to withdrawal by checking, passbooks, or certificates; liquidation or divestment was required of existing securities affiliates.52 With similar logic, the Glass committee felt that the solution to liquidity crises (runs on deposits) lay not in deposit insurance but in an institutional mechanism for managing liquidations more efficiently, in tougher reserve requirements, in greater liquidity, and in liberalization of branching restrictions. Deposit guarantees, according to Willis, were really asset guarantees—something for which the government should not be responsible. In the event of a failure of financial institutions, the public interest was best served by the prompt restoration of access to deposits; this, in turn, was best achieved through efficient institutional reorganizations. 53 (In view of the S&L crisis of the 1980s, Parker's warning seems astonishingly prescient.) During the 1920s, however, public support for deposit insurance had grown with the number of bank failures, and

BankAmerica 249 state-level programs had proved unequal to the task. By 1933, support for federal deposit insurance had become overwhelming, especially from midwestern populists in the House of Representatives. Although big banks adamantly opposed deposit insurance, thousands of smaller, undercapitalized unit banks outside the "money centers" (major cities with large banks) saw deposit insurance as a preferable alternative to the liberalized branching favored by Senator Glass. Clearly, the controversy over branch banking had not been resolved by the McFadden Act. Smaller, rural banks had successfully prevented intercity branching in most states on the grounds that the "money trust" would otherwise destroy competition and drain the countryside of its savings. To skirt these restrictions, "chain" or "group" banks (holding companies that owned multiple banks) had proliferated since 1927. Senator Glass was a leading advocate of liberalized branching as a means of improving the capitalization and liquidity of each bank (branch office) and of using dilution to reduce risk. To prevent drainage of local deposits to money centers, Glass proposed restricting interest rates on interbank demand deposits. Big banks, however, remained unsupportive; intercity branching threatened both their established urban bases and their correspondent relationships. The original Glass bill, which would have allowed statewide branching by national banks (irrespective of state laws), did not even win support from the full committee. 54 In 1933 Senator Glass was forced to yield on the issue of branch banking and, ironically, to lobby hard in favor of deposit insurance. Although President Roosevelt supported banking reform in principle, he declared that both of these specific measures were too radical. In its final version, the Banking Act created a Federal Deposit Insurance Corporation (FDIC), to which all Federal Reserve System members had to subscribe. The FDIC fully guaranteed deposits up to $10,000; it also guaranteed 75 percent of deposits up to $50,000 and 50 percent of larger deposits. As for branching, the act stipulated only that national banks be fully equal to state banks and thus allowed intercity branching when state law concurred. 55 The bank holding company, however, already offered an alternative route to geographic expansion. By 1931, 97 "group banks" (as the holding companies were called) controlled 978 commercial banks. In order to plug this potentially destabilizing loophole, the Banking Act of 1933 authorized the Federal Reserve Board to regulate such companies in terms of examination, reserves, and asset concentration (no more than

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10 percent of assets could derive f r o m a single customer). In 1935 Congress a m e n d e d this provision to e x e m p t o n e - b a n k holding companies. 5 6 The Banking Act also instituted t w o other important changes: it prohibited p a y m e n t of interest o n d e m a n d deposits a n d authorized t h e Federal Reserve Board to regulate interest rates o n time deposits (subsequently i m p l e m e n t e d as Regulation Q). This extraordinary measure, w h i c h a m o u n t e d to t h e imposition of price controls o n the liability side of the balance sheet, created n o controversy at the time, even t h o u g h n o economic rationale appeared to support it. Neither the hearings n o r previous versions of t h e bill h a d considered anything other t h a n a liberal interest rate ceiling o n interbank deposits. In congressional debate, h o w ever, Senator Glass claimed that t h e act was intended "to p u t a stop to t h e competition b e t w e e n banks in p a y m e n t of interest, w h i c h frequently induces banks to p a y excessive interest o n time deposits and has m a n y times over again b r o u g h t banks into serious trouble." 5 7 He also argued that "the p a y m e n t of interest o n d e m a n d deposits . . . h a d resulted in withdrawing f r o m t h e interior country banks of t h e United States millions u p o n millions of dollars to t h e m o n e y centers." 5 8 Studies conducted since 1933 h a v e s h o w n that neither of these argum e n t s was factually correct. 59 Rather, the s u d d e n appearance of this provision suggests that t h e r e w a s a political connection to deposit insurance. Considering that interest o n deposits w a s a m a j o r cost of doing business, commercial b a n k s m a y h a v e viewed t h e m e a s u r e as a necessary quid pro q u o for their contributions to the Federal Deposit Insurance Corporation. In 1935 Congress extended federal authority (through the FDIC) to commercial banking outside the Federal Reserve System. In granting membership, t h e FDIC w o u l d h e n c e f o r t h consider "the convenience a n d needs of t h e c o m m u n i t y to be served." Criteria for chartering by the comptroller a n d m e m b e r s h i p in t h e Federal Reserve System w e r e similarly qualified; free entry—the hallmark of dual banking for nearly a century—had b e e n curtailed. 60 Concurrently w i t h its banking reform, Congress also passed legislation to fix securities markets. Collapse of t h e stock m a r k e t in 1929 was widely viewed as t h e trigger to the Great Depression, a n d financial disclosure by t h e issuers of n e w corporate securities w a s viewed as t h e solution. 6 1 This "sunshine" approach to t h e p r e v e n t i o n of f r a u d a n d unethical financial practices w a s hardly new. Most states already h a d "blue sky" laws, requiring that companies register publicly issued securities a n d that brokers

