The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
A BUSINESS AND FINANCIAL REVIEW BY THE FEDERAL RESERVE BANK OF C H ICA G O M arch/April 1978 ECONOMIC Business insights Banking insights What is happening to the U.S. dollar? Loan commitments and facility fees Bank failures CONTENTS Business insights Instalm ent cred it—benefits and burden s 3 Banking insights Trends in capital at District banks: 7965-76 7 What is happening to the U.S. dollar? 10 Robert P. Mayo discusses the depreciation o f the dollar on the foreign exchange markets. Loan commitments and facility fees March/April 1978, Volume II, Issue 2 ECO N O M ICP E R SP E C T IV E S Single-copy subscriptions of Economic Perspectives, a bimonthly review, are available free of charge. Please send requests for single- and multiple-copy subscriptions, back issues, and address changes to Public Information Center, Federal Reserve Bank of Chicago, P. O. Box 834, Chicago, Illinois 60690, or telephone (312) 322-5112. Articles may be reprinted provided source is credited and Public Information Center is provided with a copy of the published material. Controlled circulation postage paid at Chicago, Illinois. 14 Commercial banks have begun to reevaluate their policies toward loan commitments due to concern on the part of both bankers and monetary authorities. Bank failures 22 Interest in bank failures has been renewed recently as a number of multimillion dollar banking firms have been declared insolvent. Editorial: Billings D. Barnard, Sandra Cowen Graphics: Roger Thryselius, Tom O'Connell Typesetting: Nancy Ahlstrom, Shirley Harper, Maryanne Lee, Rita M olloy Business insights Instalment credit—benefits and burdens William R. Sayre and George W. Cloos C o n s u m p t io n s p e n d in g , le d b y a u to s a n d " e q u a l c r e d it o p p o r t u n it y ," n e w life sty le s o t h e r d u r a b le s , ro s e 11 p e r c e n t in 1977. A s in a n d a tt itu d e s , a n d , p e r h a p s m o s t im p o rta n t, 1976, s p e n d in g r o s e s o m e w h a t fa ste r th a n d is s p ir a lin g in fla tio n . p o s a b le (a fte r tax) p e rs o n a l in c o m e . A s a r e s u lt, t h e ra te o f s a v in g s— d is p o s a b le in c o m e E xte n sio n sa n do u tstan d in gs n o t s p e n t o n c o n s u m p t io n — d e c lin e d to 5.1 In s ta lm e n t c r e d it e x t e n s io n s , in c lu d in g p e r c e n t , th e lo w e s t ra tio in 14 y e a rs . M a n y h o u s e h o ld s w o u ld have been u n a b le to p r e c o m p u t e d f in a n c e c h a r g e s , to ta le d $226 e x p e n s iv e b illio n in 1977, u p 17 p e r c e n t fro m 1976, an d v a c a t io n s , m e d ic a l b ills , a n d c o lle g e fe e s h a d tw ic e th e e x t e n s io n s in 1970. A t y e a r - e n d , o u t it n o t b e e n fo r th e a v a ila b ility o f in s ta lm e n t s ta n d in g s w e r e $217 b illio n , a lso u p 17 p e r c e n t lo a n s. fro m th e b e g in n in g o f th e y e a r a n d t w ic e th e m anage p u rch a se s of ca rs, T h e ra p id rise in c o n s u m p t io n s p e n d in g a m o u n t at th e e n d o f 1970. In s ta lm e n t c r e d it d u r in g t h e p a st tw o y e a rs h a s b e e n a c c o m o u ts t a n d in g is a b o u t a th ird as la rg e as o u t p a n ie d b y a m u c h fa ste r rise in c o n s u m e r in sta n d in g st a lm e n t d e b t . A q u e s t io n is p o s e d as to th e r e la t io n s h ip a b ility a n d w illin g n e s s o f c o n s u m e r s to c o n t in u e to in c u r in s ta lm e n t in d e b t e d n e s s at th e r e c e n t p a c e . F a ilu r e to d o so c o u ld e n d a n g e r y e a rs. In th e fo u r th q u a r t e r o f 1977, e x te n s io n s o f c o n s u m e r c r e d it a m o u n t e d to 17.4 p e r c e n t th e g e n e r a l e x p a n s io n , n o w t h r e e y e a rs o ld , o f D P I. In o n ly tw o e a r lie r p e r io d s h a s th is a lre a d y a fa irly r e s p e c t a b le age fo r an fa m ily m o rtg a g e s, a th a t h a s b e e n fa irly sta b le fo r ra tio b e e n h ig h e r — in th e first h a lf o f 1969 a n d th e first h a lf o f 1973. S ig n if ic a n tly , b o th th e s e u p tre n d . T h is o n e -to -fo u r a r t ic le e x a m in e s th e reco rd of e a r lie r p e r io d s w e r e fo llo w e d b y a s lo w in g in r e la t io n s h ip s b e t w e e n in s ta lm e n t c r e d it e x co nsu m er t e n s io n s , liq u id a t io n s , a n d o u ts t a n d in g s w ith b u s in e s s r e c e s s io n . p u rch ase s In s ta lm e n t d is p o s a b le p e r s o n a l in c o m e (D P I). A d ju s t e d c r e d it and, e v e n t u a lly , o u ts t a n d in g in a th e fo r c h a n g e s in t h e w a y in w h ic h in s ta lm e n t fo u rth q u a r t e r w a s 15.8 p e r c e n t o f D P I. T h a t c r e d it is e x t e n d e d a n d liq u id a t e d , th e s e ra tio s w a s e q u a l to th e a ll- t im e h ig h r e a c h e d in th e a p p e a r to h a v e r e a c h e d le v e ls th a t s ig n a le d fo u rth q u a r t e r o f 1973, a p e r io d th a t m a rk e d s lo w e r ra te s o f a d v a n c e in t h e p a st. T h e m e a n th e in g o f d e b t to in c o m e ra tio s , h o w e v e r , is n o t m e a s u r e d b y re a l G N P . T h e ra tio o f o u ts t a n d h ig h p o in t of th e last e x p a n s io n as c le a r c u t . T h e c r e d it p ic t u r e h a s b e c o m e m o r e in g s to D P I h a s b e e n risin g ir r e g u la rly s in c e c o m p lic a t e d in r e c e n t y e a r s . B a n k c r e d it c a r d s W o r ld W a r II. It w a s 4 p e r c e n t in 1 9 4 7 ,1 1 p e r h a v e e m e r g e d a s a m a jo r fa c to r in p e rs o n a l c e n t in 1957, a n d 15 p e r c e n t in 1967. S in c e f in a n c e . A u t o lo a n m a tu ritie s h a v e le n g t h e n 1967, h o w e v e r , th is s e c u la r u p t r e n d a p p e a r s ed, to h a v e b e e n s lo w in g . w ith fo u r-y e a r lo a n s now co m m o n. M o r t g a g e c r e d it is b e in g u s e d in c r e a s in g ly as a s u b s titu te fo r in s ta lm e n t c r e d it , o r s u p p le Liq u id atio n sa p p e a rtola g m e n t to it. T h e v a rie ty o f g o o d s a n d s e r v ic e s f in a n c e d b y in s ta lm e n t c r e d it h a s b r o a d e n e d m a r k e d ly . O th e r d e v e lo p m e n t s d e fy sta tistica l a n a ly s is , fo r e x a m p le , th e d r iv e fo r Federal Reserve Bank of Chicago The p aym e n ts b u rd en on of co nsu m er in s t a lm e n t b u d g e ts c r e d it is o fte n m e a s u r e d b y th e ra tio o f liq u id a t io n s to D P I, 3 ra th e r th a n b y e x t e n s io n s o r o u ts t a n d in g s . O f liq u id a t io n s 6 p e r c e n t b e lo w 1973 e x te n s io n s . c o u r s e , a v e r a g e s o f th is so rt n e e d n o t a p p ly to T h e liq u id a t io n s ra tio ro s e a lm o s t e v e r y a n y p a r tic u la r h o u s e h o ld . A t a n y tim e s o m e y e a r fro m th e e n d o f W o r ld W a r II th ro u g h h o u s e h o ld s a r e d e e p ly m ir e d in in s ta lm e n t th e 1960s, r e a c h in g a r e c o r d 15.9 p e r c e n t in d e b t , w h ile a m u c h la rg e r n u m b e r a r e c o m 1969. B e g in n in g w ith t h e 1970 r e c e s s io n , th e p le t e ly f r e e o f s u c h d e b t . T h e “ b u r d e n " o f in ra tio d e c lin e d , b u t in 1973 it ro s e to 15.4 p e r s ta lm e n t c r e d it u s u a lly s h o w s u p in s u b s t a n c e n t. It th e n d e c lin e d a g a in , r e a c h in g a lo w of tia lly in c r e a s e d d e lin q u e n c ie s o n ly w h e n a 14.1 p e r c e n t in t h e s e c o n d q u a r t e r o f 1975, g e n e r a l r e c e s s io n b r in g s la y o ffs a n d r e d u c e d w h ic h c o m p e n s a t io n fo r a ff e c te d h o u s e h o ld s . r e c e s s io n . In s ta lm e n t c r e d it liq u id a t io n s in c lu d e w a s n e a r th e lo w p o in t o f th e last D e s p it e ra p id ly risin g e x t e n s io n s fo r th e re g u la r p a y m e n t s o f in t e r e s t a n d p r in c ip a l, p ast p r e p a y m e n t s (o fte n fro m t h e p r o c e e d s o f n e w lo a n s ), a n d c h a r g e o f fs . P r e p a y m e n t s in c r e a s e d to o n ly 15.1 p e r c e n t in t h e fo u rth q u a r t e r o f 1977. T h e s lu g g is h n e s s in li v o lv e n o t o n ly a d v a n c e p a y m e n t s o f p r in c ip a l q u id a t io n s re la tiv e to e x t e n s io n s is m a g n ifie d tw o y e a rs , th e n e t e x t e n s io n s . liq u id a t io n s In 1977 n e t ra tio in b u t a lso le n d e r “ r e b a t e s " o f p r e c o m p u t e d in f in a n c e c h a r g e s . to ta le d $31 b illio n , h a lf a g a in m o r e th a n th e e x te n s io n s L iq u id a t io n s in 1977 to ta le d $195 b illio n , p r e v io u s h ig h in 1976. R e la t iv e to D P I, n e t e x u p 13 p e r c e n t fr o m th e y e a r b e f o r e a n d 60 t e n s io n s in 1977 w e r e 2.3 p e r c e n t , t h e h ig h e s t p e r c e n t in fiv e y e a rs . L iq u id a t io n s u su a lly lag fo r a n y y e a r o n r e c o r d . e x t e n s io n s b y a b o u t a y e a r. In 12 o f t h e last 15 T h r e e p r in c ip a l fa c to r s h a v e lim ite d th e y e a rs , liq u id a t io n s h a v e b e e n w it h in 2 p e r c e n t rise in liq u id a t io n s o f in s ta lm e n t c r e d it in r e o f e x t e n s io n s in t h e o th e r th re e y e a rs preceding th e y e a r . In th e r e la t io n s h ip b ro k e d o w n w h e n n e w e x t e n s io n s c h a n g e d ra p id ly . In 1968 a n d a g a in in 1976, a s u r g e in n e w in s ta lm e n t sa le s le d to an in c r e a s e c e n t y e a rs : (1) in c r e a s e d u s e o f re v o lv in g c r e d it , (2) lo n g e r m a tu ritie s o n a u to lo a n s, and (3) u s e o f m o r tg a g e c r e d it to fin a n c e c o n s u m e r o u tla y s. in p r e p a y m e n t s , a n d liq u id a t io n s ro s e 5 p e r c e n t R e vo lvin gcre d itin cre a se s a b o v e e x t e n s io n s in th e p r e c e d in g y e a r. W ith th e s lo w d o w n in in s ta lm e n t sa le s in 1974, p a r In s ta lm e n t c r e d it o fte n ta k e s t h e fo rm o f t ic u la r ly a u to sa le s, lo w e r p r e p a y m e n t s h e ld “ re v o lv in g c r e d it ," a s p e c if ie d lin e th a t m a y b e u se d r e p e a t e d ly w ith p e r io d ic p a rtia l o r to tal r e p a y m e n ts , in c lu d in g in t e r e s t c h a r g e s . Som e Instalment credit extensions outpace liquidations reta il sto re s have o ffe re d re v o lv in g c r e d its fo r y e a rs . In t h e 1970s t h e fa ste st g r o w in g ty p e s o f c o n s u m e r r e v o lv in g c r e d it h a v e billion dollars 240 ‘ b e e n lo a n s fro m c o m m e r c ia l b a n k s . 