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Federal Financial Institutions Examination Council
Staff Study
Capital Trends in
Federally Regulated Financial Institutions
June 1980
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_.. ,_ eral Reserve System, Federal Deposit Insurance Corporation, Federal Home Loan Bank Board,
National Credit Union Administration, Office of the Comptroller of the Currency
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Federal Reserve Bank of St. Louis
June, 1980
TO:
FFIEC Task Force on Supervision
FROM:
Subcommittee on Capital Adequacy
Attached is the subcommittee's background report on the capital adequacy
of financial institutions.
The subcommittee will next address itself to a study of alternatives or
supplements to equity capital, such as subordinated debt and preferred
stock. Our considerations will include the proper mix of such alternatives,
their appropriate minimum terms and their role in determining capital
adequacy.
Drafting Subgroup
Subcommittee Members
Robert F. Miailovich
Edmund G. Zito
Samuel H. Talley
Mike Fischer
Louis Roy
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Federal Reserve Bank of St. Louis
(FDIC), Chairman
(OCC)
(FRB)
(NCUA)
(FHLBB)
Gisela A. Gonzalez
Thomas A. Loeffler
Gregory Boczar
Harry Moore
Alvin W. Smuzynski
(FDIC)
(OCC)
(FRB)
(NCUA)
(FHLBB)
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Federal Reserve Bank of St. Louis
TABLE OF CONTENTS
Introduction
1
Commercial Banks
2
Mutual Savings Banks
14
Savings and Loan Associations
22
Federal Credit Unions
27
INTRODUCTION
The Federal Financial Institutions Examination Council requested that
the Subcommittee on Capital formally present to it a background paper describing the current capital situation in the nation's financial intermediaries
This document is the Subcommittee's report.
The paper is divided into four major sections--commercial banks. mutual
savings banks, savings and loan associations, and credit unions. Each of these
sections contains a discussion of the capital situation existing in the particular segment of the financial markets. Each discussion considers the
trends in capital ratios, the forces behind those trends, and the major policy
questions to be addressed by each of the regulatory agencies.
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- 1 -
CO~ERCIAL BANKS
The capital situation in commercial banks has been discussed by regulators for more than a century. At the center of those discussions is the
concern for the safety and soundness of the banking system. That concern
results, partially, from what s~ems to be a secular decline in bank capital
ratios.
The first part of this section looks at those banking industry trends to
see if there exists a secular decline. The focus is on both industry aggregates and individual bank ratios. The latter provides insight to the pervasiveness of the industry trends.
However, looking at the numbers is not enough to determine if. the trend
should be a cause for regulatory concern or action. It is important to know
the forces behind those trends. Moreover, that information is relevant for
creating bank capital policies.
Policy issues are the subject of the third part of this section. Five
areas which have been identified as pertinent to the capital situation i.1
hanks are presented. The elements of each issue are discussed and policy
questions formulated.
Trends in Bank Capital Ratios
Table 1 contains data on three capital ratios -- Total Capital to Total
Assets (TC/TA), Equity Capital to Total Assets (EC/TA), and Equity Capital
to Risk Assets (EC/RA) -- for the commercial banking industry from 1945
through 1979. Those industry averages clearly show the downward trend about
which regulators haye expressed so much concern. However, a breakdown of
those averages show that the decline does not pervade the industry.
The behavior of each of the three ratios has varied over time but all
showed a declining trend over the period covered in Table 1. The most
pronounced decline is shown by EC/RA as the growth rate EC/TA increased from
1945 through 1960 as the rate of growth in equity capital was greater than
that for total assets. However, since 1960 these two ratios have declined
steadily with the exception of the 1975 post recession cyclical upturn.
The relative movement of the three ratios also provides some information.
EC/RA and EC/TA have moved closer together as risk assets became an increasing
percentage of total assets. TC/TA and EC/TA moved further apart until 1974
as the use of debt capital increased. Since that time the ratios have maintained a forty basis point difference, approximately.
These industry trends, however, are misleading. If the data is broken
out by size groups and the trends in capital ratios noted, it is found that
most size groups did not experience downward trends in capital ratios.
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- 2 -
The Office of the Comptroller of the Currency studied capital ratios
for national banks from 1949 through the second quarter of 1979, broken out
by size groups. They found that declines were primarily registered by banks
with assets over $500 million. On average, banks below this size group either
held their ratios fairly constant or increased them.
The Comptroller's findings were supported by a study conducted at the
FDIC for all insured commercial banks for the period 1970 through 1979 .. The
data from that study are shown in Table 2. The study found that capital
ratios for banks with total assets of less than $25 million were at the.ir
high by ·~979. Banks with assets of $25 million but less than 1 billion
showed no consistent patterns over the period. Ratios of these banks at
the end of 1979 were in the middle of the range for the period. However,
banks with assets in excess of 1 billion or more showed a persistent decline
over the period with the exception of the 1975 .. cyclical upturn.
Industry average capital ratios are computed on a weighted average basis
where each bank's weight is the ratio of its total assets to industry total
assets. The fact that large banks have significantly lower capital ratios and
show a persistent decline in large part explains the declining industry averages.
A final observation needs to be made abouL the tr~nd in and values of
capital ratios for large banks. Concern has been expressed that the capital
ratios of these banks are overstated because some of the reported equity
capital represent debt which has been downstreamed from the parent. This
double-leveraged capital should not be equated with straight equity because
it usually carries fixed cost committments while straight equity does not.
An estimate of the effect of double leveraging on bank capital ratios is
presented in Table 3.
Forces Affecting Ba~k Capital Positions
Bank capital ratios, relating the amount of bank capital to bank assets,
vary in response to differential growth rates in the numerator- bank capital,
and the denominator - bank assets. The growth rate of bank assets has been
affected by the rate of inflation, innovations in bank liability management,
and the growth rate of international bank assets. The growth rate of bank
capital has been a function of the rate of return on assets, the retention rate of earnings, and net new issues of capital securities including
bank capital downstreamed from the parent bank holding company. The
"adequacy" of these bank capital ratios is affected by the economic and
bank regulatory environment in which banks operate and the magnitude of risk
inherent in bank structure and operating characteristics.
Bank Assets
Inflation-induced bank asset growth has been primarily a phenomenon of
the late 1960s and the decade of the 1970s. As inflation has increased the
demand for borrowed funds, bank assets have expanded to acconnnodate this source
of growth in economic activity. Although introduced prior to the period of
rapid inflationary growth, innovations in bank liability management have
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- 3 -
Table I
Assets and Capital for Insured Commercial Banks - Selected Years
($ in millions ratios in%)
1/
ForeignAssets
Year
Domestic£/
Assets
Riskl/
Assets
Total
Capital
Debt~/
Capital
Equity
Capital
TC'jj
TA
Ee~/
TA
EC'2_/
RA
1945y
-0-
157,582
85,701
8,672
43
8,629
5.5
5.5
10.1
1950
-o-
166,792
104,094
11,281
20
11,261
6.8
6.8
10.8
1955
-0-
209,145
142,298
15,009
30
14,979
7.2
7.2
10.5
1960
-0-
256,323
174,658
20,658
23
20,635
8.1
8.1
11.8
1965
1970!_/
-0-
375,394
255,747
29,905
1,653
28,252
8.0
7.5
11.0
39,915
576,351
448,713
42,626
2,092
40,534
6.9
6.6
9.0
1971
56,337
639,903
512,650
47,017
8.6
2,986
44,031
6.8
6.3
1972
75,418
737,699
602,521
52,410
3,991
48,419
6.4
6.0
8.0
1973
114,295
832,658
720,591
57,869
4,162
53,707
6.1
5.7
7.5
1974
133,443
912,529
868,017
63,336
4,261
59,075
6.1
5.6
6.8
1975
1976~./
142,938
952,451
815,354
68,698
4,422
64,276
6.3
5.9
7.3
171,062
l,0ll,329
955,289
77,485
5,220
72,265
6.6
6.1
7.6
1977
201,706
1,137,687
1,083,079
85,121
5,830
79,291
6.4
5.9
7.3
1978
239,209
1,273,189
1,244,372
93,283
5,865
87,418
6.2
5.8
7.0
1979
291,178
1,398,918
1,295,444
103,375
6,254
97,121
6.1
5.7
7.5
.i:,.
Sources:
1945-1965:
1970-1973:
1974-1977:
1978:
1979:
Notes:
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1)
2)
3)
4)
5)
6)
7)
8)
FDIC Assets and Liabilities of Commercial and
FDIC Assets and Liabilities of CoDD11ercial and
and Domestic Report of Condition
FDIC Assets and Liabilities of Commercial and
FDIC Annual Report
FDIC Consolidated Foreign and Domestic Report
Mutual Savings Banks, Table I
Mutual Savings Banks and Federal Reserve Board Consolidated Foreign
Mutual Savings Banks, Table IA
of Condition
Foreign Assets for the period 1970-1973 were found by subtracting domestic assets from consolidated foreign and domestic
assets. For the period 1974-1979, foreign assets were taken from the published Reports of Condition.
Total Domestic Assets for all insured commercial banks.