BankAmerica 251 obtain licenses, but these measures had proved ineffective. 62 In May 1933 Congress passed the Securities Act, requiring that companies file a registration statement and issue a prospectus for any public sale of securities. Issuers were liable to both criminal and civil penalties, and federal regulatory authorities received the subpoena power necessary to confirm accuracy of registration information. 63 Investment bankers not only resented the provisions for criminal liability, but, as a practical matter, they objected strongly to the twenty-day "cooling off" period that James Landis, a young New Deal staffer, proposed in order to defuse the feverish speculative atmosphere surrounding new issues.64 According to the industry, this delay would exacerbate risk, since market conditions often changed rapidly enough to endanger an issue. Reform-minded New Dealers, however, felt that the act was inadequate. "There is nothing in the Act," complained William O. Douglas, "which would control the speculative craze of the American public."65 The Senate, meanwhile, had been investigating brokerage practices and the operations of major exchanges. In 1933 the Senate Banking Committee concluded that "federal regulation was necessary and desirable" because of the "evils and abuses which flourished on the exchanges and their disastrous effects upon the entire Nation."66 Exchanges were too important and too much "affected with the public interest" to be left entirely to the discretion of members. 67 James Landis, who had helped draft the Securities Act, took the lead in drafting a bill to regulate securities exchanges. 68 Reactions to the early drafts, though, were largely negative. The business community generally, and the securities industry especially, felt that the draft legislation far exceeded any reasonable government intervention. 69 In particular, section 18(c) authorized a federal Securities Commission "to prescribe such rules and regulations for national securities exchanges [and] their members . . . as it may deem necessary or appropriate in the public interest." 70 Richard Whitney, then president of the New York Stock Exchange, complained that this section was more than regulation because it gave "the Commission power to manage exchanges and dictate brokerage practices."71 The Securities Exchange Act, as passed by Congress in 1934, represented a compromise between regulation and self-regulation; it created a five-member, bipartisan Securities and Exchange Commission (SEC) to implement the Securities Act (and, subsequently, the Public Utilities Holding Company Act of 1935 and the Investment Company Act of 1940). It had three substantive objectives: first, to extend federal control over credit in securities

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markets by authorizing t h e Federal Reserve Board to set margin rules and interest rates; second, to extend t h e disclosure r e q u i r e m e n t to securities brokers a n d impose a set of rules aimed at preventing manipulation of stock prices a n d f r a u d u l e n t trading practices; third, to provide supervision over the self-regulation of securities markets, particularly the practices of organized exchanges. 7 2 In 1938 t h e Maloney A m e n d m e n t authorized the formation of a n association of over-the-counter brokers and dealers, w i t h antitrust i m m u nity. Both t h e Securities and Exchange Commission and t h e organized exchanges supported this legislation. At t h e time, stabilization of securities markets represented b o t h a public and a private objective. Brokers a n d dealers organized t h e National Association of Securities Dealers to establish trading standards and m i n i m u m fees. Abstainers w o u l d suffer the competitive disadvantage of exclusion f r o m t h e trading n e t w o r k . Investment f u n d s stood n e x t in line for federal control. After sustaining deep losses in t h e early 1930s (estimated by Senator Robert Wagner at $3 billion o u t of total holdings of $7 billion), "mutual f u n d s " (open-ended investment trusts) h a d b e g u n growing again. 73 In 1939 the Securities a n d Exchange Commission completed a four-year study of investment funds, a n d its r e c o m m e n d a t i o n s f o r m e d the basis of the Investment C o m p a n y Act of 1940. 74 This act required registration and detailed financial disclosure, f u r t h e r separation of f u n d m a n a g e m e n t f r o m other financial entities, a n d SEC regulation of selling practices, capital structure, a n d accounting practices. 75 Taken together, these initiatives virtually ended competition in financial services. 76 Product portfolios (assets) w e r e restricted, sourcing of f u n d s (liabilities) was allocated, geographic markets w e r e segmented, prices w e r e fixed, a n d operating practices w e r e standardized. A stable, secure, b u t inefficient financial system was t h e result.

Regulatory-Defined

Markets

For the n e x t forty years, financial services markets in the United States w e r e primarily shaped by this regulatory regime. Eventually, m o r e t h a n $4 trillion in private financial assets w o u l d be m a n a g e d by nearly 50,000 financial institutions. Compared to t h e finance sectors of other countries, this system w a s u n i q u e by virtue of its extent, diversity, a n d fragmentation. Financial firms ranged in size f r o m credit unions w i t h a f e w t h o u sand dollars in assets, to t h e world's largest banks (money centers) w i t h

BankAmerica 253 more than $100 billion in assets. Table 24 provides a breakdown of the major asset holdings of these financial institutions. Together, the services produced by these intermediaries contributed 15 percent of the gross national product. Until the late 1970s, this system probably changed less than any other sector of the U.S. economy. Right up to 1980 (as one economist has observed) a time traveler from 1935 would easily have recognized the different types of financial institutions, most of their products, and their principal activities.77 Yet a closer look at Table 24 does suggest a few long-term trends. Commercial banking continued to dominate financial services, but with a significant decline in market share. Insurance (primarily life insurance) also declined by half in market share, although total assets grew tenfold; S&Ls, institutional investors (pension and money market funds), and securitized credit (bank loans converted to securities) stand out as sectors of high growth. In banking, where regulation was most pervasive, growth, profitability, and industry structure remained amazingly stable for nearly forty years. Bank failures, thanks primarily to federal deposit insurance, were exceptional; fewer banks failed in the years between 1934 and 1978 than in any year during the 1920s. With entry, price, and product competition restricted by regulation, rivalry for deposits and retail lending in the domestic market was limited to nonprice service—tellers, bonus gifts (such as toasters), and especially the convenience of local branches. Thus, while the number of banks remained almost constant, the number of branch offices grew exponentially (see Figure 37). Over the years, state branching restrictions eased gradually, though controls on interstate branching remained firm until the 1980s.78 Restrictions on holding companies during this period were gradually tightened, even though the relative importance of holding companies declined until the late 1960s.79 In 1956 Congress enacted the Bank Holding Company Act to extend the Federal Reserve Board's control to multibank holding companies that were not members. The act established new standards for acquisition of a bank by a holding company, and it prohibited interstate acquisitions. Most important, it prohibited bank holding companies from engaging in nonfinancial activities and sharply circumscribed nonbank financial activities. Nonbank activities "of a financial, fiduciary, or insurance nature" were allowed only when they were "so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto." 80

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Figure 37. Number of commercial banks and branches, by type, 1920-1988.

