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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
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





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
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

tier 2 capital*

1 980
*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









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
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
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


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
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.

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Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102