Risk Assets were computed as follows:
1945-1960 = Domestic Assets - Cash+ due from - U.S. Treasury Obligations
1965
Domestic Assets
Cash+ due from - U.S. Government Obligations (direct and
guaranteed)
1970-1979
Foreign Assets+ Domestic Assets - Cash+ due from - U.S. Treasury Obligations
Sanctioned for capital adequacy purposes by the Comptroller of the Currency in 1962.
Total Assets include foreign and domestic assets.
War years. Bank balance sheet structures was abnormal due to heavy investments in obligations of the U.S. government.
Before 1969, total assets included loans net of reserves for loan losses. Starting in 1969, these reserves were moved to the
liability side, and loans included in total assets were reported gross.
Beginning in 1976, loan valuation reserves became a contra-asset and total assets were reported using loans net of reserve.
Table 2
Capital Ratios for Insured Commercial Banks
by Asset Size (in millions) for 1970-1978
(Ratios in%)
Ratio
Size
U1
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
19.5
12.7
18.8
12.5
18.9
12.5
20.4
13.8
20.8
14.6
0-5
EC/RA
TC/TA
19.1
10.6
19.8
10.6
17.3
10.5
17 .0
11.4
18.7
12.9
5-10
EC/RA
TC/TA
12.5
8.4
12.1
8.3
11.1
8.2
11.7
8.7
12.1
9.2
12.6
9.3
12.7
9.3
12.4
9.3
12.4
9.4
13.2
10.1
10-25
EC/RA
TC/TA
10.8
7.7
10.3
7.5
9.9
7.4
10.0
7.8
10.1
8.2
10.5
8.2
10.6
8.3
10.5
8.3
10.6
8.5
11.0
8.9
25-50
EC/RA
TC/TA
9.8
7.4
9.5
7.3
9.1
7.2
9.4
7.7
9.5
8.0
9.8
7.9
9.9
7.9
9.7
7.9
9.8
8.1
10.0
8.3
50-75
EC/RA
TC/TA
9.7
7.4
9.2
7.2
8.7
7.0
8.9
7.4
9.2
7.8
9.7
7.8
9.7
7.9
9.5
7.8
9.5
7.9
9.5
8.1
75-100
EC/RA
TC/TA
9.6
7.4
8.9
7.2
8.6
7.0
8.7
7.4
8.9
7.6
9.4
7.7
9.4
7.8
9.2
7.7
9.0
7.7
9.3
7.9
100-300
EC/RA
TC/TA
9.8
7.4
9.2
7.2
8.7
7.1
8.9
7.5
9.0
7.6
9.3
7.6
9.3
7.6
8.9
7.4
8.9
7.5
9.0
7.7
300-500
EC/RA
TC/TA
9.5
7.3
8.9
7.2
8.4
6.8
R.2
7.0
8.6
7.3
8.9
7.3
9.0
7.4
9.0
7.3
8.8
7.3
8.7
7.3
500-1000
EC/RA
TC/TA
9.7
7.5
9.2
7.3
8.4
7,0
8.2
7,1
8.1
7.0
8.6
7,2
8.~
7,2
8,5
7,0
8.4
7,0
8.2
7.0
1000-5000
EC/RA
TC/TA
8,5
6.8
8,1
6.'
7,4
6.4
7.1
6.J
7,2
6.5
8,o
6.7
8,J
6.\1
8,1
6.H
7,7
6.5
7 ,6
6.5
EC/RA
TC/TA
7.9
6.1
1.5
5.9
7.2
5.4
6.2
4.6
5.4
4,3
6.1
4,6
7.0
5.3
6,7
5,0
6,3
4.8
6.1
4,8
50Uo+
Source:
•
Reports of Condition
Notes:
1)
2)
3)
4)
The ratios shown were computed as simple average, that is: (EC/RA)= l ~ (EC/RA)i n = number of banks in the size group.
n1=1
The size groups were formed every year.
The distributions of the ratios within each size group differed. See the text for a discussion.
Data contains both foreign and domestic assets and liabilities.
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Table 3
Estimated Effect of Double Leveraging
1/
Unadjusted for Double Leverage (%)
O'I
2/
Adjusted for Double Leverage(%)
Difference
(Adjusted-Unadjusted)
Year
EC
TA
RA
EC
TA
RA
~
TA
~
RA
1970
7.0
9.5
6.9
9.4
-.2
-.1
1971
6.8
9.2
6.8
9.0
0
-.2
1972
6.5
8.6
6.4
8.4
-.1
-.2
1973
6.5
8.1
6.2
7.8
-.3
-.3
1974
5.6
6.8
5.4
6.5
-.2
-.3
1975
5.9
7.3
5.6
6.9
-.3
-.4
1976
6.1
7.6
5.8
7.2
-.3
-.4
1977
5.9
7.3
5.6
6.9
-.3
-.4
EC
EC
Source:
"Bank Holding Company Double Leveraging." G. Boczar ands. Tally. Table 1 pp. 18 and FDIC Annual Reports.
Notes:
1)
Industry averages for specified years.
2)
These ratios were computed by subtracting double-leverage capital for the top 50 bank holding
companies from the total industry equity capital. Double leverage equity was treated as debt
capital hence only equity capital changes. Total capital. total assets. and risk assets do not
change. Since these ratios reflect data for the top 50 BHCs only, the affect of double leveraging
on industry averages is understated.
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See Table 1.
perm.i: 1 banks to i
'. this growth. Furthermore, the use of large denomination c1::.,·cificates of
?osit, federal funds, and repurchase agreements, as
well as other forms of purchased funds, has enhanced the ability of co11DI1ercial
banks to grow beyond the constraints imposed by the growth of core deposits
(demand, savings, and small denomination time deposits). Bank liability
management has also permitted the large banks to fund significant international
bank asset growth.
Bank Capital
The
position
retained
which to
ability of co11DI1ercial banks to maintain or enhance their capital
is primarily a function of bank earnings. These earnings may be
or distributed as dividends in either case providing the basis upon
issue capital securities.
Internal equity accumulation is a function of both bank profitability
and retention rates. An FDIC study found that the rate of return on bank
assets, although generally increasing from 1950 to 1970, has declined throughout the decade of the 1970s. On the other hand, the dividend payout ratio
has declined throughout the period.
Equity capital formation is also a function of the ability of banks to
access capital markets and receptiveness of the markets in pricing bank
capital securities. For smaller banks, the direct costs of issuing new
capital securities often precludes this as a source of capital. Private
placements, however, especially for debt capital, are a more attractive
source of funds.
For larger banks having access to the capital markets, the overall level
of security prices and the relative attractiveness of bank securities relative
to alternative investment opportunities are important determinants of new
issues of bank capital securities. The less favorable valuation placed on
bank stocks relative to alternative investments has generally resulted in a
relatively poor investment climate for new issues of bank capital securities.
Furthermore, bank management has been reluctant to issue new equity securities
with bank stock prices below book value and the attendant dilution of earnings
per share.
To avoid this dilution, many banks and bank holding companies have
resorted to the use of debt-type capital securities. Although issuing debt
capital is advantage,ous from bank management's perspective because debt
avoids dilution of e.a:rnings per share, interest is a tax deductible expense,
and inflation reduces the real value of interest and principal payments,
the proper role of debt capital from the regulatory perspective continues
to be an unresolved issue. Furthermore, the measurement of bank equity
is affected by the double leveraging activities of bank holding companies.
This downstreaming of parent debt to the bank as equity places additional
burdens upon the bank as debt service affects the ability of the bank to
manage its retention rate.
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-
7
-
Risks in Commercial Bankin~
The "adequacy" of bank capital ratios is dependent upon the magnitude
of the risk inherent in bank structure and operating characteristics and in
the competitive environment in which banks operate. Therefore, the trends
in bank capital ratios ought to be assessed within a framework of bank
risk exposure.
The trend toward relaxation of geographical barriers to entry, incl~ding
more permissive branch banking and holding company affiliation as well as the
extension of EFT services, has increased intraindustry competitive pressures.
Nationwide penetration of traditionally local or regional banking markets
by large banks as represented by Edge Act subsidiaries, loan production
offices, and nonbank holding company subsidiaries has also intensified competition among banks. Furthermore, the growth of nonbank financial institutions and markets-in such forms as money market mutual funds offering
transaction-type services, the continued development of the commercial
paper market, and the introduction of aggressive foreign competition-has
increased interindustry competition in providing financial services.
Commercial bank operating characteristics have also exhibited pronounced shifts in risk exposure as reflected in bank asset and liability
mix and the development of financial services not indicated in bank balance
sheets. The shift to risk assets previously noted has been accompanied by
shifts in portfolio compositions. The continuing trend toward and reliance
upon purchased liabilities as a source of bank funds has affected the
liquidity and earnings of commercial banks. As small and medium sized
banks engage in, or are exposed to, management of interest-sensitive
liabilities, the liquidity demands and earnings variability of the industry
are further accentuated. Furthermore, the development of financial services
such as foreign exchange trading, financial futures, and private placements
not only affect bank risk exposure, but also weaken the relationship between
bank capital and bank assets as a measure of capital adequacy. Finally,
severe strains in certain sectors of the domestic and international
economies including the default of New York City and several REITs as well
as lending to LDCs have demonstrated the exposure of banks to risks magnifi~d
by political and social considerations.