200 d iv id u a ls Banks - o ffe r th r o u g h r e v o lv in g bank c r e d it c r e d it to ca rd s in and c h e c k c r e d it p la n s , t h e la tte r o fte n in t h e fo rm . liquidations o f o v e r d r a ft p r iv ile g e s o n r e g u la r c h e c k in g extensions a c c o u n t s . T h e s e c r e d it s a r e u s e d fo r a v a rie ty o f p u r p o s e s , in c lu d in g c a sh a d v a n c e s . In 1977 c r e d it e x t e n s io n s o n b a n k c a r d s (v irtu a lly all b y V IS A a n d M a s t e r C h a r g e ) w e r e $31 b illio n , 21 p e r c e n t m o r e th a n in 1976 a n d t h r e e tim e s as m u c h as in 1972. B a n k c a r d e x t e n s io n s a p p r o a c h e d 14 p e r c e n t o f to ta l in s ta lm e n t c r e d it e x t e n s io n s , c o m p a r e d w it h 9 p e r c e n t in 1973 1968 '69 4 70 71 72 73 74 75 76 77 a n d 4 p e r c e n t in 1969. C h e c k c r e d it e x te n - Economic Perspectives Bank revolving credit extensions have grown rapidly 36 m o n t h s , a lim it th a t g e n e r a lly p r e v a ile d u n til th e e a rly 1970s. A s r e c e n t ly a s 1 972, le ss th an 1 p e r c e n t o f t h e n e w c a r lo a n s at f in a n c e c o m billion dollars 40 f p a n ie s had m a tu ritie s of m o re th a n 36 m o n th s. In th e fall o f 1973, a d e c l in e in a u to sa le s w a s a s s o c ia te d w ith a n e w s t r e t c h o u t in lo a n m a tu ritie s . In t h e fo u r th q u a r t e r o f th a t y e a r, 4 p e rce n t of (p r im a r ily fro m th e f in a n c e th e com pany B ig T h r e e lo a n s “ c a p tiv e s " ) w e r e w ritte n w ith lo n g e r m a tu ritie s , u su a lly 42 o r 48 m o n th s . T h e p r o p o r t io n h a s s in c e in c r e a s e d to 14 p e r c e n t in 1974, 25 p e r c e n t in 1975, a n d 52 p e r c e n t in th e fo u r th q u a r t e r o f 1977. O t h e r le n d e r s a lso in c r e a s e d m a tu ritie s . B y la te 1 9 7 7 ,5 4 p e r c e n t o f t h e n e w a u to lo a n s 1968 '69 '70 '71 ’ 72 '73 '74 '75 '76 '77 p u rch a se d / by c o m m e r c ia l banks c a r rie d m a tu ritie s e x c e e d in g 36 m o n th s . T h r e e y e a rs NOTE: Figures in bars refer to percent of total instalment credit extensions. e a r lie r o n ly 11 p e r c e n t h a d b e e n fo r m o r e th a n 36 m o n th s . For lo a n s o r ig in a t e d by s io n s r e a c h e d $6 b illio n in 1977, c o m p a r e d b a n k s , th e p r o p o r t io n in c r e a s e d fro m 6 p e r w ith le ss th a n $2 b illio n in 1969. c e n t in 1974 to 28 p e r c e n t in la te 1977. Beyond m o n t h ly ) , a r e g u la r th e re p a y m e n ts m in im u m (u su a lly a m o u n t o f r e v o lv in g is la rg e ly d e t e r m in e d c r e d it by th e L o n g e r m a tu ritie s m a k e a u to sa le s e a s ie r b y r e d u c in g m o n t h ly p a y m e n t s . In th e c a s e of a $5,000 lo a n , w h ic h is a b o u t a v e r a g e , th e b o r r o w e r . T h e r e f o r e , in c o n t ra s t to c o n v e n tio n a l in s t a lm e n t lo a n s , r e v o lv in g c r e d it e x m o n t h ly p a y m e n t at 11 p e r c e n t in te re s t an d 36 in s ta lm e n t s is $164. In c r e a s in g t h e m a tu rity te n s io n s to 48 m o n t h s , e v e n w ith an in t e r e s t ra te o f 13 in c lu d e ch arg e s, and no p re c o m p u te d liq u id a t io n s in c lu d e f in a n c e no p re p e r c e n t , r e d u c e s m o n t h ly p a y m e n t s to $134. p a y m e n t s o r r e b a te s o f u n e a r n e d in te re s t. T o A lt h o u g h th e e x te n t th a t r e v o lv in g c r e d it r e p la c e s c o n $5904 to $6432, r e f le c t in g b o th t h e h ig h e r in - th e c r e d it e x t e n s io n rise s fro m v e n t io n a l in s ta lm e n t lo a n s , e x t e n s io n s a n d li q u id a t io n s a r e u n d e rsta te d in c o m p a r is o n w ith e a r lie r p e r io d s . S im p le in t e r e s t lo a n s now o ffe re d by s o m e b a n k s , f in a n c e c o m p a n ie s , a n d c r e d it Share of new car loans over 36 months increases percent of new car loans made u n io n s a lso in v o lv e n o p r e c o m p u t e d f in a n c e c h a r g e s . S u c h lo a n s , m a d e p r a c t ic a l b y c o m p u t e r s , a llo w b o r r o w e r s to p r e p a y p a rt o f th e o u t s t a n d in g p e n a lt ie s . o ffe re d p r in c ip a l The fo r s im p le p e rso n a l w it h o u t in t e r e s t lo a n s and in t e r e s t fo rm a t is lo a n s to f in a n c e a u to s a n d h o m e im p r o v e m e n t s . A utolo a nm a tu ritie sle n gth e n U n t il 1955, fe w lo a n s o n n e w a u to s w e r e w ritte n w ith m a tu ritie s lo n g e r th a n 24 m o n t h s . T h e n , t h e m a x im u m w a s e x t e n d e d to Federal Reserve Bank of Chicago 5 te re st rate a n d th e a d d it io n a l in t e r e s t to b e sa v in g s in th e p a st tw o y e a rs . A s m o rtg a g e p a id fo r a n o t h e r y e a r o f th e c o n t r a c t , m o n t h ly c r e d it is u se d m o r e to f in a n c e c o n s u m p t io n p a y m e n ts a r e r e d u c e d 18 p e r c e n t . s p e n d in g , in s ta lm e n t c r e d it o u t s t a n d in g rise s In th e a g g re g a te , a u to c r e d it liq u id a t io n s less r a p id ly th a n w o u ld o t h e r w is e b e th e c a se . a re la g g in g e x t e n s io n s m u c h m o r e th a n u su a l C o m b in in g in s ta lm e n t c r e d it a n d h o m e after t h r e e y e a rs o f r e c o v e r y . E x te n s io n s in m o rtg a g e c r e d it p r o v id e s a m o r e c o m p r e h e n 1977 w e r e $72 b illio n , u p 15 p e r c e n t fro m a siv e m e a s u r e o f h o u s e h o ld d e b t th a n a lo o k at y e a r e a r lie r a n d 59 p e r c e n t s in c e 1974. L i in s ta lm e n t q u id a t io n s , $59 h o u s e h o ld d e b t to ta le d $870 m illio n at y e a r- b illio n , u p 12 p e r c e n t fro m a y e a r e a r lie r a n d e n d 1 9 7 7 ,1 7 p e r c e n t a b o v e a y e a r e a r lie r a n d 31 p e r c e n t fro m 1974. u p 74 p e r c e n t in fiv e y e a rs . T h is to ta l ro s e fro m M ortgage sa n din sta lm e n td e b t a n d 60 p e r c e n t in 1967. In 1977 th is to tal s u r on th e o th e r h an d , w ere c r e d it a lo n e . T h ese ty p e s of 21 p e r c e n t o f D P I in 1947 to 46 p e r c e n t in 1957 p a sse d T h e m e d ia n p r ic e o f e x is tin g h o m e s so ld in D e c e m b e r 1977 w a s $ 44,20 0, an in c r e a s e o f 66 p e r c e n t o f D P I, w e ll a b o v e th e p r e v io u s r e c o r d o f 62.6 p e r c e n t in 1973 a n d 1976. 13 p e r c e n t o v e r a y e a r e a r lie r a n d 63 p e r c e n t in fiv e y e a rs . T h e s e f ig u re s , r e p o r t e d b y th e N a tio n a l in fla tio n A s s o c ia t io n in hom e of p r ic e s R e a lt o r s , sh o w has g iv e n Aslo w e rrisea h e a d ? m o st In th e first q u a r t e r o f 1978, c o n s u m e r h o m e o w n e r s su b s ta n tia l a p p r e c ia t io n in th e ir s p e n d in g w a s d a m p e n e d b y s e v e r e w e a t h e r , e q u it ie s — a p p r e c ia t io n th a t c a n b e u se d as a n d th e im p a c t, a c tu a l a n d p o t e n t ia l, o f th e p r o lo n g e d c o a l strik e . M o s t o b s e r v e r s b e lie v e c o lla te ra l fo r n e w b o r r o w in g s . M a n y h o m e o w n e r s h a v e c h o s e n to ca sh th at s p e n d in g w ill r e b o u n d w ith t h e c o m in g in th e s e c a p ita l g a in s b y (1) r e f in a n c in g t h e ir o f sp rin g . N e v e r t h e le s s , it is p r o b a b le th a t h o m e s w ith la rg e r m o r tg a g e s , (2) ta k in g o u t c o n s u m p t io n s p e n d in g w ill rise le ss th is y e a r s e c o n d m o rtg a g e s, a n d (3) tr a d in g u p , u sin g th a n la st, p a r tic u la r ly fo r p a s s e n g e r c a r s . T h is th e in c r e a s e d su g g e sts s ig n if ic a n tly s lo w e r g r o w th in in sta l e q u ity as d o w n p a y m e n t s o n m o r e e x p e n s iv e p r o p e r t ie s . F u n d s ra ise d o u t m e n t c r e d it . H o u s in g starts a r e e x p e c t e d to o f c a p ita l g a in s a r e s o m e t im e s u se d to p a y o ff d e c lin e , m a in ly b e c a u s e h ig h e r in t e r e s t ra te s c o n s u m e r d e b ts . E v e n w h e n a d d e d m o r tg a g e have b een d e b t d o e s n o t su b s titu te d ir e c t ly fo r in s ta l in s titu tio n s. m ent c r e d it , p r o v id in g o t h e r w is e it m ay fu n d s fo r have b een do so in d ir e c t ly In s ta lm e n t by and m o r tg a g e th e th rift debt have m ig h t r e a c h e d r e la tiv e ly h ig h le v e ls , c o m p a r e d to f in a n c e d w ith in s ta l d is p o s a b le p e r s o n a l in c o m e . B u t in c o m e c o n o u tla y s th a t t in u e s to rise at a r a p id p a c e . M o d e r a t io n in m e n t c r e d it. B ecau se d iv e r t in g fu n d s fro m n a tio n a l p ro ce d u re s do in c o m e a c c o u n t in g n o t r e c o g n iz e c a p ita l g a in s th e g ro w th p r o v id e o f c o n s u m p t io n s p e n d in g w ill in d iv id u a l h o u s e h o ld s , w h ic h m ay (r e a liz e d o r u n r e a liz e d ) , as in c o m e , h o m e - h a v e b e c o m e o v e r e x t e n d e d , w ith a n o p p o r o w n e r s th a t c a sh in c a p ita l g a in s a d d to s p e n d tu n ity to a d ju s t t h e ir fin a n c ia l p o s itio n s . If a in g p o w e r w it h o u t a d d in g to d is p o s a b le in g e n e r a l b u s in e s s r e c e s s io n c a n b e a v o id e d in co m e. That at le a st p a rt o f th is s p e n d in g 1978, a n d fe w fo re ca ste rs p r e d ic t su ch a p o w e r w a s u s e d to b u y c o n s u m e r g o o d s is d e v e lo p m e n t , n o s e r io u s r e t r e n c h m e n t in th e c o n s is te n t w ith th e r e d u c e d ra te o f p e r s o n a l h o u s e h o ld s e c t o r is a n t ic ip a t e d . 6 Economic Perspectives Banking insights Trends in capital at District banks: 1965-76 Anne Weaver C a p it a l- t o - a s s e t ra tio s a n d g ro w th c a p it a l as are o fte n u se d ra te s o f q u a n t if ia b le c o g n iz e th is a n d a r e ta k in g s e r io u s ste p s to r e b u ild t h e ir c a p ita l p o s itio n s a n d liq u id ity m e a s u r e s o f th e h e a lt h o f th e b a n k in g in and d u s t ry a n d o f in d iv id u a l b a n k s o u n d n e s s . T h e p o rtfo lio s. to e lim in a t e e x c e s s iv e risk fro m th e ir q u e s t io n o f w h a t c o n s t it u t e s a d e q u a t e le v e ls o f t h e s e m e a s u r e s h a s b e e n o f c o n c e r n to Components of bank capital b a n k r e g u la to rs fo r s o m e tim e . T h e p r o b le m The o f b a n k c a p ita l a s s u m e s g r e a t e r im p o r t a n c e b ro a d d e c l in e in c a p ita l-to -a ss e t b a n k p ro fits a r e d e ra tio s fro m 1965 to 1976 m a sk s th e d iv e rg e n t p r e s s e d , b o th b e c a u s e c a p ita l is m o r e lik e ly to b e h a v io r o f th e c o m p o n e n t s o f b a n k c a p ita l. b e c a lle d u p o n to c u s h io n lo s se s o n a ssets E q u ity , d u r in g s u c h p e r io d s a n d b e c a u s e a d d it io n s to p r e f e r r e d s t o c k , s u r p lu s , u n d iv id e d p ro fits, c a p ita l in th e fo rm o f re t a in e d e a r n in g s d o n o t a n d c a p ita l r e s e r v e s , d e c lin e d as a p r o p o r t io n k e e p p a c e w ith a sse t g r o w th . T h e r e s u lt is an o f to tal c a p ita l o v e r th e p e r io d , a re fle c t io n d u r in g p e r io d s w h e n w h ic h c o n s is ts of com m on sto c k , e r o s io n o f c a p ita l- to - a s s e t ra tio s, w h ic h c a n b o th o f g re a tly r e d u c e d b a n k e a r n in g s d u r in g b e e x acerb ated th e if b a n k a sse ts c o n t in u e to 1973-75 m a rk e t g r o w ra p id ly . fo r r e c e s s io n bank and sto c k s . th e d e p ressed N e v e r t h e le s s , it r e m a in s th e m o s t im p o r ta n t c o m p o n e n t of T h ere ce n td e clin einc a p ita l ra tio s b a n k c a p ita l, c o n s t it u t in g o v e r 95 p e r c e n t of b a n k c a p ita l in e a c h o f t h e fiv e D is tr ic t states T h e p a st d e c a d e h a s w it n e s s e d a n e x c e p t io n a lly ra p id ra te o f in c r e a s e in b a n k assets. at y e a r - e n d 1976. T h e r o le o f p r e f e r r e d s t o c k , lo n g th e least B a n k a sse ts in t h e fiv e sta te s o f th e S e v e n t h im p o r ta n t F e d e r a l R e s e r v e D is tr ic t g r