In answer to pressures f r o m t h e comptroller, t h e Federal Reserve Board, a n d t h e Federal Deposit Insurance Corporation to reinforce t h e government's control over t h e structure of banking, Congress enacted t h e Bank Merger Act of 1960. This act gave b a n k regulators exclusive a u t h o r ity over mergers and acquisitions, regardless of competition factors or t h e antitrust laws. Although t h e m e a s u r e w a s soon o v e r t u r n e d by t h e Sup r e m e Court, it h a d b e e n designed to insulate decisions of b a n k regulators f r o m Justice D e p a r t m e n t oversight. 81 In 1966 Congress a m e n d e d b o t h the B a n k Merger Act a n d t h e Holding C o m p a n y Act to impose a

BankAmerica 255 competitiveness test for the approval of mergers by bank regulators. Taken together, these structural controls extended and maintained banking stability in the face of competitive pressures for change. Similarly, in the investment banking and brokerage sector, regulatory stabilization lasted about thirty years before competitive pressures became overwhelming. This stability was facilitated by the Securities and Exchange Commission's deference (despite its regulatory authority) to the anticompetitive membership rules of the National Association of Securities Dealers and the organized exchanges (especially the New York Stock Exchange). 82 The volume of securities issued and traded grew slowly and with surprising stability until the mid-1960s. 83 Industry leadership, in terms of market share and concentration, was also fairly stable. All but five of the top twenty investment banks in 1965 had been among the top twenty in 1935.84 These systems of stabilization in commercial and investment banking, together with similar controls for thrifts, funds, and insurance, were developed and maintained by an elaborate network of federal and state regulatory bureaucracies. Seven federal agencies, together with regulatory commissions in all fifty states, shared responsibility for controlling prices, guiding industry structure, defining product portfolios, and segmenting service markets (see Figure 38). The most interesting organizational aspect of this system was the overlapping jurisdiction and political competition among the three federal banking bureaucracies. Besides the normal interagency rivalries so common in Washington, they displayed other differences, especially in their priorities, which included efficient banking methods, a safe and stable system, and controllable procedures for the exercise of monetary policy. The oldest of these agencies, the Office of the Comptroller of the Currency, employed 3,000 people by the late 1970s, in fourteen regional offices and Washington. The comptroller, who was appointed by the president and affiliated with the Treasury Department, generally represented the administration's banking policies. The Office of the Comptroller regulated 4,800 nationally chartered banks, with regard to new charters, mergers, branching, consumer law compliance, prudential limits, soundness examinations, and international matters. The Federal Deposit Insurance Corporation was a member-funded, quasi-autonomous corporation whose chairman was appointed by the president. It had primary responsibility for administering the deposit insurance program, arranging mergers that arose from the need to avoid

BankAmerica 257 failures, and, on rare occasions, conducting bankruptcy proceedings. It was also responsible for the general supervision of more than 8,000 banks that it insured but that were neither nationally chartered nor members of the Federal Reserve System. Because of its primary responsibility for monetary policy, the Federal Reserve Board had become the most important and the most powerful of the three federal regulators. The board supervised 1,100 state-chartered banks that were members of the Federal Reserve System, and set discount rates and reserve requirements for all member banks. It also supervised the acquisitions and bank-related financial activities of all bank holding companies.85 Finally, through Regulation Q, the Federal Reserve Board controlled interest rates on deposits held by its member banks and (with the concurrence of the Federal Deposit Insurance Corporation and the Home Loan Bank Board) on those held by all banks.

The Bank of America and the Prosperity of Regulation Under this elaborate system of regulatory stabilization, the Bank of America prospered—perhaps more than any other bank. As early as 1945, its deposits and assets ($5 billion) had surpassed those of Chase National, making it the largest bank in the world.86 This distinction was maintained well into the 1980s by three of Giannini's successors: S. Clark Beise (1954-1962), Rudolph Peterson (1962-1969), and Alden W. Clausen (1970-1981). Transamerica Corporation, Giannini's holding company, fared less well. It was, after all, a device for circumventing public policy. As the glow wore off the first New Deal, and as the Bank of America continued to expand throughout the West, the general agitation against bank holding companies intensified. The troubles actually began in 1937 with a disagreement between Treasury Secretary Henry Morgenthau and Giannini over dividend policy between the bank and the holding company. After three years of audits, investigations, political infighting, and complicated negotiations, Giannini reached a settlement with the comptroller of the currency, in which the Bank of America strengthened its capital and Transamerica eliminated certain practices. But Morgenthau never did accept Transamerica, and worked throughout the war years to block its expansion and attract political allies.87 One of these allies was Marriner Eccles, chairman of the Federal Reserve Board and an early admirer of Giannini's. But by 1942, Eccles was likewise concerned that Giannini was trying to monopolize banking in

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the West. Together with the comptroller and the chairman of the Federal Deposit Insurance Corporation, Eccles sent a joint communiqué to Transamerica, expressing the government's opposition to further bank acquisitions. When Giannini ignored this warning, the bank regulators asked Tom Clark, the attorney general, to launch an antitrust investigation. When the Justice Department apparently failed to develop a sufficient case under the Sherman Antitrust Act, Eccles resolved to lead the attack on Transamerica through a Federal Reserve Board investigation of antitrust infringements under the Clayton Act.88 But when the Truman administration seemed unresponsive and uninterested, Eccles surmised that Giannini had brought pressure to bear, perhaps using as leverage California's critical vote in the 1948 election. Nonetheless, in 1948 the Federal Reserve Board filed a formal action against Transamerica.89 By then, the giant company controlled 38 percent of the nation's bank deposits, and had 645 branches in five western states (California, Washington, Oregon, Nevada, and Arizona). 90 Proceedings continued until 1951, when the board recommended separating the Bank of America from Transamerica. Although the Court of Appeals overturned the board's ruling in 1954, Transamerica had by then divested all of its stock in the Bank of America. Giannini, who died in 1949, had won another battle but still had lost the war for nationwide banking. Under the leadership of Clark Beise and Rudolph Peterson, the Bank of America refocused on growth within California and outside the United States. This period, from 1954 to 1970, was perhaps the most prosperous in U.S. history. Deposits increased from $8 billion to $25 billion; loans, from $4 billion to $15 billion; and earnings, from $68 million to $163 million. In California, business boomed. Millions of young Americans migrated to this sunny paradise of modernity, hoping to begin more prosperous lives. The Bank of America met this growth with an effective, threepronged strategy: it built branches, automated transactions processing, and developed consumer and mortgage credit. In all three areas, the Bank of America was ahead of its time. The branch system more than doubled in size, from 453 to 977 branches. There was almost no community in California where a customer could not conveniently make a deposit or apply for a mortgage at the Bank of America. As early as 1950, Clark Beise recognized the immense costs of this far-flung network of bricks and mortar. He automated documents handling and bookkeeping at least a decade before his competitors did. As in