Economic and Bank Regulatory fnvironment
A secular decline in bank capital ratios has been attributed to the
introduction of deposit insurance, the role of the Federal Reserve in maintaining the liquidity of the banking system, and to the active pursuit
of fiscal and monetary policy in achieving economic stabilization. With
the introduction and expanded coverage of deposit insurance and the frequent application of the purchase and assumption transaction by the FDIC
in the case of bank failures~the role of bank capital in attracting deposit
liabilities has declined. The active intervention by the Federal Reserve
in maintaining bank liquidity has reduced the exposure of banks to forced
liquidation of otherwise sound assets in resronse to deposit withdrawals.
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- 8 -
At least through the mid-1960s, government fiscal and monetary policy,
in combination with a stable and growing economy, provided an attractive
climate for banking and reduced the perceived need for bank capital to
absorb the effects of sharp variations in economic activity. Subsequent
to that period, however, and especially in light of the increased interdependency of the U.S. domestic economy with the international economic
and political climate, variability in economic activity has accentuated
the exposure of banks to broad-based credit and liquidity risks.
Summary
Bank asset growth, e, 'H~c.ially among the larger banks, has outstripped
the growth of bank capita . InfJ.ation-induced asset growth and international
bank activities facilitate,, >:1y innovaticns in bank liability management have
contributed to the declinf in bi:1.;·,',,:. capital ratios. Furthermore, the decline
in bank profitability as m,;,:.sured by rer:urn on assets and the unattractive
climate for issuing equity securities has accentuated this trend. Debt,
either directly issued by banks or down~-;treamed by bank subsidiaries as equity
from the parent bank holding company, has been substituted for equity capital.
The risk exposure of commercial banks, as represented by bank specific
risks and the economic and bank regulatory environment, affect the adequacy
of bank capital ratios. Trends in bank structure, includi.ng both intraindustry and interindustry competition, and in bank operat:Lng characteristici::
as reflected in the mix of assets, liabilities, and financial services appear
to have accentua~ed the potential demand on bank capital. Furthermore, although the economic and bank regulatory environment has probably cot'tributHl
tc a secular decline in bank capital ratios, recent variability in economic
activity has increased the potential for additional demands on bank capital
positions.
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- 9 -
Capital Adequacy at Commercial Banks:
Some Policy Questions
In this section, we discuss five policy issues associated with the
question of bank capital adequacy. (1) Is there a capital problem?
(2) Use of specific standards to measure capital adequacy. (3) Competitive disadvantages from different capital requirements. (4) The role
of bank subordinated debt and preferred stock. (5) Evaluation of banks
affiliated with bank holding companies.
1.
Is There a Capital Problem?
The preceding review of bank capital trends revealed two unmistakable
developments. First, since the end of World War II, eguity capital has almost steadily declined as a proportion of risk assets ..!/ Second, this i.ndustry trend is entirely the result of decreasing capital positions of large
banks since capital ratios of small banks have not declined.
In deciding whether historical developments and the current capital posture of the industry are a cause for concern, it is us.;;ful to look at likely
future trends. In the next few years, it se•~s prcbable that bank assets
will expand at a rate in excess of 10 percent in view of the present inflationary setting. In contrast, it seems quite likely, based on historical
expPrience, that equity growth from retained earnings and external sources
will ::rail asset growth. Consequently, industry capital ratios are expected
to continue to decline for the near future.
Since T.ost observers agree on the historical facts and prohable ne<-r~erm developments, the issue is one of judgment: Is the capital strength
c,f thi~ industry c)f serious concern? If the. answer is "yes", supervisors
will, cf course, ,;;ish to initiate appropriate corrective steps.
2. Assessment of Capital Adequacy:
Judgmental Versus Numerical Standards
A difference in assessing bank capital adequacy exists among regula.tors
as weil as financial analysts. The dichotomy revolves around whether emphasis
is pl.aced on judgmental standards or specific numerical guidelines. Proponents
of judgmental standards believe that banks operate in different ways and face
diverse external influences. As such, capital adequacy is situational and a
precise formula is not considered appropriate. Rather, reliance is placed on
the examiner's expertise in determining the overall condition of the bank
dynamically as it functions in its competitive environment. Using quantitative
and qualitative factors, a judgment is made about the institution's capital
adequacy and its ability to operate as a viable institution. Extensive guidelines are established for use in the.analytical process. But, while capital
ratios for the bank and its peers are evaluated, they are not considered the
dominant tool in determining capital adequacy.
1/
The strengthening of overall capital positions in response to the 1974-75
recession appears to have been a temporary phenomenon. In the last several
years, aggregate capital ratios have resumed their downward trend.
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-
10 -
Those favoring rn ·"'rical guidelines argue that specific capital ratios
should be used in gaug.Lg capital adequacy. This approach advocates that
capital benchmarks be established which banks must equal or exceed in order
to receive a rating signifying capital sufficiency. The process, however,
is not wholly mechanical as examiners have the discretion to assign the next
higher or lower rating if, in their judgment, circumstances warrant. This
system, it is thought, leads to a more consistent treatment of banks across
the country and provides the industry with specific criteria to guide their
behavior, yet allows for some examiner judgment to reflect mitigating or
adverse factors.
The qualitative judgment of a trained professional is an important
element in both systems. The question is one of degree: How much reliance
should be placed on numer :::al criteria?
3.
Does a competitive advantage exist due to different capital positions?
The question of competitive advantage because of different capital
positions c~nters about the claim that if one bank maintains a lower capital
posture than another, after adjusting for risk differences, then the former
bank hai; a competitive advantage. The proposition has two separate aspects·
one finds smaller banks in conflict with larger institutions; the other has
multinational and, to a lesser degree, regional banks contending with foreign
counterparts.
The preceding review of capital trends by size class shows that the
larger domestic banking organizations have substantially lower capital ratios
than the rest of th~ industry. A frequent issue raised by smaller banks is
that they are required to operate with proportionately greater capital base
than that imposed upon the larger institutions, thereby, putting them at a
distinct competitive disadvantage. In terms or direct competition, the masc
virulent controversy revolves around the nation's largest banks versus the
regional corporations. In each case, the protestants argue that larger
intermediaries are able to underprice them, thereby luring away business
because the larger banks can accept lower margins yet realize a healthy return
to investors beca~se of their greater use of financial leverage. The argument
becomes more persu;.a.s ive as legal and regulatory barriers are removed, or eroded,
fostering more direct competition in the marketplace.
Clearly, larg,;-r institutions do have lower capital positions. The question is whether those corporations, perceived as having greater asset and lia-·
bility diversificati .:m and better management resources, can effectively and
prudently operate w~th lower capital.
The international situation is less clear. National variations in accounting and reporting requirements render any comparison between the capital position of institutions domiciled in different countries extremely difficult.
Although admittedly difficult to gauge, it appears that capital requirements
differ across nations. This divergence makes it difficult to determine if
American banks are at a disadvantage when competing with foreign banks. Consequently, the first question is an empirical one: Do U.S. multinational
banks operate under greater or lesser capital constraints than their foreign
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11 -
counterparts?
If competitive disadvantages are found to exist, either domestically
or internationally, two alternatives seem feasible: move to redress the
differential over time or seek to prevent the differential from widening.
4.
The Role of Subordinated Debt and Preferred Stock
Given the marketplace's perceived indifference to equity offerings,
what are acceptable alternatives available to increase bank capital? This
question basically concerns subordinated debt and preferred stock.
The appropriate policy toward subordinated debt has been debated
for some years and this discussion grows more complex over time. Those
opposed to viewing subordinated debt as capital state that such issues do
not afford a cushion of protection against losses and that banks which have
subordinated debt have a smaller equity base than their peers. This implies
that subordinated debt is being used to try to alleviate an equity deficiency.
Voices favoring inclusion of subordinated debt as capital hold that debt aids
in protecting uninsured depositors from losses in cases of liquidation.
Furthermore, with a persistently unfavorable equity market climate, the
acceptance of long-term subordinated debt as capital has been considered
sheer pragmatism.
What has been ignored in this dialogue is the vi.rtual absence of preBankers and underwriters alike assume that regulators
frown upon preferred stock while many, including the public, attach a stigma
to this form of equity. The issue then is two fold. Firstly, commonality
should be reached among all participants as to the proper role of subordinated
::iebt. As the nature of banks' liability structure continues to change uramatically, long-term debt may have logical funding usages. It appears that some
regulators, banker::; and financial analysts are approaching subordinated <le.bt
as a funding alernative as opposed to a capital supplement. Secondly, the
involved parties must correct existing misconceptions and establish bounds
of acceptance regarding preferred stock and the intricate terms which may
sur,ound these offerings.
f erred stock offerings.
5.
How to View BHC-Affiliated Banks
Prior to the 1970 Amendments to the Bank Holding Company Act when BHC's
d:i.d little else than hold bank equities, the question of whether BHC-affiliated
banks can be examined, evaluated, and supervi.sed without reference to its BHC
coatext was of more academic than practical interest. Since First National
City Bank formed a holding company in mid-1968 and set off a surge of one-bank
holdi~g company formation, the situation has changed radically. Today, bank
holding companies are exceedingly complex structures which impact, directly
and indirectly, their subsidiary banks in a myraid of ways. Other than shell
holding companies with no debt and nonbank subsidiaries, it is now generally
conceded that the examiner, the financial analyst, and the supervisor must
consider the BHC framework as well as the banking affiliate itself in order
to fully appreciate the financial conditions and prospects of such banks.