e w at an a v e r a g e m in im a l. U s e o f p r e f e r r e d s t o c k is lim ite d p a rt o f e q u it y c a p it a l, re m a in s a n n u a l ra te o f o v e r 10 p e r c e n t b e t w e e n 1965 b a s ic a lly b e c a u s e t h e d iv id e n d is p a id after a n d 1970 a n d a lm o s t 12 p e r c e n t b e t w e e n 1970 ta x e s, m a k in g t h e e x p lic it c o s t o f p r e f e r r e d a n d 1976. C a p it a l, o n th e o t h e r h a n d , g r e w at a sto c k to th e firm h ig h e r th a n fo r d e b t. m u c h s lo w e r ra te . A s a c o n s e q u e n c e , c a p ita l- C a p it a l n o te s a n d d e b e n t u r e s w e r e s u b to -to ta l a sse t ra tio s d e c lin e d slig h tly in fo u r o f stitu te d fo r t h e g e n e r a lly m o r e c o stly e q u ity t h e fiv e sta te s o v e r t h e 11 y e a rs , fro m an a c c o u n t t h r o u g h o u t t h e s e 11 y e a rs , g ro w in g a v e r a g e o f a lm o s t 9.0 p e r c e n t in 1965 to c lo s e e v e n fa ste r in t h e 1970 to 1976 p e r io d th a n in to th e 8.5 p e r c e n t le v e l at th e e n d o f 1976. t h e p r e v io u s p e r io d . E v e n so , t h e a v e r a g e a n A lt h o u g h t h e s ig n if ic a n c e o f th is d e c lin e in c a p ita l ra tio s is n o t e a sy to a sse ss in v ie w o f n u a l g ro w th ra te o f d e b t c a p ita l w a s less th a n .75 p e r c e n t in all fiv e states. t h e s im u lt a n e o u s c h a n g e s th a t h a v e o c c u r r e d T h a t d e b t is still a r e la tiv e ly sm a ll p o rtio n in b a n k p o r t f o lio s , a c c e s s to b o r r o w e d fu n d s , o f to ta l c a p ita l c a n b e e x p la in e d in te rm s o f e x te rn a l o th e r s e v e r a l in t r in s ic d is a d v a n ta g e s o f d e b t re la tiv e e le m e n t s o f b a n k s ' to tal e x p o s u r e to risk , to e q u ity . U n lik e e q u ity , d e b t m u s t u ltim a te ly e c o n o m ic c o n d it io n s , and t h e r e is re a s o n to b e lie v e th a t it re f le c t s a real b e re t ir e d a c c o r d in g to th e te r m s o f th e in d e t e r io r a t io n in th e s o u n d n e s s o f t h e b a n k in g d e n t u r e . D e b t a ls o c a r r ie s a fix e d in t e r e s t rate, sy ste m . a n d in t e r e s t m u s t b e p a id w h e t h e r e a rn in g s F o r t u n a t e ly , b a n k e r s g e n e r a lly Federal Reserve Bank of Chicago re 7 a re p o sitiv e o r n e g a tiv e . M o s t im p o r ta n tly , Capital by size of bank w h ile d e b t is a s u b s titu te fo r e q u ity as a lo n g te rm s o u r c e o f f u n d s , it d o e s n o t s e r v e th e Im p o r ta n t d if f e r e n c e s a r e d is c e r n ib le in c r u c ia l r o le o f e q u it y as a c u s h io n a g a in st th e b e h a v io r o f c a p ita l ra tio s b y s iz e o f b a n k d e c lin e s in a sse t v a lu e s . over th e e n t ir e p e r io d 1965 to 1976. In Changes in assets and capital accounts Illinois Indiana Michigan Iowa Wisconsin 1965-70 1970-76 1965-70 1970-76 1965-70 1970-76 1965-70 1970-76 1965-70 Equity Percent change Group 1 Group 2 Group 3 Yearly avg. 45.64 64.83 53.55 8.96 89.85 95.18 49.25 11.42 57.50 70.60 49.27 10.26 107.83 104.19 55.31 12.70 43.85 52.17 41.89 7.82 87.67 91.12 30.40 11.11 49.06 62.38 51.18 9.33 80.52 95.83 75.57 11.13 50.99 57.41 27.01 8.83 78.74 76.63 37.7 10.08 Preferred stock Percent change Group 1 Group 2 Group 3 Yearly avg. - .34 - .49 0.00 - .08 n.a. - .20 0.00 - .01 0.00 0.00 0.00 0.00 0.00 n.a. 0.00 0.00 -.42 0.00 0.00 - .01 - .42 .89 .57 .02 0.00 -3.18 2.08 - .31 0.00 - 1.27 -12.50 - 0.22 0.00 .61 0.00 - .04 0.00 - .61 0.00 - .03 Capital notes Percent change Group 1 Group 2 Group 3 Yearly avg. 0.00 1.01 3.24 .09 - .37 9.29 13.94 .62 - .55 - .59 -10.13 - .07 1.65 7.58 -10.70 .71 n.a. n.a. 0.00 0.00 .40 5.82 4.39 .11 n.a. .56 13.21 .20 n.a. 6.51 10.54 .65 n.a. - .78 - .83 .09 - .64 9.32 -5.77 .39 Total assets Percent change Group 1 Group 2 Group 3 Yearly avg. 59.44 72.71 41.50 10.47 106.42 94.41 58.96 12.31 61.72 66.36 52.94 10.38 109.96 100.97 84.34 12.70 49.68 57.34 44.85 8.65 107.70 105.23 85.76 12.89 52.66 79.08 61.27 10.80 86.14 87.15 47.41 10.76 59.84 75.86 44.91 10.48 84.26 79.97 53.42 10.58 Total capital/ Total assets Percent change Group 1 Group 2 Group 3 Yearly avg. -2.21 3.25 10.30 .04 -5.39 4.51 - .43 - .15 1.19 3.39 -12.26 .33 -2.27 .00 -1.53 - .35 - 8.03 - 5.54 -12.64 - 1.21 -1.16 -3.14 .23 - .42 .19 7.63 13.30 .78 - 3.30 - 1.67 -14.26 - .42 - .05 1.07 -7.36 .06 - .45 4.25 - 3.27 .37 - 1970-76 NOTE: Group 1 commercial banks have total assets between $0-24.9 million; Group 2 banks have total assets between $25299.9 million; Group 3 banks have total assets over $300 million. SOURCE: Report of Condition data December 31, 1965, 1970, and 1976. All assets for grouping purposes were as of December 31,1976. Only banks from the five states of the Seventh Federal Reserve District in existence in their original form from 1965 to 1976 are included in the sample. This eliminates de novo, dissolved, or organizationally altered banks that would involve a change in the FDIC bank identification number. This leaves 1,004 banks from Illinois, 383 from Indiana, 622 from Iowa, 298 from Michigan, and 530 from Wisconsin for a total of 2,837 banks. All figures are averages of individual bank data. Total capital is broken down into three categories for analysis. The equity category consists of common stock, surplus, un divided profit and reserves for capital accounts and loan losses. The second category consists of preferred stock, and the third of capital notes and debentures. 8 Economic Perspectives general, equity capital grew faster at medium sized (group 2) banks than at either the largest (group 3) or smallest (group 1) banks, although this varied somewhat between the two subperiods. No pattern by size of bank was readily visible in the trends for other com ponents of bank capital. Total assets generally grew faster at small banks, followed by medium-sized banks and large banks in that order, a pattern that was most pronounced in the more recent sub period. Nevertheless, as of the end of 1976, small banks still had the highest ratios of total capital to total assets, while large banks in three of the five District states had the lowest ratios. Whether this pronounced difference in the capital-to-asset ratios of large and small banks indicates a lesser degree of soundness on the Composition of capital accounts part of large banks is not clear. Some economists Wisconsin Illinois Indiana Iowa Michigan maintain that the lower capital ratios of large banks Average percent of are justified by their greater equity to total capital diversification of assets and 99.58 99.87 99.72 99.58 98.26 1965 95.67 96.91 superior access to funds. 97.48 98.30 99.58 1976 Others, skeptical of this ex Average percent of planation, postulate that it preferred stock to total capital reflects the inability of .12 .07 0.00 .13 .68 1965 regulators to contain the .04 .04 .07 .12 .18 1976 level of risk-taking by these Average percent of banks. Many bankers, par capital notes and ticularly those managing debentures to total large banks, would point to capital superior management as the .31 0.21 .42 0.00 1.05 1965 factor enabling such banks to 1.67 3.05 1976 2.40 1.35 4.15 get by with less capital per Average percent of dollar of assets. Whatever the total capital to total assets actual case, regulators will be 9.09 9.68 8.61 9.25 8.30 1965 closely monitoring the capital ratios of both large and small 1976 8.72 8.71 8.56 8.63 8.98 Group 1 banks either until they are 8.02 8.14 8.17 8.00 8.16 Group 2 restored to historically more 8.33 7.17 8.16 7.49 7.75 Group 3 normal levels or until it is 8.49 8.41 8.33 8.52 8.48 State average determined that changed cir cumstances have rendered NOTE: Same as table on page 8. traditional capital standards SOURCE: Same as table on page 8. irrelevant to the soundness of the banking system. Federal Reserve Bank of Chicago 9 What is happening to the U.S. dollar? Excerpts from an address by Robert P. Mayo, President, Federal Reserve Bank of Chicago, at the meeting o f the International Trade Club of Chicago, February 9, 1978. Last year the dollar depreciated by about 18 percent in value relative to the Swiss franc and Japanese yen, about 11 percent relative to the German mark, and about 10 percent relative to the British pound. It gained against some others, as for example, the Canadian dollar. Using an aggregate measure of the change in the exchange value of the dollar that takes into consideration the movement in the exchange rate in terms of currencies of our 15 major trading partners weighted by their relative importance, we find the dollar has depreciated by about 4V2percent over the past year. T h esu p p lya n dd e m a n d The movements in the value of the dollar took place within the framework of the floating exchange rate system in effect since 1973. In that system the exchange rates of in dividual currencies are permitted to move relatively freely in response to the forces of supply and demand. An important source of demand for, and the supply of, a country's currency in a free-market economy is the myriad of transactions that individuals and corporations residing in a country engage in, day-in and day-out, with residents of other countries. In the case of the U.S. dollar, foreigners who buy our products, services, and our securities need dollars to make payments to us; they represent a sou rce of de mand for dollars on the foreign exchange markets. On the other side, there are U.S. residents who purchase foreign goods, ser vices, investments, and securities, and pay for them in dollars; they are a source of supply of dollars on the foreign exchange markets. 70 Other sources of supply and demand derive from the special position of the dollar in international finance. The U.S. dollar has been for many years an “ international curren cy." It has been used as a currency of settle ment for transactions between many coun tries outside the United States and as an of ficial reserve asset. This role has led to a large demand on the part of official institutions, as well as private individuals and corporations abroad, for dollars to be held for transactions purposes as well as a storehouse of value. This foreign demand for dollars has been motivated by market-oriented considerations but also by psychological, political, and expectational factors. The occasional “ hoard ing" and “ dishoarding" of privately held dollars abroad has been, at times, an impor tant element influencing the supply of, and the demand for, dollars on the foreign ex change markets—and thus the movements of the exchange rate of the dollar in terms of other currencies. T ra d ed e ficita saso u rceo fe x ce sssu p p ly Over the past three years we experienced the development of a major imbalance in our international accounts, as our trade account shifted from a $9 billion surplus in 1975 to a deficit of $9 billion in 1976 and to more than a $31 billion deficit in 1977 on the balance-ofpayments basis. This deficit in trade in goods was partially offset by our trade in services (which includes return on our investment abroad), but it still left us with some$18 billion deficit on the so-called current account. Translated into the supply and demand relationship, this meant that we have supplied $18 billion more to the foreign exchange markets through payments for these transac tions than was demanded by foreigners to pay for similar transactions engaged in by them. The trade deficit thus represented one impor Economic Perspectives tant