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the case of American Airlines, the initiative was prompted more by first-mover necessity t h a n by strategic vision. Over the next four years, working with the Stanford Research Institute and several electronics and calculating-machine companies, the Bank of America developed the Electronic Recording Machine. This proved to be the first mainframe computer applied to commercial activities—an extraordinary development, achieved outside the mainstream computer industry. 91 Eventually, it gave the Bank of America a scale advantage in recordkeeping and transactions processing that lasted into the mid-1960s. The other important innovation from the Beise years was the BankAmericard, which eventually became the first bank credit card offered nationwide. It started out, however, as a simple "charge card," modeled after those offered by oil companies and retail stores. In its feasibility studies, the Bank of America discovered a few other banks that already offered charge cards but that did so more as a convenience to customers t h a n as a profit center. The bank's research team realized, however, that profitability would be a function of market penetration; thus, for the Bank of America, with its position of statewide dominance, cards held greater potential t h a n for any other bank. 92 The product, launched in 1959, proved an immense success. It was promoted vigorously through statewide advertising and through the branches, and grew rapidly during the sixties. By 1964, 40,000 merchants in California accepted the BankAmericard. 93 In 1966 the bank decided to expand nationwide, through a licensing arrangement with other banks. In less t h a n two years, it had enrolled 6.4 million cardholders and 165,000 merchants. 9 4 The Bank of America's international activities, which Giannini had initiated during the late 1930s, expanded rapidly under Beise and Peterson. In the 1950s the bank opened several offices in Southeast Asia and Latin America, and expanded the corporate lending activities of its London office. A particularly large step was taken in 1956, with the purchase of the Banca d'America e d'ltalia—a multibranch retail and commercial bank in Italy. The bank's international expansion quickened after Rudolph Peterson became president in 1962. Peterson, w h o had spent several years in Mexico, "had more t h a n a passing interest in the international scene." In fact, "with the m o m e n t u m [in California] moving right along," Peterson was free to concentrate on international growth, to catch u p with the money-center banks—and he did. 95 In eight years, the n u m b e r of overseas branches grew from 22 to 100, with 61 subsidiaries in 77 countries.

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International assets increased to $8 billion—approximately one-fourth of the bank's total assets.96 When Peterson stepped down in 1970, he chose as his successor a relatively unknown forty-six-year-old executive named Alden (Tom) Clausen. Clausen, a credit expert with experience in international lending, inherited a growing multinational bank with the strongest domestic base of any bank in the United States. Clausen shared his predecessor's internationalist vision, but was even more committed to rapid growth.

Transition toward Deregulation Until the 1980s, regulatory reform in the financial services sector came very slowly and in small increments. The process was characterized by market-driven initiatives and technological innovations that forced regulators and legislators to make changes in public policy. As gaps opened up between changing economic conditions and outmoded regulations, entrepreneurs seized the opportunity to capture new regulatory rents through substitution and disintermediation (that is, financial transactions that circumvented banks). 97 By opening up gaps between cost and price, outmoded regulation contained "the seeds of its own destruction." 98 These competitive pressures, translated into political action, eventually resulted in regulatory change. As John Heimann, a former comptroller of the currency, described it in 1984, "No such thing as government deregulation of the financial services industry exists today. Rather, it is the market that has deregulated the industry and continues to do so."99

The Sources of Change Basic economic conditions in the late 1960s triggered the process of reform. Stimulated by rapid economic growth, a high level of business investment, and increasing competition for deposits (which was the prime route for asset growth allowed by regulation), inflationary pressures had developed and deposit interest rates (and the ratio of time deposits to demand deposits) had begun to rise in the mid-1960s.100 In 1966, as government borrowing accelerated to finance a growing deficit, a credit crunch developed; short-term rates exceeded both long-term rates and the interest rate ceilings for deposit accounts set by the Federal Reserve Board under Regulation Q. Disintermediation was the result.

BankAmerica 261 Potential depositors diverted their savings to more attractive financial instruments, and commercial customers turned to foreign capital markets and began to rely more heavily on commercial paper, new equity, or bonds. For banks and thrifts, this meant a slowing of growth, starting with deposits.101 After 1968, slower productivity growth, still larger fiscal deficits, the oil price shocks of 1973 and 1979, and persistent inflation combined to drive nominal interest rates to new heights. Further and more serious bouts of disintermediation followed, in 1969-1970, 1974, 1979, and 1981 (see Figures 39 and 40). These dramatic macroeconomic developments changed the balance sheets of financial intermediaries. On the liability side, deposits that were not interest sensitive—especially demand deposits—shrank as a source of funds (from 70 percent in 1950 to 20 percent in 1980). These were gradually replaced by time deposits and then by interest-sensitive deposits and purchased funds. On the asset side, however, competition threatened interest-sensitive business—especially commercial lending—first. So loan portfolios gradually shifted toward less competitive markets, such as mortgages, agricultural, and consumer loans, where interest rates were typically fixed for the term of the loan (and, parenthetically, where credit worthiness was substantially inferior). This was a historic reversal for financial intermediaries. To the extent that banks now held more fixed-rate loans than fixed-rate deposits, they would suffer a negative "mismatch" of funds. In other words, in periods of rising interest rates, the banks' stable revenues (on fixed-rate mortgages) would be outstripped by the rising interest costs of attracting new deposits (with large-denomination certificates of deposit). Thus, the new volatility of both interest rates and economic growth during the 1970s increased banks' exposure to "interest-rate risk" as well as credit risk. The Bank of America, as we will see, fell victim to just this problem. Related developments in international finance were part of this change. The breakdown in 1973 of the Bretton Woods system of fixed exchange rates facilitated international transmission of inflation and cross-border capital flows. These market pressures undermined the artificial segmentation of previously closed domestic capital markets, allowed access to unregulated sources of funds, and encouraged competitive entry. Foreign banks, usually operating with less liquidity and greater leverage, entered the U.S. market in large numbers during the 1970s.102 In California, for example, seventy-four foreign banks had claimed 30