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Federal Reserve Bank of St. Louis
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In fact, the Exam:.. i,'-'tion Council recently proposed a policy to foster
cooperation among the banking agencies when a BHC or an affiliated bank
experiences difficulties. So the policy question now is: What additional
steps in terms of policy actions and/or augmented agency cooperation, if any,
are needed to strengthen the supervision of BHC-affiliated banks?
An area of particular concern is the practice commonly known as double
leverage which involves the parent holding company selling debt and using
the proceeds to increase the equity account of a subsidiary bank. Double
leverage transactions, in turn, raise two additional supervisory problems:
(1) Should double-leverage equity be viewed the same as straight bank equity?
(2) Should parent BHC subordinated debt also be considered capital, paralleling
the present treatment of bank debt.
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Federal Reserve Bank of St. Louis
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MUTUAL SAVINGS BANKS
This section of the report discusses the trends in capital ratios, forces
affecting those trends, and the policy issues regarding the capital situation
of mutual savings banks (MSBs). Many of the points which were raised on the
trends and forces in the commercial banking section also apply to the mutuals.
However, certain institutional aspects differentiate the capital situation in
mutuals from that in commercials.
Mutual savings banks are specialized institutions drawing their funds
principally from individuals -- mostly in New England, New York, and
Pennsylvania 17- and investing them mainly in mortga~es, predominantly
residential.- Being mutual or~anizations, MSBs cannot sell equity capital.
Increases in their surplus accounts come entirely from earnings. Thus, the
capital situation in mutuals is chiefly a function of the profitability and
rate of growth in rea1 2~state investment as well as the rate of growth and
cost of deposit funds . ..st
Trends in Capital Ratios
The industry average capital ratio for MSBs has shown a secular decline
since 1945. However, the rate of decline has been very uneven over the period.
Since 1971 no consistent pattern is exhibited by the numbers. This trend also
holds for the size group averages as well.
Table 4 presents data on average industry assets, capital, and three
capital ratios -- Total Capital/Total Assets (TC/TA), Surplus Capital/Total
Assets (EC/TA), and Surplus Capital/Risk Assets (EC/RA). Several observations
can be made from that data.
Since 1945, total assets have grown at a faster rate than either total or
surplus capital (7.7 percent per year versus 6.8 percent or 6.7 percent). As
a result, both TC/TA and EC/TA have declined. The discrepancy in growth rates
between total assets and total capital has narrowed substantially since 1971.
Consequently, TC/TA has not exhibited a downward trend since then. Over the
same period, differential growth rates between total assets and surplus capital
continued. This was caused by increased use of debt capital. As such, EC/TA
continued to decline over the period.
];./Inmost states mutuals can only accept deposits from individuals or nonprofit organizations. In a few states, they are allowed to accept corporate
deposits and deposits of state and local governments, but only under specified
conditions.
'];_/ Real estate investment has traditionally represented a major percentage of
mutual savings bank total assets. Asset powers for MSBs vary from state to
state, however. In some states mutuals may invest in a wide variety of assets.
The constraints of being a specialized institution is not binding for mutuals
in these states.
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Federal Reserve Bank of St. Louis
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The trend in EC/RA c_i •Jsely follows that in TC/TA. Risk assets grew
rapidly from 1945 to 1970, thus EC/RA declined over that period. Since 1971,
risk assets have declined slightly as a percentage of total assets as MSBs
increased their investments in U. S. Government and agency securities. Consequently, EC/RA has stabilized somewhat. It should be noted that whether or
not the increased investment in securities reduces risk depends on the relationship between the book and market values of those securities. If book is
much higher than market, liquidity strains could force liquidation of these
securities at sizeable losses. The stabilized trend of EC/RA would not mean
much under those circumstances.
To see if there was a relationship between size and capital ratios, the
industry was divided into six size groups and average capital ratios computed
for each group. These data are present in Table 5.
Three observations can be made from these data. First, there is an inverse
relationship between size and average capital ratios. Second, within each
size group, there is no consistent pattern in the ratios over time. Indeed,
by year-end 1978, both average capital ratios were either at their highs or
in the mietlJe of the range for the period 1971 through 1978 for all of the
size classes. Finally, the number of banks in the large size groups has
increased steadily over time.
These three observations would indicate that, any secular decline in
industry averages is due to an increase in the number of large banks instead
of a wholesale decline within the industry. No size group exhibited declining
ratios over the period covered in Table 5.
Forces Affecting Capital Ratios
In the last section it was noted that the primary .reason for the secular
decline in mutual savings bank capital ratios was the discrepancy in growth
rate between assets (total or risk) and capital (total or surplus). In this
section, the forces behind those growth rates are discussed. The major forces
are the availability of deposit funds, profitability, and the inability to sell
equity capital.
Asset Growth
The rate of growth in mutual savings bank total assets depends on the
rate of growth in deposits. The primary source of funds for mutuals is deposits
from individuals. As a result, mutuals were almost precluded from the market
for purchased liabilities and from using liability management to cushion the
effects of disintermediation.~./
~/ The NAMSB reports that some mutuals have sold large CDs but that it is a
rare occurrence.
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Federal Reserve Bank of St. Louis
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Table 4
Capital Ratios for Insured Mutual Savings Banks - Selected Years 1945 through 1979
($ in millions, Ratios in Z)
Year
Total
Assets
1945 1
11.424
3.836
1.034
.005
1.029
1950
15.907
7.803
1.513
.005
1955
23 .458
16.815
2.007
1960
35.092
29.540
1965
50.500
1970
1971 2
Risk
Assets
Source:
Debt
Capital
Total Capital
Total Assets
Surplus
Total Assets
Surplus
Risk Assets
9.0
9.0
26.8
1.508
9.5
9.5
19.3
--
2.007
8.6
8.6
11.9
2.998
--
2.998
8.5
8.5
10.1
45.835
3.957
.002
3.955
7.8
7.8
8.6
68. 7 39
63. 763
5.056
.006
5.050
7.4
7.3
7.9
77 .892
71. 462
5.415
.010
5.405
6.9
6.9
7.6
1972
87.650
79.744
5.963
.059
5.904
6.8
6.7
7.4
1973
93.012
85.193
6.513
.115
6.398
7.0
6.9
7.5
1974
95.589
87.568
6.822
.169
6.653
7.1
7.0
7.6
1975
107.281
95.617
7.339
.190
7.149
6.8
6.7
7.5
1976
120.840
105.457
7. 976
.213
7.763
6.6
6.4
7.4
1977
132.201
114.491
8.810
.353
8.456
6.7
6.4
7.4
1978
142.353
122.567
9.652
.354
9.298
6.8
6.5
7.6
1979 3
147 .108
126.791
10,228
. 382
9.846
7 ,Q
6.7
7.8
I-'
O"I
Total
Capital
Surplus
FDIC Annual Reports
1)
2)
3)
Assets reported represent aggregat)e book value less valuation allowances and premiums.
Assets reported on aggre!llte book value basis. Reserve accounts which had been deductions against assets were shifted into the surplus
account. It is not possible to make the data comparable to pre-1971 data because the reserve account was not separated out.
,
1979 data t~rough September only. Valaation reserve and unearned income were added back into total assets and surplus to make 79 Cata
comparable to '71 through '78. Total Capital includes subordinated debt.
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Federal Reserve Bank of St. Louis
Table 5
Capital Ratios for Mutual Savings Banks by Asset Size for Sdected Ye.a.rs
(Ratios in %)
Size 1
Ratio 3
1971
1972
1973
1974
1975
1976
1'977
1978
1979
,,.,,,,---,-
0-25 2
TC/TA 4
EC/RA 5
56
7.96
9.06
42
7.68
8.44
34
30
7.86
8.24
24
7.67
8.22
19
7.48
8.61
15
7.90
9.24
15
8.24
9.29
12
7 .68
8.14
8,64
9.66
25-50 2
TC/TA~
EC/RA
71
7.68
8.58
72
7 .52
8.27
67
7.75
8.17
63
8.03
8.48
59
7. 77
8.75
48
7.56
8.62
33
7 .67
8.56
29
7.89
8.75
23
7.96
9.01
50-lOt
TC/TA5
EC/RA
65
7.69
8.46
58
7 .58
8.46
64
7.55
8.20
68
7 .58
8.16
76
7.37
8.18
82
7.44
8.43
80
7.43
8.35
77
81
7. 72
8.61
100-30~ 2
TC/TA5
EC/RA
63
7.22
7.99
73
7.11
7.87
74
7.27
7.95
76
7.36
8.02
80
7.07
7.88
82
6.88
7.80
96
7.03
8.02
98
7.32
8.43
98
7.34
8.32
300-l,~oo 2
TC/TA5
EC/RA
54
6.87
7.50
59
6.83
7.45
59
7.08
7.67
58
7.20
7. 77
63
6.99
7.80
66
65
6.89
8.00
66
6.88
7.98
70
6.85
7.88
18
6.80
7.34
22
6.56
7.09
24
6.89
7.28
25
6.99
7.43
27
6.62
7.27
32
6.26
7.09
34
6.38
7 .14
40
6.64
40
7 .58
8.46
-----
.....