known element of the excess supply that was experienced by the exchange markets. In overall terms the underlying cause of our burgeoning trade deficit has been a faster growth in our imports than in our exports: while our imports were up by almost 22 per cent in 1977, our exports increased by less than 5 percent. This rapid rate of growth in imports was particularly keenly felt in certain sectors of our industry as foreign products such as steel, shoes, television sets, and cars made deeper inroads into our domestic markets. As a result, we have witnessed a growing pressure for import restrictions as a means of solving the problems of the affected industries, as well as of our growing deficit. Our government used and is using existing channels developed through U.S. laws and in ternational treaties to deal with legitimate complaints of individual industries against unfair foreign competition. But we must not permit ourselves to act unilaterally in regard to our import problems by the imposition of arbitrary import restrictions! Few, if any, nations would tolerate such measures! They would retaliate; protectionism invites more protectionism. And the spread of import restrictions that would follow would do a great damage to the U.S. economy as well as to our worldwide national interests! If we want to find a lasting solution to our trade problems, we must look deeper into the un derlying causes and seek the solutions there. E xp an d in gU .S .e co n o m yd ra w sinim p o rts Probably the most important underlying cause of the rapid expansion in our imports relative to our exports has been the recent wide variation among the free world nations in economic performance. Our economy has been healthier, and has been growing con siderably faster, than the economies of our major trading partners taken as a group. This expanding U.S. economy has been drawing in imports more rapidly than the sluggish economies abroad have been been in creasing their demand for our products. There are two possible remedies for the im balance in our trade arising from this source. Federal Reserve Bank of Chicago We could slow down our imports by slowing down our economy, or we could hope for acceleration of our exports as a by-product of improvement in economic growth in major industrial countries abroad. The first alternative we cannot accept. We need more growth, not less, so that we can make further inroads on unacceptably high levels of unemployment, and so that we can continue to provide stimulus to economic expansion worldwide by our own economic advances. Obviously, the second alternative is preferable, from the world’s viewpoint, as well as our own. With this in mind, our gov ernment has consistently used international meetings—such as the economic summit of the heads of major states last year, the ministerial meetings of the Organization for Economic Cooperation and Development, and many other formal and informal channels—to nudge our friends abroad into economic expansionary action that would benefit them in reducing their record-high unemployment, benefit the developing countries of the world by providing further stimulus to their economic growth, and benefit us by improving markets for our exports. T h eo il d e ficit Another underlying cause of our rapid growth in imports—and of our trade deficit— has been our voracious appetite for imported oil. Last year our oil import bill came to about $45 billion—up from $36 billion in 1976and up from less than $5 billion as recently as 1972. That $45 billion figure has become a millstone around the neck of the floating dollar! What can be done? In the final analysis, we must take our own energy bull by the horns! We cannot continue to live in a fool’s paradise where, for example, the real price of gasoline is now about 16 percent lower, and natural gas and electricity is some 44 percent lower, than it was some 30 years ago. We need an effective national energy policy so that we can make decisive progress toward diminishing our reliance on imported sources of energy. 11 Surging trade d eficit. . . billion dollars, census basis 175 exports (f.a.s.) other 150 - 125 - 100 automotive other capital goods machinery agricultural nonagricultural industrial supplies imports (f.a.s.) other consumer goods capital goods automotive fuels nonfuel industrial supplies - 75 - 50 - 25 1973 1974 1975 1976 1977 T h ee xch a n gera te sa n din te rn a tio n a l co m p e titive n e ss Another underlying cause of our deficit may have been a gradual erosion of the com petitiveness of U.S. goods on the world markets. Competitiveness of any country's goods on the world markets is generally determined by the quality of its products, d e liv e ry prom ptness, and follow -up services—but above all, it is determined by the prices of its products. The final prices of a country's products on the world markets as they confront foreign buyers of these products are determined through a two-tier process. The first tier relates to the rate of price changes—the rate of inflation—which determines the prices of the country's goods in its own currency. Next, it is the movement of exchange rates through which specific domestic prices are "translated" into specific international prices. This constitutes the sec ond tier through which international com petitiveness is determined. On the "first tier" the domestic wholesale prices of manufac tured goods rose by almost 7 percent in the 12 United States, in Germany by 3 percent, in Japan by 2 percent, and in Switzerland they actually declined by almost 1 percent between the end of 1976 and late 1977. O b viously, our competitive position against these countries in terms of domestic prices eroded during the year, and the movements in the exchange rates of these currencies relative to the dollar—the second-tier process—may be viewed as compensating for the trends on the first tier. If we weigh the changes in the exchange rate of the dollar with respect to the currencies of Japan and 13 major European countries by the volume of trade, and adjust these weighted changes for the inflation in prices of manufactured goods experienced domestically by these countries, we find that although the dollar depreciated by about 10 percent in 1977 against these currencies taken as a group, the U.S. com petitive position (as determined by the twotier process) in respect to our 14 major trading partners was almost precisely the same at the end of 1977 as it was in 1973! T h ec a p ita la cco u n t To sum up, our current deficit may have been caused at least in part by our relative loss of competitiveness during the earlier part of . . . contributes to the dollar’s decline percent change change in exchange rates of selected currencies relative to the U.S. dollar (weekly) - Swiss franc/ British / pound /•^ Japanese j ^ J y / y/ f yen\ / German mark dollar (trade-weighted) s Canadian dollar'" ___________________________ / July Aug. Sep. Oct. 1977 Nov. N N Dec. Jan. 1978 Economic Perspectives the 1973-77 period, and the observed movements in the exchange rate of the dollar relative to major currencies has been a part of the lagged process by which markets have tended to reestablish that competitiveness. Data for 1977 on the supply and demand for dollars on the foreign exchange markets arising from money and capital transactions between the United States and countries abroad are available only through September. They indicate that the demand for dollars in the capital account amounted to about $29 billion, while the supply of dollars (arising from acquisition of foreign assets and in vestments by U.S. residents) came to about $13 billion. This, on the surface, would appear to be a rather “ favorable” constellation of the supply and demand forces. However, a close look at the figures indicates that threequarters of that observed “ demand” for dollars was actually a “ residual demand,” representing acquisition of dollars by foreign official institutions as they intervened in the foreign exchange markets in their efforts to moderate the rise of their currencies relative to the dollar! Private foreign demand for dollars appeared to have fallen quite short of supply in the money and capital transactions, particularly in the last few months of the year. In part, the causes of this trend were “ economic” in origin; in part, they were a reflection of prevailing market psychology. On the economic side, the trend reflected continued excess of our corporate long-term investment abroad over foreign investments in the United States. It also reflected the ac tivities of U.S. banks and others in accom modating demand for credit around the world in the form of loans and purchases of foreign securities. It was largely the presence of adverse “ psychological” factors in the market that resulted in reduced demand for dollars on the world's money markets. M arketp sych o lo gy The impetus toward reversing the adverse capital flows affecting the dollar must co m e fro m im p ro v e m e n ts in the “ psychology” of the international financial Federal Reserve Bank of Chicago markets. We have to restore the apparently shaken confidence of foreign investors—as well as U.S. investors. In our ability to reduce inflationary dangers, we must resolve national policy uncertainties in respect to our energy and tax policies. There is no easy answer, and no easy solu tion, to what has been happening to the U.S. dollar. An improvement in the position of the U.S. dollar will require systematic progress on many fronts. We are on the right road. Ou r ac tions and our economic policies are evolving with the integrity of the dollar in mind. We are not practicing a policy of “ benign neglect” in respect to the dollar as some of our friends abroad have accused us just because we have not intervened more heavily in the foreign exchange markets! Our policy of limited of ficial intervention has proved to be very con structive thus far, particularly as it has tended to throw speculators off guard. Intervention is a management strategy, albeit a very valuable one; it is not a cure. C onclusion In perspective, our policies in respect to the dollar must be guided by two broad prin ciples. One such principle derives from our existence as a viable member of the trading community of nations. That viability is largely predicated on our ability to maintain a healthy, noninflationary economy, and on our ability “ to pay our way” —to see to it that our international accounts are kept in a reasonable balance. No nation, just like no in dividual, can go on spending forever more than it earns! The other principle comprises considerations involving the viability of the entire world trading system. That viability is predicated on the proposition that all trading nations must sacrifice certain self-serving ob jectives for the benefits they derive from a free international exchange of goods: no na tion can expect to build economic benefits for itself by heaping adversities on others. As long as we, as well as other nations, adhere to these principles of national and in ternational responsibility, I am convinced that the future of the dollar will be secure. 