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Figure 39. Disintermediation: market interest rates and Regulation Q ceilings, 1960-1987.

percent of t h e commercial-loan m a r k e t by 1979 (up f r o m 7 percent in 1970). The worldwide oil crisis in 1 9 7 3 - 1 9 7 4 unleashed long-term forces that also contributed to this destabilization of financial markets. In addition to spurring domestic inflation, t h e s u d d e n fourfold increase in oil prices caused large n e w flows of revenues across national borders, f r o m oil-consuming countries to oil-producing countries, especially in t h e Middle East. Since these i m m e n s e revenues could n o t immediately be absorbed by t h e small and underdeveloped populations of t h e producing countries, t h e y w e r e reinvested in U.S. banks. But because t h e U.S. e c o n o m y h a d stagnated, big banks eagerly lent these funds to developing countries, desperate to leverage their o w n economic growth. Eight years later, w h e n these lucrative sovereign loans w e n t bad, m o n e y - c e n t e r banks like t h e Bank of America faced massive international credit problems at t h e very m o m e n t of deregulatory a d j u s t m e n t . A wide array of financial innovations flowed f r o m these various disequilibria. W h e r e regulatory constraints w e r e especially binding, or w h e r e

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loopholes opened opportunities to breach geographic or functional segmentation, the most aggressive firms devised new products and organizational innovations. Among the earliest examples of these were Negotiable Certificates of Deposit (CDs), created by Citibank in 1961, when its ability to attract deposits fell behind loan demand. In the late 1960s and 1970s, the federal funds and Eurodollar markets developed as alternative sources of funds for banks, while a market for commercial paper (debt, or promissory notes, issued by large corporations to raise funds) became a serious form of disintermediation. In Massachusetts, mutual savings banks invented Negotiable Order of Withdrawal (NOW) Accounts, to compete with commercial banks for checkable deposits. Eventually, the securities industry created Money Market Mutual Funds (MMMFs) to breach the provisions of the Glass-Steagall Act and attract savings in search of market-interest rates.103 Organizational innovations, in the form of bank holding companies, were used during this period to circumvent the product and market constraints of the McFadden Act and the Glass-Steagall Act. The number of one-bank holding companies (exempted from regulation under the 1956 Bank Holding Company Act) increased from 550 to 1,441 between

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1965 and 1970. Even after 1970—when amendments to the Holding Company Act were passed, extending regulation to one-bank holding companies—800 more were formed during the next eight years.104 Most of these were intended to facilitate expansion into nondepository financial services; between 1971 and 1977, the Federal Reserve Board received nearly 700 acquisition proposals and more than 3,300 notices of de novo ventures by bank holding companies, in every conceivable "closely related area"—leasing, mortgage banking, trusts, investment advice, insurance brokerage, general finance, data processing, community development, and so on.105 New technology also worked to destabilize the regulated financial system. Especially during the 1970s and early 1980s, information processing and telecommunications capabilities dramatically affected the supply and demand for financial services and transaction products, and altered industry operations and structure. This revolution began in back-office operations, with the introduction of mainframe computers for data processing and of reader/sorter document processors and data retrieval systems that enhanced these computational capabilities. With the development of digital switching, which facilitated rapid data transmission, the revolution spread from headquarters to branch-office integrated networks, and later to wholesale operations—commercial lending, interbank transactions, and international banking—via electronic transfer of funds. During the 1980s, new technology reached into the "front office" (retail markets) with the development of Automated Teller Machines (ATMs), Point-of-Sale (POS) terminals, and magnetic cards and "smart" cards for credit and debit transactions.106 The impact of these innovations on operations and competition is a story in itself. Besides the more obvious effects on retail distribution and new-product definition, these technological changes fundamentally altered the economics and structure of the financial services industry and its regulation. Initially, they introduced some economies of scale, especially for multibranch banks.107 Eventually, however, these advantages were largely dissipated by the fact that smaller banks could contract for such processing services.108 More importantly, electronic processing and communications technologies created significant economies of multiproduct scope. By spreading production and distribution costs across a broad line of electronic transactions, financial services companies (and bank holding companies) could lower unit costs and create competitive advantages. Such scope

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economies also created greater scale economies—possibly increasing up to a firm size of $2.5 billion in assets.109 The effect of these economies was to lower the barriers to crossing the two key regulatory boundaries: product and geographic segmentation. 110 On the product side, as Edward Kane has explained it, the technology "allows management to coordinate unregulated substitute arrangements such as sweep accounts or the activities of an array of subsidiary firms." Thus, since product-line homogenization is more likely, "exclusionary rules would tend to lose their effectiveness." 111 With respect to geographic segmentation, electronic transfers of funds significantly reduced the costs of market expansion. Automated teller machines (which undermined the traditional structure of intrastate branch banking), nationwide credit card services, discount brokerage services (outside the traditional money centers), and direct (nonagency) insurance sales were some of the products that helped breach New Deal regulatory boundaries. 112 New ideas about the causes of the Great Depression also helped undermine the theoretical premises underlying existing policy. Research conducted since the mid-1960s provided mounting evidence that integrated financial services firms neither caused the collapse of the banking system nor had a significantly higher failure rate than unit banks or private investment houses. 113 Structural analysis of branching, interstate banking, and bank holding companies revealed no unwarranted propensity toward concentration and no flight of capital from rural communities to money-center banks. 114 Indeed, as a part of the broader reassessment of regulation discussed in Chapter 1, congressional committees, bank regulators, and presidential commissions produced a nearly continuous stream of reports and reviews throughout the 1970s and early 1980s.115 A final source of change was the failure of regulation itself; it was not just inefficient but caused gross distortions and discontinuities by retaining outmoded rules in the face of new conditions. Examples abound: the Federal Reserve Board's inability to adjust Regulation Q to market rates; the extension of interest rate ceilings to S&Ls in 1966; the willingness of the Securities and Exchange Commission to allow fixed commission rates on stock exchanges, until bypass by institutional investors forced a change; the incredible success of money market funds that drained banks and thrifts of their deposits; the failure of bank supervisors to prevent commercial banks from purchasing worthless assets; the failure of regulators, through laxity and politicization, to control the credit practices of the savings and loan industry.

