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September 27,1974 Bank capital has slipped appreciably over the past five years, measured in relationship to such common yardsticks as risk assets, invested assets, or total assets. The ratio of equity capital to invested assets— perhaps the most widely used measure— dropped from .111 in 1969 to .094 in 1973, and a further slippage (if slight) apparently oc curred in the first half of 1974. The ratio is necessarily inexact, because of the exclusion of hard-to-measure foreign branch assets, but it gives a broad measure of the declining long-term trend. For regulatory authorities, this de velopment has prompted increased alertness to conditions in the banking industry. For bank analysts, recognizing the rapidly changing complexion of the industry, this shift has triggered an intensive re search effort in an attempt to deter mine the function and optimal size of bank capital. Some researchers have claimed, on the basis of historical evidence, that the decisive factor in bank failures is not inadequate capital, but rather the incompetence or defalcation of management. But however useful this finding may have been in past periods, it does not appear to be relevant to the present situation. Some recent studies suggest measuring the adequacy of capital in relationship to the risk posture of the individual bank, or alterna tively to the weighted sum of such factors as asset quality, management quality and debt ratios. 1 Too much fine-tuning? Historically, bank capital ratios have tended to decline over time, partly because the greater stability in the economy has reduced the margin of uncertainty in banking, and partly because the growth in management expertise has permitted finer tuning of bank operations. However, events of the past year have caused regu latory authorities to question whether fine-tuning has gone too far, especially in the increasing trend toward liability management. Banks used to depend primarily on low-powered deposit flows to finance asset expansion, but now with their increased profit con sciousness, they tend to rely more on purchased money to make profitable loans and investments. (Large certificates of deposit are included in this category, although they are technically deposits.) Leveraging of this type represents a greater degree of risk, in the sense that highly leveraged banks are most vulnerable in any kind of liquidity squeeze. The ratio of pur chased funds to invested assets jumped from 22.5 percent in 1969 to 31.6 percent in 1973, and the ratio definitely worsened further in the first half of this year. (The denominator of the ratio includes "other" time deposits IPC, which is composed mainly of large CDs, plus net Federal funds purchased and other liabilities for purchased funds.) During the past year, some banks have found themselves in a liquidity squeeze because of a number of (continued on page2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. worrisome factors— high borrowing costs, heavy bank loan demands, inappropriate maturity structures of assets, and other difficulties asso ciated with borrowing short and lending long. In a squeeze of this type, which is accentuated by heavy dependence on purchased money, deposit flows decelerate because of disintermediation while borrowing costs soar because of high interest rates. Moreover, with this liquidity squeeze, bankers are forced to be come more selective in granting loans. These factors do not neces sarily lead to capital impairment, but impairment can result as dis intermediation forces banks to sell long-term assets and incur capital losses in the process. Liquidity and capital A recent study by First National City Bank points out two functions of bank capital: "First, to permit ac quisition of the institutional struc ture necessary to perform the inter mediation function and provide related services, and second, to provide protection against unantici pated adversity leading to loss in excess of normal expectations." This functional definition is correct as far as it goes, but it doesn't go very far, and could lead the layman to think that capital is simply a stock of money set aside by a bank for these specific purposes. It overlooks the need for banks to have an ade quate margin of capital left over 2 after covering unanticipated losses — a margin adequate enough to maintain public confidence in dis turbed financial markets. Capital is listed on the liability side of a bank's balance sheet, represent ing essentially the amount of long term money that has been invested in the institution. Impairment of capital can result from deposit out flows or from loan, security or operating losses, any one of which can force the bank to adjust its assets to the new liability situation. A high percentage of liquid to total assets of course makes these adjust ments less painful. Regulators' mandate The mandate of the regulatory