13 Loan commitments and facility fees Randall C. Merris Commercial banks in recent years have begun to reevaluate their policies toward loan commitments—agreements in which banks obligate themselves to lend, upon customer demand, up to specified dollar limits over predetermined future time periods. These reappraisals have been prompted in part by concern on the part of both bankers and the monetary authorities over the high activation rates and large dollar volumes of loans extended under outstand ing commitments during periods of tight credit. The most recent such episode was in 1974 when tight money-market conditions and strong loan demand led major banks to boost the prime rate—the interest rate charged on business loans to banks' most creditworthy customers—to an unprecedented 12 percent. The monetary authorities' concern was that loan commitments made during earlier periods, when banks had easy access to funds, would require large-scale bank lending in 1974, hampering Federal Reserve efforts to restrict the growth of bank credit. Bank regulators were concerned that the high costs attached to honoring these commitments could threaten profitability and capital positions of some commercial banks. Although bank loan commitments are not new financial instruments, these agreements have grown dramatically in dollar magnitudes and have assumed an increasingly critical position in bank management since World War II. Of special importance has been the growth of fee-based com m itm ents— contracts for which customers pay explicit bank charges called commitment facility fees (or simply facility or commitment fees). These fee-based commitments differ from credit lines, which are the traditional and still prevalent type of bank loan commitment. In 14 place of explicit fees, credit line agreements typically require the customer to maintain compensating balances—minimum average checking account balances. Growth of fee-based commitments has been spurred by a number of major banking developments since the early 1960s. A primary factor has been the increased reliance of commercial banks on open-market sources of funds to meet loan demands arising from commitments. The greater variability in the costs of these managed liabilities, compared with the relatively stable cost of traditional deposit sources of funds, has introduced ad ditional uncertainties into bank management of loan commitments. At the same time fluc tuations in interest rates applied to loans un der commitments (i.e., takedowns) have been considerably greater in the post-1965 period. Increased variability of both bank costs and revenues has prompted many banks to analyze in detail the profitability of individual customer accounts and to make greater use of explicit pricing of loan commitments and other bank services. For a long time loan commitments of com mercial banks were viewed as a rather minor service performed as an adjunct to the actual loan contract. Nearly all loan commitments were in the form of credit lines related in a rather mechanical way to the volume of business loans. Largely as a consequence of the greater turbulence of financial markets in recent years, however, loan commitments have gained recognition as a distinct and separable service of commercial banks. This new view of commitments focuses on the financial advantages accruing to a business firm from assurance of future credit availabili ty, a service that commands a price even if the commitment remains unused. In general terms, loan commitments are Economic Perspectives viewed as insurance policies for which firms should be willing to pay a “ premium"—either in the form of a facility fee or through com pensating balances. Banks maintain some, but not complete, control over policyholder claims by reserving the right to vary interest rates applied on commitment takedowns in most of these contracts. It is extremely unlike ly, in normal times, that all holders will decide to d raw dow n th e ir commitm ents simultaneously. As a result, banks are able to pool risks and forecast loan usage for com mitments in much the same way that in surance companies use contingency tables to estimate claims. Unlike claims under most forms of in surance, however, takedowns under loan commitments are not independent events ruled by accident or nature. Because takedowns occur at the discretion of business firms which are affected by tight credit con ditions at about the same time, the possibility exists that a large proportion of commitment holders will turn to their banks for funds simultaneously. During periods of especially tight credit, such as in 1969 and 1974, takedowns were increased sharply enough by a sufficiently large number of commitment holders to engender concern. C o m m itm e n tfe a tu re s Loan commitment is a term loosely applied to a variety of agreements varying from infor mal understandings to legally binding con tracts between commercial banks and their customers. A loan commitment may be negotiated between the parties and tailored to specific operating policies of the bank and particular credit needs of the customer. All major banks and many smaller ones have detailed operating policies regarding com mitments. Any one bank frequently uses several standard types of commitments and further customizes these agreements to in dividual customers. Even commercial banks are not always in agreement as to what constitutes a loan com mitment. Some banks consider all or nearly all short-term business loans to arise from com Federal Reserve Bank of Chicago mitments, even if the bank has had no contact with the loan customer prior to the loan application. At the other extreme are banks that view themselves as making no com mitments whatever. Fortunately, most banks' commitment policies are better defined and managed than either of these extreme views might suggest. Nevertheless, differences in terminology regarding commitments persist. Loan commitments typically include four major elements—disclosure of the commit ment to the customer, the dollar limit on loans under the agreement, interest rates on takedowns, and the time period during which the agreement is effective. While some banks have adopted internal guidelines for use in screening customer loan requests, these guidelines typically are not considered loan commitments unless they have been com municated to customers. Thus, terms such as “ disclosed credit lines" or “ confirmed lines" often are used to distinguish commitments from internal guidelines. Although all credit commitments involve disclosure to the customer, either orally or in writing, their treatment of the other major elements varies widely. Confirmed credit lines include lend ing limits but do not detail other terms and conditions of usage. Credit lines sometimes are open indefinitely or until further notice from the bank, but most often are on an an nually renewable basis. On the other hand, formal loan com mitments, sometimes called “ firm" com mitments, include all four major elements of commitment agreements. Not only dollar loan limits, but also lending rates and the period for which the agreement is in force, are stated in writing. The lending rate is usual ly specified to bear a fixed relationship to the prime rate. The period during which formal commitments are in force is normally one to three years, depending on the purpose of the borrowing. There is usually a clause requiring a bank to show cause for not honoring a for mal commitment, and proviso clauses stipulating that the customer must maintain minimum adequate working capital, limiting the customer's reliance on nonbank external financing, or imposing other controls on the 15 firm's operations sometimes detail the con ditions under which the bank may be released from its obligation to lend. Two of the most important types of formal commitments are revolving credits and term loan commitments. A revolving credit entitles the customer to take down and repay loans repeatedly during the time the agreement is in effect, so long as the total loans outstanding at any time do not exceed the dollar limits of the commitment. Banks may require that a revolving credit be repaid in full for some part of each year. Term loan commitments are for bank loans having original maturities ex ceeding one year. Some commitments apply directly to term loans, whereas other com mitments begin as revolving credits and allow conversion to term lending during the life or upon expiration of the revolving credit agree ment. Revolving credits and term loan com mitments are two principal types of com mitments on which banks often charge ex plicit fees. Another major category of formal com mitments is the standby commitment, which is used to back an issuance of commercial paper—promissory notes issued by large cor porations and used as a close substitute for bank loans. Although collateral is not re quired on commercial paper, investors typically require some assurance that issuers will be able to repay or refinance the debt upon maturity. Under standby commitments banks promise to provide refinancing through bank loans when the commercial paper matures. Corporations sometimes find bank refinancing less expensive than com mercial paper, and take down large amounts of standby commitments. At other times, when commercial paper is relatively less ex pensive, standby commitments remain un used and serve only as credit assurance. In many instances a large corporation will have loan commitments outstanding from dozens of banks to cover its commercial paper. The fees charged for these commitments are referred to as standby fees. Credit lines traditionally have been a major component of “ customer relationships"— longstanding cooperative arrangements by 76 which a bank provides total packages of bank services to business customers. Standing ready to provide loans, especially in times of tight credit, is vital to maintaining the loyalty of the customer and the long-run profitability of his account to the bank. Advance commitment of funds also may serve as an important part of the loan ap proval mechanism used in major banks. So long as total loans to a given borrower remain within the dollar limits of the commitment, pre-approved lending reduces administrative costs for a bank loan department by eliminating the need to review and approve each loan separately. Knowing both the overall dollar volume of commitments and the totals for separate com mitment categories, senior bank manage ment is better able to forecast loan demand. However, knowledge of the usage rates of various types of commitments is also necessary. U sa gera te s Usage rates (i.e., the percentages of com mitments taken down at any given time) vary significantly among credit lines, revolving credits, term loan commitments, and other types of commitments. Usage rates tend to be highest for formalized agreements, especially for fee-based commitments. Thus, term loan commitments and revolving credits have higher usage rates on average than confirmed credit lines. Usage rates also display more cyclical variability for some categories of com mitments than for others. Credit lines and revolving credits are designed to meet both foreseen and unforeseen short-term borrow ing needs and so have more cyclical and seasonal usage than term loan commitments. Nonbank financial institutions, especially finance companies, are major users of com mitments, either directly or as backing for commercial paper, and are often treated as a separate commitment category. These com mitments are most similar in form and usage to the revolving credits issued to commercial and industrial borrowers. Banks also issue construction-loan and Economic Perspectives mortgage-loan commitments for loans secured by real estate, collectively called real estate commitments. Ultimate usage rates are near 100 percent for real estate com mitments. A construction commitment is tied directly and formally to a specific construc tion project and includes a date for total takedown or a