--.J
2
1,000 + 4
TC/TA
EC/RA5
Source:
FDIC Reports of Condition for Mutual Savings Banks
Notes:
1)
2)
3)
4)
5)
Size groups in millions of dollars
Numbers in this row represent the number of institutions in this sifz-e ,grt>l!tp f~ the specific ~ r .
Ratios computed as simple averages i.e.: TC
1 n TC
(TA) = l-=1(TA) i
where n • number of MSBs in the size group.
For 1971-1978, total assets include loans on a gross basis. In 1979 loan loss reserves were established
hence total assets include loans on a net basis.
Risk Assets ~ total assets - cash and due from ~ U,S, Treasury securities,
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Federal Reserve Bank of St. Louis
n
7,i6
1.L6
8.17
6. 71
ll.t&
Recent changes in regulations give mutuals more control over asset growth.
Money market certificates of deposit enable mutuals to offer competing rates
and thereby diminish the adverse effects of disintermediation. Their ability
to use liability management should also be enhanced by the recent changes in
the rules surrounding issuance of cotmnercial paper. Conttnercial paper can act
as a substitute for large certificates of deposit.1.f
Growth Rate in Cap_ital
Since mutuals cannot sell equity capital, all increases in their capital
account must come from inflows of subordinated debt capital or retained earn-.
ings. As was pointed out in the first section, debt capital has become more
popular among mutuals. It seems to have been responsible for stalling the
declining trend in TC/TA.
Internal generation of capital has not kept pace with the rate of growth
in assets. Two factors seem to be responsible for this situation--increased
cost of funds and decreased return on assets.
For many years, mutuals have funded real estate investment (primarily lowcost mortgages) with low-cost deposits. Thus, the maturity structure of their
asset side is long-term while that of the liability side depends very much on
economic conditions.
Since the late '60s, disintermediation has become a real problem for
depository institutions, especially those which rely primarily on deposits of
individuals as do mutuals. To cope with the problem of disintermediation,
more attractive--higher yielding--deposit forms had to be found. Hence, the
cost of funds for mutuals has gone up substantially.
The increased cost of deposits squeezed net interes-t margins because the
return on the asset side could not be adjusted in response to changes in
deposit costs. Real estate investment had tied up funds in low fixed-rate
mortgages. Moreover, in states where usury ceilings prevented the issuance of
new mortgages at higher rates, a mutual's ability to increase its return on
assets depended on its ability to invest in either alternative assets or in
mortgages from outside the state.§_/
'}_/ The FDIC recently eased the restraints on issuance of commercial paper by
mutuals. However, participation is expected to be small since the commercial
paper will be unsecured. Only mutuals which can obtain the highest credit
ratings are expected to take advantage of the new powers. The FDIC has left
open the question of issuance of secured commercial paper. See FDIC PR-8-80
(2/5/80) page 3.
§../ Ability to increase the yield on the mortgage portfolio for institutions in
these states has been improved because of the development of an active secondary
;;1arket in mortgage-backed securities, ~ - , GNMA certificates.
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Federal Reserve Bank of St. Louis
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Summary
In the first sectio.:, it was found that the secular decline in capital
ratios of mutual savings banks was caused by a discrepancy in the growth
rate of assets relative to capital. The evidence discussed in this section
shows that asset growth rate is determined by the growth rate in deposits and
that the rate of growth in capital depends on debt and profitability.
A mutual savings bank's control over its asset growth has been limited
since they mainly rely on individuals for funds and have not been able to
use liability management. Recent regulatory changes may increase control over
deposit growth, but time is needed to see how effective the new tools will be.
Control over profitability is also limited. Disintermediation, increased
cost of deposit funds, and inability to adjust the asset portfolio in response
to increasing cost of funds have, in times of increasing interest rates,
squeezed interest margins.
Policy Issues
The discussion in the previous section indicates that the two major policy
issues relating to the mutual savings bank industry are minimizing the constraints of the asset and liability sides and providing additional sources of
capital.
Sources of Capital
The two issues to be considered with respect to the capital structure of
mutual savings banks are:
(1)
Whether or not debt capital ought to be counted for safety and
soundness purposes: and
(2)
What, if anything, can be done to enable mutuals to obtain equity
capital.
Debt capital can be used for financing purposes. Because of its long-term
nature, debt capital tends to reduce both the interest rate risk of the institution's portfolio and the likelihood of liquidity problems -- it is fixed-term
debt and cannot be withdrawn before maturity. However, debt capital cannot
absorb losses arising from the normal course of business. Hence, whether or
not it benefits the bank from a safety and soundness perspective remains an
unanswered question.
Nothing can be done about the ability of mutual savings banks to issue
equity capital without a change in their charter. The conversion question has
been highly debated throughout the years. At the center of the controversy
lies the question of the distribution of the surplus account.
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Federal Reserve Bank of St. Louis
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One way to solve the conversion problem for mutuals is to have them become
federally chartered institutions under the auspices of the Federal Home Loan
Bank Board. Having done so, they can convert to stock associations using the
regulations applicable to savings and loan associations.I/
Another possibility would be for mutuals to change
commercial banks. The accumulated surplus prior to the
could be declared an absolute minimum level, hence, not
If feasible, the rules used for savings and loans could
their charters to
date of sale of equity
eligible for distribution.
be used.
A third option would be to have the states simply give MSBs the right to
convert to stock savings banks. The surplus account could be handled as discussed in the first two options. Alternatively, the mutuals could sell
preferred stock, thereby bringing in a new layer of equity but allowing the
surplus to remain the common stock. The advantage of this approach is that it
preserves the business philosophy of the mutual institution but allows the sale
of equity. The other approaches required MSBs to become other types of
financial institutions.
All of these alternatives have some attractive features and some negative
ones. The persistence of the problem suggests that no easy answer can be found.
Moreover, even if mutuals are given the right to sell equity, it is not clear
that they would be either willing or able to exercise that right. It does,
however, seem to be the case that if the current economic instability continues,
pressure on the surplus account of mutuals could be expected to increase.
The ,Asset Side
Two questions should be considered in attempting to resolve the constraints
of the MSB asset portfolio:
(1)
Should mutuals be allowed to evolve from specialized institutions
through the expansion of asset powers; and
(2)
how can the negative effects of fixed-rate mortgages be reduced or
eliminated.
Many people question the continued viability of specialized depository institutions. They claim that the need is no longer there and that their design is
obsolete given the economic environment.
The specialized institution was created to provide a safe depository for
individual funds and to provide low-cost funds to the housing market. Individ-
7/ Conversion would require a two-step process. First, the mutual would have
to convert from a mutual savings bank to a mutual S&L association. Second, it
would convert from a mutual S&L into a stock S&L. There currently do not exist
any rules for direct conversion from a federally chartered mutual savings bank
into a federally chartered stock savings bank.
Conversion rules for a savings and loan association are contained in Section
563B of the Rules and Regulations for Insurance of Accounts. Federal charters
for stock savings and loans are discussed in Part 552 of the Federal Regulations.
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Federal Reserve Bank of St. Louis
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uals today have a wide variety of safe instruments into which they can place
their funds. Moreover, with the financial innovations which have taken place
in real estate financing, a wider range of investors can now participate in
these markets. The forced stream of funds into the real estate market from
specialized institutions may no longer be needed.
On the other side, however, are the concerns that if specialized institutions are abolished, real estate funding, especially for the individual homebuyer, will be adversely affected. This sector would have to compete with all
other investments. It is feared this would have an adverse effect on the
housing market or increase costs to the point where the purchase of a home would
become unrealistic.
Regardless of which way the first question is answered, the pressures
created by the increased volatility in interest rates suggests that the fixedrate mortgage cannot survive. Regulators will have to find ways to minimize
the negative effect of these instruments.
Several possibilities have beendi.scussed.
They include:
(1)
Elimination or elevation of usury ceilings;
(2)
More use of variable rate or roll-over mortgages;
(3)
Keeping fixed-rate mortgages but offering tax-free or reduced tax
interest on passbook accounts.
Action has already been taken on some of these but the effort is a relatively
new one. Its effects have not yet been determined.
It might be up to the regulators to discuss alternatives, assess their
impact, and attempt implementation of some solutions. How much can be done by
regulators alone depends on the course of action chosen. Support from both the
state or congressional level may be needed.
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Federal Reserve Bank of St. Louis
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SUMMARY OF NET WORTH TRENDS IN THE SAVINGS AND LOAN INDUSTRY
This paper discusses the net worth trends in the savings and loan industry, the
forces affecting those trends, and net worth pol icy issues currently being
considered by the Federal Home Loan Bank Board.
Summary
The relative net worth position of insured savings and loan associations has
declined since the mid-1930's. This decline, which has been most pronounced
since 1974, has been primarily caused by earnings of associations being unable to
keep pace with savings and asset growth. Over 80% of insured associations are
mutuals, which must rely on retained earnings to build up net worth. The level of
net worth of the industry is governed by statute and regulations, both of which
have been changed on numerous occasions since 1933; most changes have had the
effect of lowering the requirements. Congress has recently passed legislation
authorizing a reduction in the overall statutorily required net worth, and the
Bank Board intends to amend its regulations governing minimum net worth. Other
policy issues on net worth being considered by the Bank Board include the
required level of net worth in light of probable future changes in the industry,
and sources of net worth for mutual associations.