authorities is to protect depositors' interests, and above all to protect the integrity and viability of the financial system. Regulators gen erally carry out this mandate by attempting to ensure bank solvency. Capital is considered a yardstick of the strength of the bank because it represents a market evaluation of the institution, placed upon it by outside investors. The concern for solvency, then, or viability, must include consideration of a bank's earnings flow along with its risk posture. The onset of the bank holdingcompany movement has added a new dimension to discussions of adequate capital. Authority to regu late the expansion of bank holding companies has been vested in the Federal Reserve Board of Governors. Each acquisition, merger or de novo expansion of a bank holding com pany requires prior application and approval on the basis of its com petitive effects, its impact on the strength of the underlying bank, and its explicit gains in service to the public. The holding company, in fact, is supposed to be a source of second-line strength to the bank. The Federal Reserve has approved many applications over the past three years, and has thus helped project banking into a more com petitive atmosphere. In its rulings, however, the Fed has recognized that this movement involves in creased risk. Consequently, it has insisted that each bank's activities be regarded as distinct from those of the holding company. The prime concern of the regulatory authorities is properly the individual bank, and vigilance over its activities has only been heightened by the advent of the holding-company movement. Dynamic tension Federal Reserve Governor Holland recently placed the question of capital adequacy in terms of "a kind of dynamic tension between the forces impelling the progressive activities of banks and the com pelling need for prudent conduct of the nation's banking business." For example, when bank holding companies expand and diversify, they seek to enter bank-related businesses partly to reach new sources of earnings, by performing 3 various services for a fee as an offset to the slow growth in traditional earnings sources. In so doing, holding companies have sometimes moved too rapidly into the fairly extensive list of activities now per missible to holding-company subsidiaries, both domestically and overseas. C = 3 Ventures of this sort can involve managerial talents qualitatively different from those likely to be familiar to most bankers. Sometimes the proposed activity may require a sizable amount of capital most readily obtained through heavy upstreaming of bank dividends to the parent holding company. The activity thus may divert capital and management talent away from the banking subsidiary, where they might have been used to shore up a thin capital position or a shallow layer of management. Viewing the rapid expansion of banking activities in both domestic and foreign markets, Holland argues, "Prudence would dictate that such expansion be supported by a strong capital base and an ade quate liquidity position." Bank managers are now being forced to make the hard choice between continuing expansion into highly profitable fields or slowing that expansion to permit augmentation of capital and to ensure appropriate liquidity. Joan Walsh @2 ) o uo;§umsBM • M l • uo§aJO • epBA9 [s| • ogEpi Blf IIE M E H . E | U JO p | B 3 . E U O Z JJV BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 9/11/74 Loans (gross) adjusted and investments* Loans gross adjusted— Securities loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other Securities Deposits (less cash items)— total* Demand deposits adjusted U.S. Government deposits Time deposits— total* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD's) 84,058 66,856 1,290 23,959 19,838 9,491 4,296 12,906 80,316 21,970 402 56,038 17,684 29,029 5,913 15,813 Weekly Averages of Daily Figures Week ended 9/11/74 Change from 9/4/74 Change from year ago Dollar Percent + + + + + + + 7,887 + 8,147 - 503 + 3,579 + 2,426 + 702 -1,031 + 771 + 6,326 + 154 44 + 5,649 + 125 + 5,336 - 213 + 3,456 543 638 180 303 33 12 110 + 15 2 — 67 + 154 — 88 25 + 31 — 73 — 26 + 10.35 + 13.88 — 28.05 + 17.56 + 13.93 + 7.99 19.35 + 6.35 + 8.55 + 0.71 — 9.87 + 11.21 + 0.71 + 22.52 — 3.48 + 27.97 Week ended 9/4/74 Comparable year-ago period -1 0 7 183 -2 9 0 Member Bank Reserve Position Excess Reserves Borrowings Net free ( + ) / Net borrowed ( - ) 25 249 274 - 93 488 356 + 1,309 + 679r + 241 + + 522r + 905 - Federal Funds— Seven Large Banks Interbank Federal fund transactions Net purchases ( + ) / Net sales ( - ) Transactions: U.S. securities dealers Net loans ( + ) / Net borrowings ( —) 696 *lncludes items not shown separately. Information on this and other publications can be obtained by calling or writing the Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 397-1137. • E>|SE|V
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