timetable for periodic takedowns increasing to 100 percent usage during the construction period. Similarly, a mortgage commitment is tied to a particular commercial or residential property as of a closing date. Real estate commitments are a totally separate entity and normally are not discussed along with “ regular" commitments because the bank's uncertainty about usage rates, which is substantial for credit lines, revolving credits, and term commitments, is not as important for real estate commitments. Le n d in gu n d e rco m m itm e n ts Estimates from the latest available Federal Reserve survey of bank lending, covering loans contracted in the first full week of November 1977, indicate that slightly over 40 percent of the dollar amounts of short-term business loans (i.e., loans with maturities less than one year) and over 48 percent of long term business loans were contracted through commitments. In general, the largest banks originate a larger proportion of their business lending through commitments than smaller banks. For example, 54 percent of the dollar volume of short-term business loans of the 48 largest banks in the November 1977 survey were made under commitments, compared to 33 percent of the same category of lending by other banks. Over 62 percent of the long term business lending by the 48 largest banks was under commitments, compared to about 32 percent for other banks. Generally, large loans are more likely to originate from commitments than are smaller loans. In the November 1977 survey, for ex ample, only 19 percent of the dollar amount of short-term business loans in the $1-99 thousand size category arose from com mitments, compared with 50 percent of short term lending in the $100 thousand and over Federal Reserve Bank of Chicago size category. Similarly, about 37 percent of the dollar amount of long-term loans in the $1-99 thousand category were made under commitments, compared to over 53 percent for the loans of $100 thousand and over. The prevalence of commitments for large loans is explained in part by the lead time for advance planning afforded by a loan commitment, which is especially critical when the loan represents a sizable portion of the bank's total lending and is to be outstanding for a long time. P ricin gco m m itm e n ts Facility fees, like interest rates, are quoted as annual percentage rates and are paid either in full when the commitment begins or at regular intervals during the life of the con tract. Some banks use a base fee to which are added, depending on the customer, supplementary facility fees or compensating balance requirements related to the dollar amounts of the commitments or the takedowns. During the 1950s and most of the 1960s, the basic facility fee was Va percent per annum on the unused dollar amount of the commitment but at times was increased by some banks to Vi percent on the unused amount. The major purpose of the facility fee on commitments is to pay for the creditassurance services provided by the bank. Like prices of other goods and services, facility fees serve as an economic rationing device. They can be varied by the bank as a means of con trolling the dollar volume of loan com mitments. Increases in facility fees, other fac tors unchanged, will result in a reduction in dollar amounts of commitments demanded by new and existing customers. Commercial banks change their basic facili ty fees very infrequently. One reason for the “ stickiness" of these fees is that banks have other methods available for influencing the volume of commitments. Commercial banks can change the availability of the funds borrowed under commitments by altering compensating-balance requirements when applicable or can vary other elements of the 17 commitment agreement. Interest and non interest terms on the loans assured by the agreements also can be modified in lieu of changing the facility fee. For example, a business firm previously qualifying for loans at the prime rate might terminate the agree ment or carry a smaller commitment when faced with a higher loan rate—say, prime plus one percent. Inflexibility of facility fees also results from the manner in which fee charges influence loan demand, especially when the fee is applied to unused portions of commitments. The effects on loan demand are illustrated best by looking at changes in facility fees dur ing two recent episodes of tight credit and strong loan demand. • In the spring of 1969 several large New York City banks raised their facility fees from Va percent to V i percent per annum on unused portions of new commitments and renewals of existing ones. • In the fall of 1974 several major moneycenter banks imposed a Va percent fee on total dollar amounts of new and renewed com mitments in addition to the Vi percent fee already levied against unused segments of their commitments. Levying facility fees against the unused por tions of commitments has significantly different implications for loan demand than placing fees on total commitments. The fee increase in 1969 was aimed at reducing the amount of outstanding commitments and thereby stemming the growth of business lending. However, increasing the fee only against unused commitments provided an offsetting incentive to commitment holders to increase the usage of the commitments that remained in force. Given the size of the commitment, an in crease in the fee on the unused portion amounts to a decrease in the effective loan rate on takedowns. Consider a commitment carrying a Va percent fee on the unused por tion in early 1969 and obligating the bank to lend at the T/i percent prime rate quoted from mid-March to early June 1969. The effec tive, or marginal, interest rate on loans under this commitment is V /a percent rather than T/i 18 percent because of the Va percent facility fee on unused commitment amounts. The borrower pays only T / a percent more by tak ing down the commitment since the Va per cent fee is "saved" on each dollar of com mitments used. Now suppose that after the facility fee in crease in 1969 from Va percent to V i percent, the commitment holder chose to renew his commitment. With the prime rate still at T/i percent, the new effective rate on takedowns would be 7 percent—the T/i percent prime minus the V i percent fee on unused commit ment amounts. Thus, an increase in the com mitment fee would result in a reduction in the effective cost of takedowns and probably would have the undesired effect of en couraging greater usage of commitments during a tight money situation. It is noteworthy that the prime rate was in creased in June 1969 from 7Vi percent to 81/2 percent—the largest single movement in the prime in modern history. This prime rate in crease occurred soon after the Va percentage point increase in facility fees on unused com mitments by some major banks. Some part of this hike in the prime rate may be explained by the need to adjust the loan rate to the new facility fee schedules. Indirect evidence that banks learned a lesson in facility fee policy from the 1969 episode is provided by the experience of 1974. Banks that increased fees in 1974 avoid ed simultaneously decreasing effective loan rates on takedowns. Since the additional Va percent fee (or more in some cases) was placed on the total amount of new and re newed commitments, thecommitment holder could not reduce the fee charge by simply taking down the commitment. From the banks' viewpoint the additional fee on total commitments had the advantage of reducing the dollar volume of commitments without stimulating an offsetting increase in takedowns. Even when applied to total commitments, higher fees tend to increase observed usage rates because these agreements become a higher-cost financial resource. This is because the higher commitment fees lead holders to Economic Perspectives economize on the volume of unused com mitments, resulting in higher observed usage rates. R e gu latio n It has been suggested on occasion that bank loan commitments should be subject to public regulation, either by placing reserve requirements on commitments or by limiting overall dollar volumes. Each of these alter natives, however, presents serious problems owing to the rather special nature of commitments—namely, that these contracts are contingent claims on the banking system. Because no transaction involving the actual transfer of funds is made until the commit ment is taken down, commitments do not appear on bank balance sheets. Thus, regula tion of commitments would not operate directly on an item appearing on the balance sheets of commercial banks. If reserve requirements were placed on loan commitments, however, banks would need to alter accounts which do appear on their balance sheets—liquidating loans and in vestm en ts or attracting additional deposits—in order to obtain funds to meet these requirements. By absorbing loanable funds, reserve requirements against loan commitments could prove a heavy burden on banks. The probable result would be that some banks would eliminate loan com mitments (formal commitments at least) from the list of bank services provided. Many banks probably would impose additional compen sating balance requirements, facility fees, and higher loan rates on commitment takedowns. In this way, the implied costs of reserve re quirements against commitments would be shifted onto banks' credit customers. The establishment of ceilings on dollar volumes of outstanding loan commitments would cause serious regulatory problems. Restrictions on loan commitments would have to be extended to entire business loan portfolios of commercial banks. Otherwise, banks simply could shift large volumes of lending from formal commitment status to lending without prior commitment or to Federal Reserve Bank of Chicago agreements sufficiently informal as to avoid, at least technically, the official definition of a commitment. Unless all business lending and commitments were regulated in the same way, a reversal in the trend toward formal commitments would enable banks tocircumvent quantitative controls on commitments. If different quantitative restrictions (or reserve requirements) were imposed on different categories of business loans and loan commitments, the consequence would be bank credit allocation with its multitude of regulatory costs and inequities. Despite the monetary authorities' oc casional concern over the pro-cyclical effects of loan commitment usage, the need for regulatory control over loan commitments has not Been clearly demonstrated. The fee revisions in 1969 and 1974 have shown that banks' control over outstanding formal com mitments can be maintained during tight credit periods. Some firms holding bank credit lines in 1974 sought to convert them to fee-based commitments. While assuring customers that confirmed lines would be honored as readily as formal commitments, banks balked at converting these informal lines. It should be remembered that commitment agreements expire and must be renegotiated. Even if many large, unused commitments ac cumulate during a period of slack loan de mand, many of them expire as businesscredit demand recovers. After that occurs, and before credit pressures of the recovery have mounted, banks have several options. They can reduce the sizes of commitments, raise facility fees and compensating balance re quirements, or alter other interest and non interest terms on loans. Moreover, commit ment holders have little incentive to ac cumulate commitments in anticipation of a credit crunch if the agreements are expected to expire before credit stringency appears. Indeed, the othewise