Trend of Net Worth
The trend of the relative net worth position of the industry is illustrated
below:
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Year
1940
1945
1950
1955
1960
1965
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
Net-Worth/Assets {%)
7.03
7.18
7.31
6.56
6.86
6.66
6.75
6.34
6.01
6.23
6.19
5.80
5.57
5.45
5.50
5.60
- 22 -
Annualized
Asset Growth{%)
11.73
15.03
18.42
13.99
12.41
6.50
17.26
18.11
11.92
8.78
14.41
15.87
17 .18
14.03
10.80
As can be seen from the above, the net worth position of the industry trended down
only slightly between 1940 and 1970. This period was generally characterized by
steady growth, low inflation and stable prices, low cost of money, and few
periods of severe tight money or disintermediation. However, the period from
1970 to 1978 saw a substantial decline in the industry's relative net worth, from
6.75% to 5.50%.
The decline was greatest in years which were generally
considered good--1971 and 1972, and 1975 through 1978. During these years
associations enjoyed good earnings but exceptional savings growth outpaced
earnings, causing a decline in the net worth to assets ratio. During 1973 and
1974, when the industry suffered disintermediation, tight money, an earnings'
squeeze, and real estate recession, the net worth ratio improved over 1972.
Usually, during periods of tight money and poor earnings, the concurrent lack of
savings growth wi 11 result in an improved net worth ratio. 1979 was a good
earnings year for the industry, with a slowdown in savings growth during the last
quarter which resulted in an improvement in the industry's net worth ratio.
Forces Effecting Net Worth Trends
The net worth of savings and loan associations is governed by both statute and
regulation; the regulations both have an effect on the level of net worth of the
industry and are affected by those net worth trends. The initial requirement was
contained in the Home Owners' Loan Act of 1933, wh·ich authorized the creation of
Federal associations, and required reserves equal to 10% of savings. One year
later the National Housing Act required that reserves be built up to 5% of
insured accounts within 10 years, which was amended one year later to allow 20
years to accumulate the necessary reserves. The National Housing Act pertained
to FSLIC insurance of accounts, and was applicable· to all insured associations,
inc i!.:di ng state-chartered associations.
These reserves became known as the
Federa·1 Insurance Reserve ("FIR"), which is a separate net worth account,
segregated from undivided profits, and other reserves. FIR can only be used to
absorb losses. The FHLBB adopted regulations governing FIR, which have been
amended over 30 times, mostly in response to changing economic conditions. The
initial changes specified the rate at which FIR must be built up, and what
percentage of earnings must be transferred to FIR. In 1956, an overall net worth
requ'irement was added on top of the FIR requirement, and in 1964, the net worth
requirement included a provision to require additional net worth for "scheduled
items," which are delinquent loans, foreclosed real estate, and other substandard
assets. In 1971, associations were permitted to use as their savings base, upon
which the FIR requirement is calculated, the average savings balances for the
three most recent fiscal closings, which was changed one year later to permit
averaging year-end savings for five years. These changes to permit "averaging"
were in response to rapid savings growth in preceding years and the difficulty
many associations were having in complying with FIR and net worth requirements,
and represented a substantial liberalization of the requirements. By averaging
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Federal Reserve Bank of St. Louis
- :n -
savings over five years, associations experiencing rapid savings growth may only
be required to maintain FIR and net worth at 3% to 3-1/2% of current assets, and
sometimes even less. In 1972, an Asset Composition Index was adopted, with the
total net worth requirement being the greater of the FIR requirement plus 20% of
scheduled items plus 5% of secured borrowings, or the amount required by an Asset
Composition Index. In 1973, associations were permitted to use subordinated debt
to meet 20% of the net worth requirement, although subordinated debt is not
considered net worth by the FHLBB for the purposes of capital adequacy and it may
not be used to meet the FIR requirement. Failure to meet its minimum FIR or net
worth levels may subject an association to strict regulatory sanctions, which are
usually placed into a formal written agreement between the association and the
FSLIC. These sanctions usually include limitations on types of loans made,
limitations on operating expenses, restrictions on types of savings accounts
which may be offered, and any other measure deemed necessary to help the
association regain compliance with the minimum FIR and net worth levels.
The greatest economic factor affecting net worth during the past decade has been
inflation. While inflation has had some effect on the average size of loans to
purchase homes, savings growth, operating expenses, and portfolio risk, its
greatest impact has been on the cost of money for associations. The long time
problem of savings associ at ions--"borrowing short and lending l ong"--has been
mitigated in the past by controlled and stable cost of money. The passage of
Regulation Q, which established a differential between the rates which could be
offered on savings and certificates by commercial banks and savings associations,
assured a steady supply of low cost money to savings associations for home
mortgages.
However, persistent inflation has eroded the effectiveness of
Regulation Q, as higher interest rates on government obligations, money market
funds, and other securities, coupled with greater consumer sophistication, have
reduced the flow of savings dollars into thrift institutions. To counter this,
savings rates have been permitted to increase, and market interest rate sensitive
savings instruments have been authorized which, together with increased use of
borrowed money, have resulted in rising cost of funds for savings associations.
During period of rising cost of money, the yield on association's assets
typically does not increase as quickly as the cost of money. The bulk of the
industry's assets consist of fixed rate, fixed term mortgages. While loans made
during tight money period may have very high interest rates, they do not offset
the bulk of the association's loan portfolio of lower rate loans. This results
in a reduced spread between asset yield and cost of savings, and lower earnings.
In an industry which is heavily dependent on retained earnings for its net worth,
any decrease in earnings will adversely affect its net worth position.
Asset powers are being introduced which wi 11 improve associations I ability to
make their mortgage portfolios more market rate sensitive. Associations in
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Federal Reserve Bank of St. Louis
- 24 -
California and some other states have been offering variable rate mortgages which
now constitute over 50% of the loan portfolio in some very large associations.
"Rollover" mortgages and other flexible payment mortgages have been authorized
for Federal associations which should help associations adjust the yield on their
loan portfolios in response to changing market conditions.
Losses due to foreclosures and delinquencies have been minimal for the industry
for many years. Scheduled items (a defined term which includes loans three
months or more delinquent, foreclosed real estate, and loans made to sell
foreclosed real estate) have ranged from 1.3% of assets in 1975, at the peak of
the recession, to 0.8% in 1979. One reason for the excellent payment performance
of mortgage loans in recent years, despite the increased burden of mortgage
payments on family incomes, has been inflation induced equity in homes, which has
produced a high motivation by borrowers to meet their obligations.
Policy Considerations
Congress has recently amended the statutorily required reserves of associations
to require reserves between 3% and 6% of savings, depending on economic conditions as judged by the FHLBB. In addition, the Bank Board is considering the
following policy issues related to net worth:
1.
The Required Level of Net Worth
The current net worth requirements are not intended to be a test for capital
adequacy, but rather a screening point. Associations which fail the requirement are subject to supervisory review and regulatory sanctions. The net
worth requirements are the same for all FSLIC associations, regardless of
size, or whether the association is mutual or stock, state- or Federallychartered, or whether it is a subsidiary of a holding company.
Two proposals to change the required net worth are being considered. One
proposal which has been published for comment would eliminate the concept of
FIR, and establish a net worth requirement based on beginning of year savings
balances averaged over five years, plus certain other items. This proposal
would reduce the requirement somewhat, but would continue to serve as a
screening device for further supervisory review of association's operations
which fail the standard. The other proposal, which is being considered at
staff levels, to develop an asset index which is sensitive to asset risk,
size of associations, diversification, and other factors.
2.
Sources of Net Worth for Mutual Associations
Other than retained earnings, mutual associations have virtually no other
source of net worth. Deel ining net worth ratios, asset powers which wi 11
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Federal Reserve Bank of St. Louis
- 25 -
likely be granted in the near future, and the uncertain economic climate have
emphasized the need for net worth instruments to augment the capital of
mutual associations.
Associations, whether mutual or stock, may issue subordinated debt and use
subordinated debt to meet up to 20% of the associations' net worth requirement. Mutual capital certificates, which are similar to preferred stock,
have been recently authorized by statute but have not yet been issued by any
associations. Other proposals involving the purchase of capital notes of net
worth deficient associations by net worth surplus associations, or by the
FSLIC, have been advanced but generally found unfeasible. In 1974, the
Senate authorized the conversion of Federal associations, which had all been
mutuals, to stock ownership.
Since then, 61 conversions of Federal
associations have taken place, all but one of which have raised permanent
capital for the associations.
AWS:bw
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Federal Reserve Bank of St. Louis
- 26 -
N..::.TIONAL CREDIT UNION ADMINISTRATION
WASHINGTON, D.C.
20456
CAPITAL ADEQUACY
This brief study on the capital adequacy question for credit unions was
prepared in response to the request of the Federal Financial Institutions
Examination Council's Task Force on Supervision. The Task Force asked for a
background paper on the question of capital adequacy for banks, savings and loan
associations, mutual savings banks and credit unions. The Task Force's
Subcommittee on Capital Adequacy is assembling a consolidated background paper
based on the input from OCC, FDIC, FHLBB, and NCUA. The background paper is
being prepared in accordance with the theme of "Where we are now and how we got
there."