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Together, these important forces of change created new pressures on the prevailing structure of political interests. As the political interests within the financial sector and its regulatory bureaucracies were realigned during the 1970s, the process of administrative and legislative reform gained momentum. Yet it was a slow and piecemeal process, with results that scarcely matched the amount of political discourse and effort.

Regulatory Reform As the observation by comptroller John Heimann has already suggested, regulatory reform in the banking sector was little more than the political acknowledgment of de facto competition. We've seen that the pressure for interest rate deregulation began as early as the credit crunch of 1966. But the Federal Reserve Board's initial response was to seek broader regulatory authority to set different rate ceilings for various categories of time deposits. And to prevent competition for deposits from thrift institutions (which were not then subject to Regulation Q), the board also asked that the Home Loan Bank Board and the Federal Deposit Insurance Corporation be authorized to set interest rate ceilings for S&Ls and mutual savings banks in consultation with the Federal Reserve Board. Congress obliged with the Interest Rate Control Act of 1966.116 In subsequent rounds of yield inversion and disintermediation, the Federal Reserve Board tried without success to "tune" the ceiling structure for different categories of deposits. But smaller regulated accounts simply proliferated. As banks created a stream of new consumer-type instruments, such as money market certificates and small-saver certificates, the board would impose new interest rate ceilings.117 Then, when rising market-interest rates threatened these Q-controlled certificates, the big banks turned to foreign borrowing and to repurchase agreements. In 1973, when the gap between market rates and Regulation Q reached 4 percent, the Federal Reserve Board did take steps toward deregulation by suspending the ceiling on time deposits over $100,000. But this divergent treatment of large and small depositors only created new opportunities for disintermediation. Mutual funds, which invested in certificates of deposit and commercial paper, could offer small savers earnings higher than those allowed by Regulation Q. So could investment banks, which were beginning to offer Money Market Mutual Funds. Because distribution channels to small savers were still undeveloped, this

BankAmerica 267 product remained relatively dormant for several years. But when the interest rate gap widened again in 1978, the pace of disintermediation quickened. By then, the investment banks had improved their distribution and had added features to their funds (an example is Merrill Lynch's Cash Management Account). Assets in money funds jumped from $78 billion in 1980 (from zero in 1972) to $230 billion in 1982. Thrifts, meanwhile, were even more constrained than banks when it came to diversifying their sources of funds (through holding-company activities) or managing their assets to minimize interest rate risk. State usury laws limited interest rates on loans, and the Home Owners Equity Act of 1933 limited their asset mix to a heavy concentration of home mortgages (which were long-term, fixed-rate instruments). 118 In an effort to attract deposits, mutual savings banks in New England created NOW accounts, as previously mentioned. S&Ls turned increasingly to nonprice methods of competition; free checking accounts and other giveaways (toasters, can openers, and umbrellas) were the most apparent, but convenient parking, drive-in facilities, and the proliferation of branch offices were more important. 119 Still, with the record-high inflation and widespread disintermediation in 1973-1974, thrift earnings declined sharply. After recovering briefly in the late 1970s, return on equity fell again in 1980, nearly to zero. Serious pressure for a regulatory fix first developed after the recession of 1975-1976. While the Treasury Department and various congressional committees reviewed proposals for systemic reforms, interest groups sought specific remedies to their own immediate problems. Thus, commercial banks originally focused on getting NOW accounts and interest rate equity with S&Ls (for which the ceilings were slightly higher). As disintermediation by the money funds worsened, the banks shifted their focus; they began to press for a phase-out of Regulation Q and access to some of the investment banks' own product markets. Thrifts, on the other hand, wanted relief from state usury ceilings, broader lending authority, and adjustable mortgage instruments that would help relieve their problem with mismatched loan and deposit rates. For its part, the Office of the Comptroller of the Currency wanted a restructuring of regulatory responsibilities that would consolidate control in a single, cabinet-controlled entity. The Federal Reserve Board wanted to expand its authority over reserve requirements, to stanch the flight of its members to less-regulated charters, and to expand its control over the money supply.

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A batch of bills reflecting these piecemeal interests was introduced in Congress during 1979.120 As the industry's problems deepened in the fall of that year, with recession and record-high inflation, support for legislative action grew. By combining nearly everyone's wish list, the Carter administration forged a successful political coalition.121 In March 1980, Congress enacted the Depository Institutions Deregulation and Monetary Control Act. This bill, according to one senator, looked like a cross between "a Christmas tree" and "a forest primeval."122 Reflecting its diverse origins, the Depository Deregulation Act actually consisted of five separate titles: (I) The Depository Institutions Deregulation Act of 1980, (II) The Monetary Control Act of 1980, (IE) the Consumer Checking Account Equity Act, (IV) Powers of Thrift Institutions and Miscellaneous Provisions, and (V) State Usury Laws.123 Title I was the centerpiece. The act created a six-member Depository Institutions Deregulation Committee, composed of the five key banking regulators and the secretary of the Treasury. The committee was charged with implementing a phase-out of Regulation Q within six years or sooner. Title II extended the Federal Reserve Board's authority over reserve requirements to all depository institutions that used its payment systems. Title in allowed commercial banks and S&Ls to offer interest-bearing checking accounts (to individuals, but not to businesses). It also raised federal deposit insurance ceilings from $40,000 to $100,000, as a new tool to help banks and thrifts compete with nondepository firms. This little-debated measure subsequently provided banks and thrifts with a perverse incentive to take risks. Under Title IV, federally chartered thrifts received several new powers: an expansion of geographic scope for residential mortgage lending, parity with commercial banks on consumer finance, and broader authority to make construction and development loans. Investment authority was increased to 20 percent of total assets in consumer loans, commercial paper, and corporate debt securities. And under Title V, state usury ceilings on residential mortgages and certain agricultural loans were preempted.124 Despite all this, the 1980 Deregulation Act proved to be just another stage in the decomposition of the regulatory tarbaby. It may have mitigated disintermediation, but the S&L sector was still stuck with a portfolio of long-term, fixed-rate mortgages. Higher, short-term rates only aggravated their mismatch, pushing net income into the red by 16.5 percent