minor difficulties that some banks encountered from loan pressures in 1974, as well as the resulting concern on the part of the monetary authorities, were exacer bated by efforts of public officials to hold bank lending rates—particularly the prime 19 In fo rm a tio nonco m m itm e n ts Mellon Bank NA, headquartered in Pittsburgh, has been a leader in developing specific procedures for managing commitments and has been collecting detailed data on dollar amounts of formal commitments and credit lines since 1959. The Board of Governors of the Federal Reserve System has gathered data on loan commitments since the late 1960s and since January 1975 has compiled a Monthly Survey of Loan Commitments showing amounts of unused commitments and loans made under commitments by 136 large banks. Some in formation on commercial banks’ commitment policies is available also from Changes in Bank Lending Practices and the Survey of Terms of Bank Lending, both published by the Federal Reserve System. This information provides a useful starting point for developing generally accepted terminology regarding loan commitments and refining bank commitment policies. Federal Reserve survey* Monthly survey of loan commitments Terms of lending at commercial banks Changes in bank lending practices Banks included 136 weekly reporting banks, accounting for about 85 percent of commercial and industrial loans, 95 percent of nonbank financial loans, and 75 percent of real estate loans of all weekly reporting banks About 340 banks selected to represent all sizes of banks About 120 selected large banks Reporting period End of each month beginning with January 1975 Quarterly sample for the first full business week of each February, May, August, and November—begin ning with February 1977 Quarterly sample for mid-month of each February, May, August, and November—beginning with February 1967 Source Federal Reserve Statistical Release G. 21 Federal Reserve Bulletin and Federal Reserve Release G.14 Federal Reserve Bulletin Description Federal Reserve Bulletin, April 1975 Federal Reserve Bulletin, May 1977 Federal Reserve Bulletin, April 1968 Information on commitments Outstanding amounts of unused commitments and loans made under commitments. Major commitment categories include formal commitments, disclosed credit lines, and commitments to nonbank financial firms. Percentages of amounts of loans made under commitments for various size classes of loans. The sample contains separate strata for 48 large banks and the other banks in the sample. The data are classi fied as short-term business loans, long-term business loans, construction and land development loans, and loans to farmers. Essentially qualitative information from senior bank lending officers about changes in their lending practices since the previous reporting period. Information concerns changes in review procedures for credit lines of nonfinancial business customers and establishment of new or larger credit lines by finance companies. • Statistical releases mentioned in this table can be obtained from Publication Services, Division of Administrative Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551. 20 Economic Perspectives rate— below the level dictated by market forces. To the extent that banks yielded to pressures to restrain rate increases, they denied themselves the use of a major method for controlling commitment usage— raising the price of borrowings. Though formal controls appear un warranted, commitments nevertheless pose problems that merit the attention of bank management and supervisory authorities. Some banks still have fairly informal commit Federal Reserve Bank of Chicago ment policies and could benefit from specific guidelines and better internal data on loan commitments. Consideration should be given to uniform disclosure of dollar amounts of loan co m m itm ents, at least formal agreements, as addenda items on all bank balance sheets. Disclosure would enable in vestors to evaluate the impact of loan com mitments on individual banks' risk positions, and also could contribute to more consistent and effective bank examination procedures. 21 Bank failures Chayim Herzig-Marx Public interest in bank failures has been renewed recently as a number of multi million dollar banking firms have been declared insolvent. Legislators, who share the concern, have asserted that "the existing structure of regulation of banking institutions under Federal law . . . is incapable of insuring the safe and sound operation of the commer cial banking system of the nation."1 Regulators have responded with increased bank surveillance and with "early warning systems" to guard against further failures. When banks fa il, investors and sometimes depositors sustain losses; society bears some costs as well. However, the dollar magnitude of such losses is far less than one might expect, and the actual amount of losses sustained is to some extent dependent upon the manner in which regulatory authorities dispose of the failed bank. Yet the mechanics of handling bank failures remain a mystery to most people. Historical background Waves of bank failures have recurred throughout American history. During the panic of 1893 nearly 500 banks suspended operations, out of only 9,500 banks then in ex istence. During the monetary crisis of 1913, 105 banks failed and in each of the next two years, over 150 banks failed. In the 1920s an average of 588 banks failed each year.1 2 Between 1930 and 1933, the last four years prior to the establishment of the Federal Deposit Insurance Corporation (FDIC), 9,100 banks suspended operations in this country—an average of 43 banks per 1U.S. Senate, A Bill to E sta b lish a F e d e r a l B a n k C o m . ., S. 2298,94th Congress, 1st Session, 1975, p. 2. m is s io n . 2Data on bank suspension prior to 1934 are not whol ly comparable with data from later years. Some suspend ed banks subsequently reopened. 22 week. During these four years depositors sustained losses of $1.3 billion. These failures prompted extensive legislation aimed at preventing a recurrence of such disastrous numbers of insolvencies. Banks were barred from paying interest on demand deposits and from engaging in certain activities, such as stock underwriting, on the grounds that these practices had proved excessively risky. While the wisdom and effectiveness of these restric tions has been questioned, the establishment of the Federal Deposit InsuranceCorporation in 1933 did indeed bring about the long sought-after stability in the banking system. By guaranteeing the safety of depositors' funds, federal deposit insurance effectively put an end to banking panics. A potential in solvency at one bank no longer threatened deposits at other banks in the same economic region, putting an end to the domino effect which had always plagued American banking. Federal deposit insurance, however, does not stand as the only bulwark against banking panics. Monetary and fiscal policies of the government are aimed at preventing economic depression, whether due to severe contractions of the money supply or to other causes. The ability and willingness of the Federal Reserve System to provide liquidity to the banking system also helps to insure that the public will not lose faith in bank deposits as a safe and sound means of holding money balances. The effectiveness of federal deposit in surance in reducing numbers of bank failures is readily seen. During the first four years of FDIC experience, only 249 banks failed, of which 180 were insured. Losses to depositors of insured banks were only $717,000, while losses to depositors of uninsured banks were $6.7 million and losses to the FDIC were just under $9 million. The establishment of deposit insurance thus has had two effects. First, the number of failing banks has been Economic Perspectives Table 1 Basic data on frequency and disposition of bank failures, by year, 1934-1976 Number of failed banks Year Insured Noninsured Deposits in failed banks Insured Noninsured Failure rate (per 10,000 banks) Insured Noninsured Disposition of insured failed banks Deposit payoff Purchase and assumption (th o u s a n d s ) 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953* 1954 1955 1956 1957* 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 9 26 69 77 74 60 43 15 20 5 2 1 1 5 3 5 4 2 3 4 2 5 2 2 4 3 1 5 1 2 7 5 7 4 3 9 7 6 1 6 4 13 16 52 6 3 7 7 12 5 2 3 0 0 0 1 1 0 4 1 3 1 1 2 0 1 1 5 0 1 4 2 0 1 4 1 0 0 0 1 0 2 0 0 1 1 $ 1,968 13,405 27,508 33,677 59,684 157,772 142,430 29,717 19,185 12,525 1,915 5,695 347 7,040 10,674 6,665 5,513 3,408 3,170 44,711 998 11,953 11,330 11,247 8,240 2,593 6,930 8,936 3,011 23,444 23,438 43,861 103,523 10,878 22,524 40,134 54,821 132,152 20,480 971,2% 1,575,832 339,574 864,859 $ 35,364 583 592 528 1,038 2,439 358 79 355 0 0 0 147 167 0 2,552 42 3,056 143 390 1,950 0 360 1,255 2,173 0 1,035 1,675 1,220 0 429 1,395 2,648 0 0 0 423 0 79,304 0 9 1,004 800 6.4 18.3 48.9 55.2 53.7 44.3 32.0 10.4 15.0 3.8 1.5 0.8 (T.7 3.7 2.2 3.7 3.0 1.5 2.2 3.0 1.5 3.8 1.5 1.5 3.1 2.3 0.8 3.8 0.8 1.5 5.2 3.7 5.2 3.0 2.2 6.7 5.2 4.4 0.7 4.3 2.8 9.0 11.1 287.8 32.4 16.6 40.1 41.8 135.3 58.8 23.5 25.3 0.0 0.0 0.0 14.5 12.8 0.0 55.6 14.5 46.2 16.0 17.6 37.3 0.0 22.5 23.5 125.3 0.0 28.4 123.8 64.9 0.0 36.5 152.1 42.6 0.0 0.0 0.0 54.1 0.0 97.1 0.0 0.0 38.3 36.4 9 24 42 50 50 32 19 8 6 4 1 0 0 0 0 0 0 0 0 0 0 4 1 1 3 3 1 5 0 2 7 3 1 4 0 4 4 5 1 3 0 3 3 0 2 27 25 24 28 24 7 14 1 1 1 1 5 3 5 4 2 3 2 2 1 1 0 1 0 0 0 1 0 0 2 6 0 3 5 3 1 0 3 4 10 13 ♦ “Disposition of insured failed banks” and "Num ber of insured failed banks” do not agree because some insured failed banks subsequently reopened. Federal Reserve Bank of Chicago 23 reduced dramatically. Second, for banks with deposit insurance, the risk of financial loss has shifted from depositors to the FDIC's in surance fund, accumulated from premiums paid by insured banks. To understand how the FDIC shifts risk from depositors to itself, it is necessary to understand what happens when a bank fails. A discussion of general provisions governing bankruptcy pro ceedings will help to clarify the role of the FDIC. Bankruptcy in general Bankruptcy is a legal proceeding in which a financially distressed firm is placed under the supervision of a court. The court appoints one or more trustees to oversee the operations of the firm during adjudication. Any creditor failing to receive timely repay ment of amounts due him may sue to initiate bankruptcy proceedings against the debtor firm. Firms owing amounts in excess of their abilities to repay may themselves file for bankruptcy to obtain protection from their creditors pending resolution of their in debtedness. In a typical bankruptcy proceeding, creditors present their claims against the failed firm. If the creditors can agree to a debt restructuring, usually in volving extended debt maturities as well as some debt "forgiveness," the firm may con tinue in operation. Otherwise, the assets of the firm are liquidated and the creditors are compensated from the proceeds. The determination of how much each creditor is paid becomes crucial. Most creditors share in the liquidation proceeds in proportion to their financial claims on the firm. These are called "general creditors." Some creditors are able to establish a prior claim to the liquidation proceeds. Called "preferred creditors," they must be paid in full before any distribution can be made to the general creditors. The benefit of es tablishing a credit preference is evident (law suits over assertions of preferences are com mon), making the validation of preferences one of the most important aspects of bankruptcy proceedings. 