News Release

The following opinion piece by Chicago Fed economists Robert DeYoung and Thomas Klier was featured in the 'Viewpoint' section of the July 9, 2004 issue of American Banker.

The City of Broad Shoulders--But No Big National Banks

Now that the merger between J.P. Morgan Chase & Co. and Bank One Corp. is in the books, it is time to ask this question: How did Chicago -- a longtime financial center at the heart of the Midwest economy and the third most populous U.S. city -- end up without a nationwide banking headquarters?

The near-complete exodus of large commercial-bank headquarters from Chicago is the direct and unfortunate result of Illinois' long history of restrictive banking regulations.

For most of the 20th century, Illinois law prohibited its banks from opening branch offices. The size of a local community largely dictated the size of its banks, with Chicago banks naturally growing bigger than those in downstate counties. These regulations were designed to keep depositors' funds safe and local economies stable by preventing "excess" competition.

Although well intended, these laws kept Illinois banks artificially small, geography-bound, and ill prepared to compete in a more competitive post-deregulation environment. Bank One's road to New York was paved with these good intentions.

Illinois was not unique, or even unusual, in restricting bank growth. States like Texas and Colorado had similar prohibitions on branching, and dozens of other states restricted the growth options for their banks, though less severely. But such restrictions were not universal. For instance, California has never placed geographic restrictions on its banks, and as a result, Bank of Italy (now Bank of America) had the nation's first successful branch banking system. And in the mid-1980s about a dozen states in the Southeast signed reciprocal agreements that allowed their banking companies to expand across one another's borders.

Large commercial banks tend to gravitate toward large cities, where corporate business opportunities and other location benefits are strongest. But over the past decade some of the nation's largest banking companies have been migrating toward states that have a history of unrestricted branching.

We examined the 23 largest commercial bank acquisitions in the United States since 1991; in each deal the acquired company had at least $20 billion of assets in today's dollars. Remarkably, in nearly half these mergers -- 11 out of 23 -- the post-merger headquarters was in the smaller of the two banking cities. Although these mergers had a variety of idiosyncratic causes and effects, there is a common thread running through them: the lasting effects of historical state banking laws. In 10 of these 11 mergers, the city that retained its headquarters was either Charlotte, just the 33d-largest metropolitan area in the country and home to NationsBank and First Union at the time of their mergers, or San Francisco, the home of Bank of America and Wells Fargo. Not coincidentally, these cities are in states that did not attempt to manage the geographic scope of their banks.

Illinois began relaxing its branching restrictions in the 1980s and phased them out fully by 1993, but by then the damage was done. The growth opportunities for Chicago's commercial banks had been stunted over the years, while banks in other cities were gaining the critical mass needed to make large acquisitions and the experience to efficiently operate a far-flung company.

First Chicago attempted too late to become a superregional bank by merging with National Bank of Detroit in 1995. The combined bank was swallowed by Bank One shortly thereafter. Two other leading Chicago institutions, LaSalle Bank and Harris Bank, had been acquired as domestic-entry vehicles by ABN Amro in 1979 and Bank of Montreal in 1984, respectively.

And though Northern Trust is a leader in private banking, it is basically a large niche bank, not a contender for nationwide retail status. Even the problems that famously brought down Continental Bank of Illinois in 1984 can be traced to Illinois' restrictive laws. Had Continental been free to branch organically throughout the state (like California banks) or acquire companies in other states (like North Carolina banks), a larger base of core deposits would have left it far less vulnerable to the funding runs that occurred in the aftermath of the Penn Square debacle.

The legacy of Illinois' banking laws is the absence of Chicago companies from the short list of banks competing for nationwide retail preeminence. The folly of this episode is that these laws were introduced to protect local banks but ultimately had the opposite effect: They limited the ability of even the most successful Chicago banks to survive in a competitive industry.

Today, Chicago has no major home-owned commercial banks left to protect. Some will argue that the JPMorgan Chase-Bank One merger was preordained by the personalities involved, but this is merely anecdotal evidence that misses the larger point. The lesson to be learned, or relearned, has applications far beyond the industry. Regulatory or legal restrictions aimed at protecting local economies -- for example, promoting a "living wage" by holding local minimum wages above the national level -- eventually run afoul of the laws of economics and result in excessive long-run costs in exchange for short-lived (including political) benefits. The same can be said for trade policies aimed at protecting domestic jobs, or tax policies that attempt to reduce the outsourcing of labor.

All of these policies, however well intentioned, end up depressing local economic activity, driving away jobs, and weakening local companies. How else to explain that Charlotte -- and not Chicago -- has become a national banking center?

Mr. DeYoung and Mr. Klier are senior economists at the Federal Reserve Bank of Chicago. The authors' views do not necessarily reflect those of the Chicago Fed or the Federal Reserve System.