The definition of capital for credit unions differs from the banking
definition of capital. Capital for banks includes subordinated debt (debentures
and long-term notes) and equity capital (preferred and common stock, retained
earnings, surplus, contingency and other capital reserves). Capital for credit
unions include members~ shareholdings and equity capital. Since credit unions
do not sell stock, equity capital does not include preferred and common stock
nor does it include subordinated debt.
For comparative purposes this study on capital adequacy in credit unions
has been tailored to the banking definition of capital and thus equity capital
is defined as required Regular Reserves, all other reserves and retained
earnings. The Regular Reserve is an appropriation of retained earnings that is
used to absorb losses. The capital adequacy question in cr~dit unions is one of
whether there is sufficient equity to absorb losses from loans, investments,
etc. while providing for future dividend needs of credit unions members.
This study has been limited to an analysis of assets and equity in Federal
credit unions. Federally insured state chartered credit unions were not
included in this study since our experience has shown that they follow the same
trends. The study analyzes assets and equity within specified asset
categories. The asset categories have been geared closely to those of banks and
savings and loan associations for comparability purposes. It should be noted
that if more asset categories had been used for the credit unions with assets
under $2 million, the conclusions drawn might be different for those groups.
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Federal Reserve Bank of St. Louis
- 27 -
NATIONAL CREDIT UNION ADMINISTRATION
WASHINGTON, O.C.
20456
ASSETS IN FEDERAL CREDIT UNIONS
Assets in Federal Credit Unions are now more than 4 times greater than they
were in 1968. Outlined below is a schedule evidencing this phenomenal 11 year
growth.
1968 - 1979
Asset
Category
Under 2 Million
$2 to 5 Million
Over $5 Million
TOTAL
% Increase in
Assets
Increase or
(Decrease) lfFCUs
(1,914)
925
1,143
154
24.5
43.2
360.7
428.4
(a) There was a 1.2% increase in the number of FCU's from 1968 to 1979.
This schedule is the result of computing the increase or decrease in the
total amount of assets and the total number of operating Federal credit unions,
within the stated asset categories, between 1968_and 1979. The percentages
shown represent the proportion of the total asset growth attributable to the
three asset categories. This data, and all other data within this study is
derived from aggregate yearend data published in annual reports of the National
Credit Union Administration. For the reader's information, at the end of 1979,
there were 12,738 operating Federal credit unions. Of these 9,920 had assets of
less than $2 million and 1,643 had assets of between $1 million and $2 million.
The schedule above illustrates that a large number of credit unions grew
and advanced from the under $2 million asset category to either the $2-5 million
asset category or the over $5 million asset category; primarily the latter.
This was true even though the number of operating credit unions only increased
by 1.2% during this period. One of the major reasons for the marked growth was
the introduction of share insurance for member accounts in 1971.
Although asset growth in Federal Credit Unions has been exceptional, it was
accompanied by substantial increases and decreases in the growth rate during the
11 year period. The schedule below outlines the activity by credit union asset
categories within this period.
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Federal Reserve Bank of St. Louis
- 28 -
NATIONAL CREDIT UNION ADMINISTRATION
WASHINGTON, O.C .. 20456
PERCENT INCREASE IN ASSETS
Asset
Category
$-2 Million
$2-5 Million
$5-10 Million
$10-20 Million
$20 Million & Over
1969
1970
5.5
9.7
3.9
8.7
19.4
41.3
44.4
28.7*
1971
1972
1973
1974
1975
1976
1977
1978
1979
4.4
3.9
15.1
14.3
33.1
54.4
5.4
8.6
18.5
14.9
43.8
4.5
6.8
18.5
10.1
36.5
4.6
7.1
16.8
15.6
34.8
3.9
12.4
16.0
18.7
40.1
3.5
10.7
6.7
30.7
38.4
1.7
8.5
12.3
18.2
27.0
.7
5.3
.2
2.1
8.3
13. 7
16.6
57.2
56.8
*This 19~9 percentage is for Federal credit unions having assets of $5 Million or more
You will note that as the above asset categories progress, the percentages of
increases from year to year become more sporatically different than those of the
previous year. Of particular note are the 1977 - 1979 year end percentages of
increased assets within each asset category. These significant differences seem to
be attributable to economic conditions at those points in time. The trend shows
substantial slow downs in asset growth. There are two exceptions: (1) the $10-20
million asset category in 1977 and the (2) $5-10 million asset category in 1978.
These singled out increases seem to be strictly attributable to Federal Credit
Union~s moving into and out of the $5-10 million asset categories.
EQUITY IN FEDERAL CREDIT UNIONS
Equity in Federal Credit Unions has increased almost 3 times from the beginning
of 1968 to the end of 1979. Outlined below is a brief schedule evidencing the
overall increases by asset category. The percentages shown represent the proportion
of the total equity growth attributable to the three asset categories.
% Increase in
Equity
Asset Category
1968 - 1979
Under $2 Million
$2 to $5 Million
Over $5 Million
16.1
35.0
236.0
TOTAL
287.1
Equity growth has followed the same trends in growth per asset category as asset
growth from year to year, proportionately. As in our analysis of assets, those
credit union's that progressed to the over $5 million asset category were those
primarily responsible for the substantial over all increase in equity. Outlined on
the next page is a schedule that outlines the increases or (decreases) in equity for
the past 10 years, inclusive of the increase from 1968 to 1969.
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Federal Reserve Bank of St. Louis
- 29 -
NATIONAL CREDIT UNION ADMINISTRATION
WASHINGTON, D.C.
20456
PERCENT INCREASE IN EQUITY
Asset
Category
$-2 Million
$2-5 Million
$5-10 Million
$10-20 Million
$20 Million & Over
1969
7.5
13.1
30.3
1970
2.5
10.0
24.7
38.9
46.5
1971
2.8
7.5
10.1
37.1
48.9
1972
1.0
11.1
10.1
28.3
40.4
1973
3.8
5.3
15.3
14.5
37.7
1974
4.5
6.9
19.9
9.4
31.2
1975
0.4
4.9
8.7
12.3
38.9
1976
1.3
8.0
14.9
11.2
32.2
1977
2.4
8.3
4. 1
29.3
29.8
1978
(5.5)
2.4
4.8
15.8
19.8
*This 1969 percentage is for Federal credit unions having assets of $5 Million or more
As in assets there was a significant decline in the rate of equity growth for 4
out of the 5 asset categories at the end of 1978 and at the end of 1979 for credit
unions having assets in excess of $10 million. This was preceded by a 10.8 percent
decline in equity growth at the end of 1977 for those Federal Credit Unions in the $5
to 10 million asset category. Again, inflationary pressures are to blame.
Regulatory Influences
As noted in the beginning, Federal Credit Unions are required to maintain a
Regular Reserve by appropriations from retained earnings. During the 10 year period
of this study, the requirements for appropriating to the Regular Reserve have been
changed two times. Until October 1970, Federal Credit Unions were required to
transfer 20% of their net earnings to the Regular Reserve until the Regular Reserve
equaled 10 percent of all the members' shareholdings. In addition, they were
required by regulation to set aside, in a Special Reserve for Delinquent Loans,
additional net earnings so that the total of these two reserves would equal 10 •
percent of the loan balance 2 to 6 months delinquent, 25 percent of the loan balances
6 to 12 months delinquent, and 80 percent of the loan balances that were 12 months
and over delinquent. After this date, Federal Credit Unions were required to set
aside 10 percent of their gross earnings until their Regular Reserve equaled 7 1/2
percent of risk assets and then 5 percent of gross earnings until the Regular Reserve
equaled 10 percent of risk assets. The Special Reserve for Delinquent Loans was also
required. Then in April 1977, the required transfer to the Regular Reserve was
reduced to 10 percent of Gross Income until the Regular Reserve equaled 4 percent of
risk assets and then 5 percent of gross income until the Regular Reserve equaled 6
percent of risk assets; all being for Federal Credit Union's in operation for four or
more years. For those in operation for less than four years, the required transfer
was the same as it was for all Federal Credit Unions as of October 1970. One
significant difference as of April 1977, however, was the fact that the requirements
to maintain the Special Reserve for Delinquent Loans were now eliminated.
A portion of the 1970 increases in equity may be attributable to the change in
the method of appropriating for the Regular Reserve. Any significant affect is
doubtful however, since Federal Credit Unions would have been subject to the new
formula for only two months of the calendar year. The one change that may have
contributed to a slow down in equity growth during 1978 within all but one of the
asset categories ($5-10 million asset category being the exception), is the reduction
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Federal Reserve Bank of St. Louis
-
30 -
197
8.
13.
8.
11.
14.
NATIONAL CREDIT UNION ADMINISTRATION
WASHINGTON, O.C.
20456
in the required transfer to the Regular Reserve as of April 1977, and the elimination
of the Special Reserve for Delinquent Loans. This provided additional past earnings
for dividends. These past earnings were used to retain liquidity during a period of
exceptionally high loan demands due to inflation. The affect of the change can be
witnessed on the immediately preceding schedule.
