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ESSAYS O N ISSUES T H E FEDERAL RESERVE BANK O F C H IC A G O O C T O B E R 1991 N U M B E R 50 Chicago Fed Letter First and ten: A fresh start for banks in the 1990s Optimism regarding the banking in dustry has been in short supply in recent years. This is not surprising, given the apparent abundance of bad news and the relative scarcity of good tidings. Last year, in particular, was a tumultuous finale to an eventful and turbulent decade for the industry. Most are all too familiar with the re cent troubles in the banking industry. Banks with heavy concentrations in commercial real estate loans have suffered large losses. In addition, the loan portfolios of many banks have exhibited other signs of weakness. Banks have responded to deteriorating loan portfolios by increasing provi sions and charge-offs, deepening the pressure on earnings. These problems have contributed to many bank fail ures, adding to the liquidity problems of the bank deposit insurance fund. Despite the recent turmoil in the banking industry, however, there is cause for optimism. The condition of the industry is difficult, but manage able. Asset quality is stabilizing and banks have built up their loan loss reserves to a level that provides much better coverage for problem loans. The improving economy should facili tate further improvement. Although the economic recovery is likely to be more modest than in the past, it will occur and banks will benefit. Aaiother hopeful sign is the U.S. Treasury’s proposal for banking reform. If enact ed, the main elements of the proposal would provide a long-expected and much-needed legislative response to some of the fundamental problems facing the industry. There are still a number of significant concerns. Resolving the critical issue of deposit insurance reform is particu larly important. But the major ele ments are in place for an exciting and rewarding future for the banking industry. Cause for optimism At this point, most of the banking industry’s troublesome asset problems have been identified. Thus, it is rea sonable to expect that the quality of loan portfolios will stabilize and, over time, show signs of improvement. While there could be more unfavor able developments in commercial real estate in some regions, these problems should be manageable. Most banks appear to have sufficient capital to weather the storm. The resumption of property sales is an encouraging sign. There is a growing belief that some of the current deeply discounted prices represent a bottom ing in the collapse of real estate values (see Figure 1). These transaction prices are well below earlier levels, but the fact that sales are occurring makes it possible for lenders to begin to eval uate projects. The commercial real estate components of banks’ loan portfolios are emerging from a freefall phase during which it was all but impossible to determine the collateral value of many real estate projects be cause there was not a price or value basis for establishing reasonable prop erty values. The financial markets seem to share this sense of increased optimism. After a decline of some 40 percent during 1990, share prices of real estate investment trusts are only 25 percent below their January 1990 levels. It is far too early to forecast even a modest rebound in commercial construction, but once the necessary 1. Real estate bottc share price index A \ \r 1990 1991 SOURCE: Standard & Poors. adjustment process is completed, new building will not be far behind. Back to basics A second reason for optimism is the tightening of credit standards and pric ing, a trend that should stabilize credit quality and profitability. After years of slippage during which credit standards were significantly weakened, banks are undergoing a self-correcting process. Federal banking supervisors have played a role in this process—lending officers are quite aware that examiners are looking over their shoulders. Con sequently, there has been a heavy su pervisory focus on some specific catego ries of lending, especially highly lever aged transactions. This self-correcting process has resulted in a restraint on bank credit extension, popularly referred to as the “credit crunch.” The word “crunch,” however, is incorrect. A crunch occurs when creditworthy borrowers who would normally find it possible to obtain a loan, even under adverse economic . circumstances, cannot obtain financing. A crunch is most likely to occur when all lenders serving a particular class of customers find their lending capacity contracting. We have experienced this type of credit shut-down in the past. This, however, has not been the case in recent months, particularly in the Mid west. While the regulatory process has played a role in this credit restraint, it has not been the principal cause. Rather, the driving force has been the market. That is, the industry is reacting to ad verse developments, which is exactly how the process should work. More over, borrowers are re-thinking their attitudes about the desirability of excess leverage. Both lenders and borrowers are returning to the basics. Profitability should improve Bank profitability is likely to improve, although it has not yet shown up in the numbers. While competitive pressures remain intense, spreads are widening. Surveys conducted by the Federal Re serve Bank of Chicago during the last twelve months, for example, suggest that spreads on loans to high quality corporate customers have gone up by 30 basis points since the third quarter of 1990. As asset quality stabilizes, the need for continuing high levels of loan loss provisions will diminish. This, in turn, will result in a rebound in earn ings. In addition, competitive pressures from some international banks that forced spreads to very narrow margins have eased. The adoption of risk-based capital standards by the major industrial countries has played a role in this pro cess. As uniform and consistent stan dards have become effective, the com petitive inequality that stemmed from differences in national capital require ments has been reduced. The adop tion of the risk-based standards has increased pressure for higher earnings and capital on an international basis, providing U.S. institutions with an im proved opportunity for profit. The improvement in the capital posi tion of U.S. banks is a crucial element for future prosperity. Regulators have