BankAmerica 269 and bringing tangible net worth close to zero.125 Although commercial banks also suffered, they were less rigidly mismatched in mortgages and had greater flexibility on the liability side to stanch the disintermediation. Meanwhile, the Depository Institutions Deregulation Committee moved very slowly, unable to agree on pace or balance among the competitive products of its diverse constituency. As record-high interest rates persisted into 1982, the rate of S&L failures accelerated sharply.126 In something of a panic, Congress passed the Garn-St. Germain Depository Institutions Act of 1982.127 This law, like the Depository Institutions Deregulation and Monetary Control Act before it, was a collage of pending bills that represented disparate, particularistic interests. It was clearly an emergency measure, designed to relieve the thrift industry. On the liability side of the business, the act provided for easier and broader access to funds. S&Ls and commercial banks were authorized to offer Super NOW accounts to a wider range of customers, as well as Money Market Deposit Accounts, with unrestricted interest and a minimum-balance requirement of $2,500 (these accounts thus competed directly with money funds). On the asset side of their business, thrifts were granted new freedoms as to how they used their funds. Henceforth, they could buy state and local securities and corporate bonds (up to 20 percent of assets), and could expand their lending into previously restricted markets, including nonresidential real estate, education, and commercial loans. An important provision of the act, for both thrifts and commercial banks, was the preemption of state restrictions on the execution of due-on-sale clauses in mortgage contracts.128 The Garn-St. Germain Act also vested the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation with much broader authority and discretion to bolster or bail out ailing institutions. These powers included making loans or guarantees, purchasing assets or liabilities, and, what was most significant, arranging mergers and acquisitions between thrifts and other financial institutions, including bank holding companies across state lines. Finally, the act allowed thrifts to alter their charters easily, from state to federal, or from thrifts to banks.129 Although the deregulatory acts of 1980 and 1982 fostered increased competition within the banking sector, neither law explicitly addressed restrictions on interstate banking or the Glass-Steagall separation of commercial and investment banking. Both of these public policies were vig-

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orously defended by powerful, well-organized interest groups. But here, too, entrepreneurship and eventually regulatory failure kept a h e a d of reform. Large banks w e r e breaching geographic barriers t h r o u g h ingenious distribution channels, at least for the p u r p o s e of generating loans. Under t h e Edge Act, banks w e r e allowed to establish interstate offices to serve international customers; at t h e same time, Loan Production Offices attracted domestic business. Cash m a n a g e m e n t was performed nationally by growing networks of credit cards. Expanding deposits proved m o r e difficult; automatic teller machines helped, b u t only in intrastate markets. Third-party, or "shared," ATM networks held t h e potential for national deposit taking b u t w e r e still restricted by state laws. Through these sorts of devices, domestic a n d foreign banks m a n a g e d to establish almost 7,500 offices outside their h o m e states. Eventually, state regulatory policies gave way. During t h e early 1980s, t h r e e states authorized unrestricted interstate banking, and t w o dozen others joined regional compacts that allowed reciprocal cross-border mergers b u t prevented entry by money-center banks. 130 These arrangements, although sustained b y the courts, proved transitory. A w a v e of interstate mergers to save failing banks m a d e interstate banking a reality in all b u t n a m e . By the end of the decade, eight states h a d authorized unrestricted branching, seventeen had approved nationwide reciprocal branching, a n d the rest w e r e allowing regional branching o n a reciprocal basis. 131 Product-line restrictions, as b e t w e e n banks and other financial services firms, w e r e dissolving in a similar m a n n e r ; t h e changes w e r e driven by technological innovation a n d inventive loopholes, rather t h a n by judicious reform. N o n b a n k financial companies, including American Express, Prudential/Bache, Sears, a n d Merrill Lynch, continued to develop their electronic transactions capabilities to contrive products for bypassing commercial banks. Frustration with this apparently o n e - w a y product substitution led Citibank's chairman, Walter Wriston, to complain that "the b a n k of t h e f u t u r e already exists, a n d it's called Merrill Lynch." 132 Perhaps the best, most explicit example of regulatory circumvention w a s the appearance of t h e " n o n b a n k b a n k " — a n organizational loophole for breaching or escaping t h e geographic a n d product-line restrictions o n commercial banks. 133 The Bank Holding C o m p a n y Act defined a b a n k as a n y institution "which (1) accepts deposits that t h e depositor has a legal right to w i t h d r a w o n d e m a n d , and (2) engages in t h e business of making

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commercial loans." 134 During the 1970s, the Federal Reserve Board periodically honed the definition, presumably enforcing its mandate under the act: "to prevent the undue concentration of commercial banking activities" and "to maintain the traditional separation between banking and [commerce] in order to prevent abuses of allocation of credit." 135 Technically, a firm was not a bank if it performed only half the normal functions of a bank—that is, if it either "accepted demand deposits" or "made commercial loans," but not both. In 1980 a Gulf and Western subsidiary, Associates First Capital Corporation, announced its intention to acquire the Fidelity National Bank, in California. Associates' application to the comptroller of the currency proposed divesting the bank's commercial loan portfolio, thereby removing the bank from the Federal Reserve Board's jurisdiction. The comptroller approved the application, and the nonbank bank was born. By 1981, nonbank banks had started to multiply. Small banks bought by Household Finance, Avco, and Parker Pen divested their commercial loan portfolios and became eligible for the Federal Reserve Board's checkclearing services and for coverage by the Federal Deposit Insurance Corporation. Citicorp then acquired a national charter for conducting credit card business out of South Dakota, thereby avoiding New York's usury laws. At first (according to a former official) the Federal Reserve Board was "asleep at the switch." But in 1982, with de facto repeal of the Bank Holding Company Act under way, the board moved to block nonbank banks. To stop the takeover of Beehive Thrift and Loan by First Bankcorporation of Utah (a bank holding company), the board ruled that a NOW account was a "demand deposit." Later that year, w h e n Dreyfus Corporation (mutual funds) acquired Lincoln State Bank (chartered in New Jersey), the board objected, but the chairman of the Federal Deposit Insurance Corporation asserted jurisdiction and approved the acquisition. In March 1983, Dimension Financial Corporation filed thirty-one nonbank bank applications with the comptroller. These nonbank banks, planned for twenty-five states, would concentrate at first on providing trust services and large consumer loans, and would eventually engage in brokerage, insurance, tax planning, and other services—but not commercial loans. According to one congressional staffer, this "blatantly greedy" application "scared a lot of people" and "mobilized Congress."136 Now Jake Garn, chairman of the Senate Banking Committee, and Ferdinand St. Germain, chairman of the House Banking Committee, both

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expressed concern over this sort of runaway de facto deregulation. Promising to develop a legislative solution, they pressed Tod Conover, then comptroller of the currency, to impose a temporary moratorium on hundreds of pending applications. This action signaled the last gasp of deregulatory momentum during the Reagan administration.