RELATIONSHIP OF EQUITY TO ASSETS
As we commented previously, equity followed the same growth patterns as assets
during this 11 year period. The only difference was that assets increased at a rate
of 1.5 to 1 over equity primarily within the asset categories exceeding $10 million.
This asset growth has forced equity to asset ratios to drop at a constant rate for
those Federal Credit Union's having assets of less than $10 million, and at a more
rapid rate for those credit unions having assets over $10 million, all except for
1979. Outlined below is a schedule of equity to asset ratios depicting these trends.
1968 to 1979
EQUITY TO ASSET RATIOS
BY ASSET CATEGORY
Asset Category
1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979
- -- -- -- -- -- -- -- -- -- -- --
$-2 Million
$2-5 Million
$5-10 Million
$10-20 Million
$20 Million & over
TOTAL
7.8
7.8
7.5
7.8
8.0
8.1
7.7
7.9
7.3
7.9
7.9
8.2
8.0
7.8
7.4
8.0
7.7
7.7
7.6
6.8
7.0
7.5
7.5
7.6
7.3
6.5
6.4
7.2
7.7
7.3
7.1
6.4
6.1
6.9
7.4
7.3
7.2
6.3
5.9
6.8
7.1
7.2
6.7
6.1
5.3
6.3
6.9
6.9
6.6
5.7
5.0
6.0
6.9
6.7
6.4
5.7
4.7
5.7
6.4
6.4
6.0
5.6
4.4
5.3
6.9
6.8
6.5
6.1
4.7
5.7
*This 1968 percentage is for Federal credit unions having assets of $5 Million or
more
A graphical display of the above Equity to Asset ratios is found on the next
page.
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Federal Reserve Bank of St. Louis
- 31 -
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https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
I
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N
M
NATIONAL CREDIT UNION ADMINISTRATION
WASHINGTON, D.C.
20456
The reductions in equity to asset ratios are primarily attributable to assets
increasing at a rate of 1.5 to 1 over equity. They are also attributable to
inflation in operating costs that causes a reduction in surplus retained earnings.
Of primary note is the constant increase in the cost of dividends to retain deposits
in Federal Credit Unions. Dividend costs have continually increased even though
interest rates on loans have remained unchanged during the entire 11 year period.
Almost two-fifths of all Federal credit unions paid a year-end 1978 dividend of more
than 6%, compared to slightly less than one-third at year-end 1977.
Since the maximum dividend rate payable on shareholdings by Federal credit
unions was raised from 6% in late 1973, the number of credit unions paying the
maximum rate has increased every year since that time and by year-end 1977, nearly
2,000 credit unions or 15.2% of the total in operation paid the maximum rate. The
very high level of interest rates that prevailed throughout 1978 caused many Federal
credit unions to raise their dividend rate to the legal maximum. Consequently, more
tha~ 2,700 credit unions paid the maximum rate as of December 31, 1978, 40.2% more
than at the end of 1977.
The schedule below illustrates the increasing dividend rates.
SCHEDULE OF AVERAGE DIVIDEND RATES
Asset Category
1968
1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979
- -- -- -- -- -- -- -- -- -- --
$0-2 Million
$2-5 Million
$5-10 Million
$10-20 Million
$20 Million & Over
TOTAL
Not Avail 4.8
II
5.3
II
5.4
4.9
5.5
5.6
II
II
II
5.3
5.4
4.8
5.5
5.6
5.7
5.8
5.5
4.9
5.5
5.6
5.7
5.8
5.5
5.1
5.7
5.8
5.9
5.9
5.7
5.3
5.9
6.1
6.2
6.3
6.1
5.3
6.0
6.2
6.3
6.4
6.Z
5.3
6.0
6.1
6.2
6.4
6.2
5.5
6.1
6.3
6.4
6.5
6.3
5.8
6.3
6.4
6.5
6.7
6.4
5.9
6.5
6.5
6.6
6.7
6.6
*These 1969 and 1970 percentages are for Federal credit usions having assets of $5
Million or more
Since the Federal Credit Union Act was amended in 1974 to permit the board of
directors to establish the dividend period as frequently as daily, or any other
interval the board desires, provided that the last dividend period in any calendar
year ends on December 31, the number of Federal credit unions declaring more frequent
dividends has increased steadily. Although still relatively small, the number of
Federal credit unions declaring dividends more frequently than quarterly rose
substantially during 1979 to 373, and almost one-sixth (16.4%) of these declared
dividends on a daily basis. In 1977, the number of credit unions declaring the more
frequent dividends was 275 and just 27 paid daily dividends.
The trend toward more frequent dividend periods is also evident by the number of
Federal credit unions paying dividends on a quarterly basis. Nearly 37% of the
credit unions paid a quarterly dividend in 1978, compared to about one-third in 1977
and 26% in 1976.
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Federal Reserve Bank of St. Louis
- 33 -
NATIONAL CREDIT UNION ADMINISTRATION
WASHINGTON, O.C.
20456
Federal credit union's gained the authority to issue share certificates and a
variety of different types of share accounts with the passage of PL 95-22. The
credit unions did not begin using these accounts until 1978, so there is not a marked
increase in the cost of dividends.
Money Market share certificates now amount to 7 percent of total shareholdings
and are growing at an annual rate of 40 percent. Even though these accounts and
certificates would be treated as liabilities in so far as the banking definition of
capital is concerned, they are still responsible for reducing available net earnings
after dividends and equity balances.
The comparison of equity to assets has revealed another trend. Liquid assets
had been declinirrg in relationship to total liabilities at about the same pace as the
equity to asset ratios. Attached is a table which depicts this trend and of
particular note arc: the significant declines at the end of 1977, and 1978. The table
denotes that Federal credit union's had transfered their investments to longer term
and higher yielding investments such as investments in other credit unions (mainly
corporate central Federal credit unions) and Federal agency securities. At the end of
1978 U.S. Government securities, including Federal agency securites and Common trust
investments accounted for $3.7 billion or almost two thirds of total investments.
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Federal Reserve Bank of St. Louis
- 34 -
NATIONAL CREDIT UNION ADMINISTRATION
1NASHINGTON,
O.C.
20456
TABLE 1
LIQUID ASSET AND CAPITAL TO ASSET RATIOS
AT FEDERALLY-INSURED CREDIT UNIONS,
1971 - 79
Narrow Definition 1/
Liquid Asset As A Percent of Total
Liabilities
Broad Definition 2/
Liquid Asset As A
Percent of Total
Liabilities 3/
Total Capital As 4/
Percent of Total Assets
Year
1971---------1972--1973--------1974--------1975--------1976---------1977--------1978---------1979-------}_/
14.9
14.7
12.8
13.4
14.7
13.0
10.6
7.5
11.4
17.9
19.6
17.8
17.5
20.9
20.3
19.0
13.6
18.3
7.5
7.2
6.9
6.8
6.3
6.0
5.7
5.3
5.7
Under the Narrow Definition, liquid assets are defined as the sum of cash, shares,
deposits and certificates in other credit unions and financial institutions, and common
trust investments. This definition reflects the fact that a very high proportion of
credit union government security holdings have long maturities and cannot be liquidated
without significant losses.
J:../ Under the Broad Definition, liquid assets includes the Narrow Definition plus total
investments in U.S. Government and Federal Agency securities.
3/
Represents total shares plus notes payable and all other liabilities.
!:_/
Total capital represents the sum of total reserves and retained earnings.
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Federal Reserve Bank of St. Louis
- 35 -
NATIONAL CREDIT UNION ADMINISTRATION
WASHINGTON, O.C.
20456
WHERE WE ARE AND HOW WE GOT THERE
Federal credit union asset growth, particularly among those credit unions having
assets greater than $10 million, has outpaced equity growth by 49 percent. The asset
growth is attributable to improved services within the larger asset sized credit
unions that has resulted from legislative changes and consumer demands. On the other
side, equity has declined as the result of increased operating costs and dividend
expenses when interest rates on loans have not changed since 1934. This situation has
resulted in a rationing of credit to members because Federal credit unions can no
longer borrow at a rate that is less than what they are permitted to charge. It has
also caused a conversion of more liquid investments to longer term and higher
yielding ones. This action is risky in that greater losses may be incurred if any of
the investments have to be liquidated.
WHAT CAN BE DONE?
One solution is to obtain passage of higher permissable interest rates. * This,
however, will not be the ultimate answer. Credit unions will have to be more
efficiently managed so that operating costs can be stabilized along with dividend
costs. Loans will have to be limited to shorter maturities and will have to be
granted on a rationing basis until the high demand can be curbed. Without the
increase in permissable interest rates, one can only predict that Federal credit
unions will be paying dividends only from current earnings since surplus earnings
from prior periods will be non-existent especially in the larger rapidly growing
credit unions.
Assuming that interest rates will not increase, we must stress the most
efficient use of earnings and surplus funds, even to the point of rationing credit so
that funds will be available to invest in higher yield investments. We will have to
caution credit union management to declare dividend rates that are commensurate to
what is necessary to retain the members' deposits.
*NOTE:
Subsequent to the preparation of this paper, the interest rate on loans was
increased from 12 to 15 percent.
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