strongly encouraged the nation’s larg est banking organizations to improve their capitalization, a campaign that clearly has produced results. The na tion’s largest banks have increased their equity positions, measured on both accounting and market capitaliza tion bases (see Figure 2). In addition, most banks have the added protection of a layer of supplementary capital elements, such as subordinated debt and perpetual preferred stock. Just a decade ago, the amount of these sup plementary capital elements was negli gible. Adding core capital—consisting primarily of common shareholders’ equity—to these supplementary ele ments reveals an encouraging trend: the real capital positions of large U.S. banks have more than doubled in the last ten years. As a result, for the first time in many years there are a number of U.S. banks—both regional and money centers—with market capi talization ratios as high as the tradition ally well-capitalized Swiss, German, and Japanese banks. I o f large banks ~___________ p e rc e n t o f a ss e ts Adjusted tier 2 capital* 1 980 1991 *Tier 2 capital includes loan loss reserves, hybrid capital instruments, subordinated debt, cumulative perpetual preferred stock, and intermediate term preferred stock. Adjusted tier 2 capital excludes loan loss reserves. SOURCES: Standard & Poors and Salom on Brothers. Despite the difficult adjustment, dereg ulation has clearly yielded benefits. Much of the regulatory structure that impeded the business has been re moved. Institutions operating in this more open environment have been Well-capitalized banks have a clear and important advantage in this increasingly able to achieve a high level of operat ing efficiency. Most important, howev competitive environment. This factor bodes well for Midwestern banks, whose er, is the significant public benefit resulting from this process: both retail capital positions compare very favor and wholesale customers have had ably with the rest of the nation, and for access to a wider array of services at smaller banks, which have maintained their traditionally high levels of capital. very competitive prices. Benefits o f deregulation The operating environment for the industry should be more favorable as a result of the deregulation of the 1980s, which is producing the expected bene fits. Some of the bankers who have experienced the tumult of the past de cade might debate the desirability of this process. It is useful to remember, however, the experience of other in dustries that have been deregulated; it has not been an easy road for broker age, trucking, airline, and the other industries that have gone through this transition. There was no reason to expect that the transition for banking would, or should, be any different, and it has not been. Given the deep public interests included in banking, as well as the potential taxpayer exposure, the concerns are clearly different, but the adjustment process is not. In response to increased competition the industry has been consolidating— the number of banking organizations declined by more than 20 percent during the 1980s. Interstate consolida tion is not only reducing overall oper ating expenses and pushing costs down, it is increasing capital positions and creating more diversified institu tions. As this process continues, future regional downturns, like those that occurred in the Southwest and North east, will pose less of a threat to the health of the U.S. banking system. Continued consolidation, however, will not mean the demise of the small er- and medium-sized institution. These banks will have many opportu nities to thrive and profit in their own markets. Those community banks that know their markets and their custom ers very well, and can be particularly 1984 '85 ’86 ’87 ’88 ’89 ’90 SOURCE: FDIC. responsive to local needs, will prosper. Nevertheless, competition will intensify for all banks, large and small. Efficien cy will be all-important. The need for deposit insurance reform There is cause for optimism, but the gains of the past decade, as well as the prospects for the future, will be threat ened if we fail to reform our system of deposit insurance. Since 1987, the FDIC reserves have declined from a high of $18 billion to a current official estimate of approximately $4.5 billion; some estimates place the fund balance at a much lower level (see Figure 3). There is a compelling need for recapi talization and reform. No system of dealing with problem institutions can be fail safe; the insurance fund will occasionally face losses, that is its basic purpose. Clearly, however, the sheer magnitude of some of the individual claims and the rapid depletion of the bank insurance fund in the last three years are indicative of deeper structural problems with our insurance system. Developing means of addressing prob lems before situations deteriorate and lead to large claims against the insur ance fund is fundamental to any solu tion. The concept of progressive supervisory intervention and prompt corrective action in the Treasury’s reform propos al is an important step toward achieving this goal. The ultimate risk to the bank insurance fund will be signifi cantly reduced by adopting a known, understood, and acknowledged system under which regulators will take pro gressively specific steps to deal with deteriorating capital positions. Some might argue that emphasizing capital avoids the narrower issue of deposit insurance reform. In my view, the emphasis on capital is absolutely ap propriate and will ultimately reduce claims against the insurance fund. Indeed, the success of a problem bank in raising new capital is the principal factor determining whether or not it will fail. Problem banks that are un able to raise new capital fail the ulti mate market test and should be pre sumed to be insolvent. Progressive supervision would also be an impor tant step toward ensuring that institu tions considered “too big to fail” will not burden the U.S. taxpayer or the banking industry since banks would be more likely to be recapitalized before they become insolvent. There are any number of specific examples in which a regulator’s insis tence on increased capital levels has made the difference between failure and success. Establishing specified levels of capital would provide bench marks against which regulators would take appropriate action. A regulator would take increasingly severe supervi sory action as an entity’s