Tom Clausen: Business as Usual,

1970-1981

Although Tom Clausen thought well of deregulation in principle, his business strategy for BankAmerica (as it was now named) remained essentially unchanged until 1981. The bank's senior management spoke approvingly of increased competition, and cautiously of greater risk, but these phrases did not translate into any significant strategic or organizational change during the 1970s. There were several reasons for this. Foremost was BankAmerica's unique competitive advantage—a statewide system of more than a thousand branches. This distribution system gave BankAmerica a broader and deeper access to low-cost funds, and a degree of market dominance that no other bank could match. It meant that BankAmerica did not experience a squeeze on net interest margins in the mid-1970s, when most other banks did. It meant that disintermediation was not a significant problem in the mid-1970s, when it first hit other banks. BankAmerica's demand deposits and passbook savings accounts continued to grow at a healthy rate even in the 1980s. It meant that BankAmerica's market saturation and first-mover locational advantages could preempt much of the new competition from S&Ls and nonbank financial companies. In fact, it meant that BankAmerica did not have to adjust, at least not yet. This very strength in distribution, however, reinforced another element of inertia: BankAmerica's failure to modernize its electronic processing and distribution capabilities effectively. Part of the problem was the absence of any compelling short-term need. The rest was due to short-term cost controls and a void in technical management. After developing a position of technology leadership in the 1960s, BankAmerica seemed to let things go in the 1970s. Looking back at this period, Tom Clausen attributed the problem to a lack of good technical management after the retirement of Al Ziff, the bank's computer innovator, in the mid-1970s. 137 Thereafter, a succession of executives came and went, starting and abandoning a series of processing projects.138 One

BankAmerica 273 system, named COOLS, failed as a result of supplier problems. Another, involving National Cash Register's pioneering development of image technology, simply didn't pan out. A technology audit performed in 1980 pointed to a number of problems: "a lack of significant productivity gains in the branches," smaller competitors catching up with BankAmerica's cost advantage, service difficulties associated with inflexible batch-oriented systems, and a continued reliance on mainframe computers and paper-based transactions right into the 1980s.139 With automated teller machines, BankAmerica ran a pilot program in 1975 but decided that the economics didn't warrant a full-scale rollout. Samuel Armacost, who as president of BankAmerica would subsequently have to reverse this decision, attributed the delay to a combination of Clausen's lack of experience with technology and to a perverse sort of focus on short-term costs.140 Since the bank had a branch in every town and demand was growing on every side, it was hard to see a need to be first with this unproven technology. A third factor that contributed to the bank's strategic stasis was the incredible strength of the California market, which seemed impervious to the economic shocks that plagued the rest of the nation. California's huge economy, already larger than that of most countries, scarcely missed a beat during the recession of 1974-1975. Agriculture, construction, aerospace, computers, entertainment, and increasing trade-related activity with Asia all contributed to strong loan demand and deposit growth for BankAmerica. And the California housing market was the most vigorous of all. In the late 1970s, the real estate market grew at 30 percent a year. In 1978, for example, BankAmerica's single-family mortgage portfolio jumped 37 percent. California's extraordinary growth shielded BankAmerica from two negative object lessons that subsequently proved important. In the mid1970s, money-center banks in the East, which were expanding more slowly, had become deeply involved in real estate investment trusts (or REITs), a high-risk instrument developed to help expand lending to the commercial real estate business. BankAmerica had little need for this additional growth and had taken a very conservative position on these trusts. When East Coast real estate went sour in the recession of 19741975, banks such as Chase Manhattan, Bankers Trust, and even Citibank suffered huge losses on these loans.141 Whereas they were forced to revamp their credit policy systems and "internally rebuild their houses," BankAmerica was not. As Armacost put it from the perspective of a

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decade later, "they had done what the Bank of America had to do in the early 1980s," but without the benefit of double-digit inflation. 142 BankAmerica also underestimated the risks of mismatch. In 1974 Leland Prussia, who would shortly succeed Clarence Baumhefner as head cashier, had anticipated falling interest rates. He implemented a decrease of the bank's positive mismatch (the imbalance between fixed-rate deposits and fixed-rate loans).143 When short-term rates fell sharply later in 1974, BankAmerica made a lot of money (because interest on mortgages exceeded interest payments on deposits) and Prussia received much of the credit.144 Still another reason for BankAmerica's strategic inertia was its decentralized organizational structure, with a tradition of autonomous branch managers operating full-service branch banks, and a corporate culture oriented to loyalty, lifetime employment, low salaries (without incentive compensation), and promotions from within. There was a growth tradition as well as a service tradition, but nothing that could be called a competitive experience. The flip side of the bank's strengths—the statewide branch network and presence in more than a hundred countries— was also a weakness. This huge organization was like an oil tanker or, better yet, like AT&T: without a severe crisis, it could scarcely slow down, much less "turn on a dime."145 The changes that were made during this period scarcely prepared BankAmerica for deregulation. Budgetary coordination was strengthened with the implementation of a "building-block system" designed to calculate "the contribution of individual units to overall profit." At the same time, credit authority was shifted increasingly from headquarters to line organizations. Loan authority in the field was increased from $5 million to $20 million. Responsibility for larger loans was more or less divided between the General Loan Committee, the comptroller, and the cashier.146 And finally, BankAmerica did not engage in strategic planning until 1979, when the Managing Committee designated a new function for that purpose.147 The strategy adopted by Clausen in 1974 focused on two goals, one explicit, the other implicit: first, to increase return on equity by 15 percent annually; second, to surpass Citicorp in profitability. Furthermore, because Clausen was convinced that a global economy was rapidly developing, he pushed hard for BankAmerica to catch up with the money-center banks in Europe and Latin America. Surplus funds from the California Division, the opportunities for recycling petrodollars as

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40 Total deposits (in dollars)

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