capital deteri orated and it moved down in the zones. All parties would understand that a line list of specific actions would be triggered when an institution falls into an unsatisfactory zone. If correc tive action by the institution fails to restore an adequate level of capital, the bank would be forced to merge or close. Importantly, this action would occur before actual insolvency. Once the concept has been estab lished, the exact capital levels associat ed with each zone can be determined through consultation and negotiation. The adoption of the risk-based capital standards for banks is an example of this consultative process. Certainly there are a number of issues to be considered as a result of this major change in procedure. The extent of supervisory involvement with some institutions will undoubtedly increase. But only the weaker institu tions would be affected. For stronger banks, quite the opposite would occur. For example, for some activities, stron ger banks may be able to simply notify regulators, rather than having to file an application. There is also the concern that early closure will result in the loss of private assets of stockholders and creditors. Shareholders, however, would have a claim on any surplus arising from the sale of a bank or its assets. As we have seen from recent experience, the ulti mate cost to the insurance fund of deferring action is much greater. In the long run, prompt closure will min imize costs. There is also the difficult issue of whether the appropriate supervisory response should be absolutely specific and mandatory for each zone. While a mandatory response has appeal to some, a strong argument can be made for the exercise of supervisory judg ment, particularly at the outset of this new procedure. This exercise of judg ment would put far more pressure on the supervisors, nevertheless, supervi sors will need the latitude to use dis cretion in the event of mitigating cir cumstances. It is important to realize that the adop tion of the Treasury’s proposals for progressive supervisory intervention Karl A. Scheld, S en io r Vice P re sid en t an d D irecto r o f R esearch; David R. A llardice, Vice P re sid en t a n d A ssistant D irecto r o f R esearch; Carolyn M cM ullen, E ditor. Chicago Fed Letter is p u b lish ed m o n th ly by th e R esearch D e p a rtm e n t o f th e F ed eral Reserve B ank o f C hicago. T h e views ex p ressed are th e a u th o rs ’ a n d are n o t necessarily th o se o f th e F ederal Reserve B ank o f C hicago o r th e F ederal Reserve System. A rticles may b e re p rin te d if th e source is c re d ite d a n d th e R esearch D e p a rtm e n t is p rovided with copies o f th e rep rin ts. Chicago Fed Letter is available w ith o u t ch arg e from th e Public In fo rm atio n C e n te r, F ederal Reserve B ank o f C hicago, P.O . Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 and prompt corrective action will not completely resolve the thorny issue of “too big to fail” nor will it do much to restore creditor discipline. ate additional pressure to avoid exces sive risk-taking and create private sector claimants that have an active interest in seeking the closure of insolvent banks.1 The continued invocation of the “too big to fail” doctrine will have serious equity and competitive implications for the banking industry, ffealthy banks— big and small—ought to be particularly concerned, ffowever, there is no need to accept the status quo. Regulators need to work with the industry to iden tify institutional practices that make the financial system prone to systemic risk. Some progress has been made, most recently in the area of electronic pay ments, but more is needed. Deposit insurance reform is a particu larly important issue for Midwestern banks. It is a time honored maxim that survivors pay. Certainly this is the case under our system of deposit insurance. Midwestern banks are among the most consistently profitable in the country, and industry conditions in the region are comparatively favorable. Therefore, institutions in the Midwest are likely to be among the survivors that will have to pick up the check. To complete the reform of the deposit insurance system, some form of credi tor discipline will also need to be rein troduced. In today’s system, creditor discipline is supposed to be supplied by uninsured depositors. However, policy makers have been so concerned about deposit runs that they have been unwill ing to permit uninsured depositors to suffer losses. Given these concerns, it would seem more appropriate to rely on other creditors—particularly subor dinated debtholders—to restore market discipline. Forcing banks to maintain a cushion of subordinated debt will cre Conclusion Thus far, the banking system has been able to cope with some major prob lems—more than many would have imagined a decade or two ago. This difficult period has laid a foundation for improved profitability. As the econ omy improves, so will the operating environment for banks. Asset quality problems will continue to moderate for the industry as a whole. And as earnings increase, banks should further improve their capital positions. How ever, if legislators and regulators fail to address the need for deregulation and deposit insurance reform, the indus try’s future prospects will be called into question. Picking up the deposit insurance check will have competitive implications for Fortunately, it is entirely possible that those institutions that are survivors. Congress will enact reform legislation The only responsible way to reduce that will accelerate the deregulation these costs is through reform of the process, increase opportunities for regulatory system. If these reforms are not forthcoming and the costs of depos banks, and reduce the cost of deposit it insurance are not reduced, the profit insurance. For these reasons, it is possi ability of domestic banks will suffer and ble to be optimistic about the future. foreign banks and nonbank competi —Silas Keehn tors will be able to make further in roads in the customer base of U.S. banks. Once U.S. banks have lost these 1 in-depth discussion of these issues can An customers, they may find it difficult to be found in the July 1990 and May 1991 attract them back. issues of the Chicago Fed Letter. I U5-ZZZ (2IS) 06909 sxouini xoa O d J01U93 uoiiE u u o ju j D ijqnj O O V O IH 3 A O 3 N V 9 3 A t f 3 S 3 ^ I T W O a 3 3 jo^ T PT4 oSu3 iqr)