24 Bankruptcy in banking Like any other business, a bank can voluntarily place itself in bankruptcy or can be sued by creditors who are refused repay ment. These events rarely occur, however, because the banking industry is subject to ex tensive public regulation. In particular, a bank can be placed in receivership (the equivalent of bankruptcy) by a regulatory authority, but only by the authority issuing its charter.3This is an important distinction between banks and other commercial businesses since in banking the chartering agency, which represents neither the business itself nor creditors of that business, has the power to force the firm into bankruptcy proceedings. Fairly wide latitude is granted to bank supervisors in determining whether a bank should be placed in receivership. If a bank is insolvent, if its capital is impaired, if it is engaging in practices that are likely to result in substantial financial loss to depositors, or if it is about to engage in such practices, the supervisor is justified in taking control of the bank and placing it in receivership. A bank is insolvent when its assets, even though li quidated in an orderly and prudent manner, would not suffice to pay off its noncapital liabilities. A bank's capital is "impaired" when charges against the capital account (e.g., to write off losses or uncollectable debt) exceed the sum of contingency reserves, undivided profit, and surplus. Because of supervisors' wide latitude, a bank is usually closed long before it actually defaults on its debts. Once a bank is declared insolvent, it is taken over by regulatory authorities and closed to all business. The Comptroller of the Currency or state bank supervisor places the bank in the hands of a court with jurisdiction in such matters (usually a federal district court). The court appoints and oversees a receiver, whose job is to examine the books and accounts of the bank and to verify assets and liabilities. The receiver is also responsible 3The Federal Reserve and the Federal Deposit In surance Corporation, although they are both heavily in volved in bank supervision and regulation, lack the legal power to close a financially distressed bank. Economic Perspectives for collecting interest and principal due on outstanding loans and investments. Public notice is given, usually for about three months, for all creditors of the failed bank to present proof of their claims. The receiver judges the validity of all claims presented. A large body of case law exists dealing with preferences in bank failures.4Most trans actions with a bank arise out of a debtorcreditor relationship. For example, one who deposits money with a bank is a creditor, and the bank stands as a debtor to him. In order to establish a preference in a bank failure case, one must demonstrate that his relationship with the bank was not simply that of a creditor, but rather that the relationship was one of principal and agent or that the bank was acting in a trust capacity. Banks often act as agents for municipal governments or other political subdivisions in the collection of tax es. The political units thereby achieve the preferred status of a principal with respect to the tax deposits rather than that of a creditor. Another situation establishing a preference occurs when money is deposited in a bank with the express stipulation that the funds are to be used to purchase certain securities. The bank then acts as the agent for the depositor, and his claim on the bank takes priority over that of other depositors. Pledging assets to secure deposits also establishes a preference. Depositors who are not preferred creditors are merely general creditors of failed banks. General creditors share pro rata in all liquida tion proceeds, but only after preferred and secured creditors have been compensated. At federally insured banks, the Federal Deposit Insurance Corporation relieves depositors of financial risk by entering into the bankruptcy proceedings. When an in m o s t state banking laws do not deal specifically with preferences. Am ong Seventh District states only Iowa makes explicit the order of payment of creditors of failed banks. Section 524.1312of the Iowa Code specifies that, in the event that liquidation proceeds are not sufficient to pay off all creditors in full, the order of distribution is, first, all costs of the receiver; second, all preferred claims (in full or p r o rata if proceeds are not sufficient to com pensate all preferred creditors); third, depositors; fourth, all other general creditors; fifth, holders of capital notes and debentures. The Iowa code thus elevates depositors above other general creditors. Federal Reserve Bank of Chicago sured bank fails, the FDIC guarantees to each depositor the amount of his account, up to the current insurance limit (now generally $40,000). The FDIC then becomes subrogated to the rights of depositors to the extent of in surance payments; that is, each depositor's claim to liquidation proceeds passes to the FDIC for the amount by which the FDIC reimbursed the depositor. The FDIC then becomes a general creditor of the failed bank and shares in liquidation proceeds pro rata with other general creditors. Claims of capital investors in failed banks rank below those of general creditors. There are three classes of capital investments; capital notes and debentures, preferred stock, and common stock. In order to be ex empt from interest rate ceilings and reserve requirements, capital notes and debentures must be explicitly subordinated to all deposits. They are also, therefore, subor dinated to all creditors' claims that rank on a par with deposits. Thus, holders of capital notes of a failed bank will not receive any recovery on their investment until all preferred and general creditors recover the full amount of their investments. If any funds remain after holders of capital notes have been paid off in full, stockholders may receive something. In cases in which the failed bank had both preferred and common stock outstanding, preferred stockholders have priority. The Federal Deposit Insurance Corpora tion thus plays a key role in settling depositors' claims against failed banks. In fact, in the vast majority of failure cases, the Cor poration is appointed receiver for the failed bank and for failed national banks must be ap pointed receiver. Regardless of the method of disposition chosen, substantial monetary out lays on the part of the FDIC will normally be required. Disposing of failed banks The FDIC has several options for dispos ing of failed banks. Unlike other business failures, which can be wound up only by a debt restructuring or by a liquidation, bank 25 failures can be handled in five distinct ways: (1) by "purchase and assumption"; (2) by "deposit payoff"; (3) by chartering a Deposit Insurance National Bank; (4) by providing financial aid; (5) by reorganizing. Only reorganizing does not involve the FDIC. Purchase and assumption. The FDIC is empowered to dispose of failed banks by arranging a merger with a sound bank (which may be newly chartered for that express pur pose). In a "purchase and assumption" negotiations are entered into between the FDIC and sound banks interested in acquiring the business of the failed bank. Acquiring banks must assume all deposit liabilities of the failed institution and may choose to assume other liabilities as well. In the typical case the assuming bank acquires all matured liabilities with the exception of long-term debt. Con tingent liabilities are usually not assumed.5 The assuming bank will acquire some, but not all, assets of the failed bank. Many of the failed bank's assets will not be sound, making them undesirable for purchase. If the bank failed through defalcation, some assets may be fictitious. Undoubtedly, some loans w ill have been classified .6 Typically, therefore, the assuming bank will acquire a smaller dollar amount of assets than liabilities. The difference is made up by a cash payment from the FDIC to the acquiring bank. Potential assuming banks bid com petitively for the opportunity to acquire the sound and ongoing business of the failed bank. Each competing bank submits a bid to the FDIC, which includes a promise to pay to the Corporation a specified sum of money, called a "premium," if the bid is accepted. Usually the FDIC will accept the bid that 5For an exhaustive definition of contingent liabilities, see Glenn G. Munn, E n c y c lo p e d ia o f B a n k in g a n d F in a n c e , 7th edition, 1973, pp. 222-3. In general, con tingent liabilities are obligations not expected to fall due. Some examples in banking are letters of credit, accep tances, accom m odation endorsements, liabilities resulting from pending or possible litigation, and futures contracts to deliver foreign exchange. Matured liabilities are those whose incurrence is definite and accomplished, such as deposits, capital notes, and rental charges for space and equipment. ‘Classified assets are those a bank examiner believes unlikely to repay all interest and principal. 26 carries the highest premium. The premium is "paid" in the form of a lower cash advance from the FDIC. That is, the FDIC pays out to the winner of the bidding enough cash to make up the difference between liabilities assumed and assets taken plus premium. In this transaction the FDIC gains title to all the assets not specifically selected by the assum ing bank (hence the term, "premium," in that the FDIC gains title to certain assets without any corresponding liabilities). The size of the premium and the FDIC's ability to collect in terest and principal on the assets it receives g overn th e chances that th e failed b a n k 's s t o c k h o ld e r s w ill r e c o v e r th e ir in v e s tm e n t. In addition to administering the ex change of assets and liabilities and paying the cash advance, the Corporation sometimes makes long-term loans to beef up the assum ing bank's capital position. Deposit payoff. The FDIC is seen most clearly in its role as guarantor of deposits when a bank failure is handled by the liquida tion or "deposit payoff" method. When a failed bank is paid off, the FDIC (assuming it has been appointed receiver) assesses the validity of depositors' claims against the failed bank. Secured or preferred depositors, such as political subdivisions, are paid first out of the failed bank's assets. Other depositors who have valid claims receive the value of their deposits from the FDIC, up to the insured maximum. Usually, the FDIC dis burses funds in the form of deposits in another bank. If a depositor has received a loan from the failed bank, the amount of the loan may be offset against his deposit. In exchange for paying depositors the value of their deposits, the FDIC acquires legal claims against the failed bank's assets and becomes a general creditor of the failed bank in the depositors' stead. As the assets of the bank are liquidated, creditors are compensated from the proceeds. The FDIC shares pro rata with other general creditors, such as depositors whose accounts exceeded the insurance maximum, suppliers of business forms or office equip ment, and similar other parties to whom the bank owes money. Economic Perspectives Deposit Insurance National Bank, in frequently, the FDIC sets up a new bank in place of the failed bank for a temporary time, normally two years. Chartered in effect by the Comptroller of the Currency, with no capital, the bank is titled Deposit Insurance National Bank (DINB) and is automatically granted deposit insurance. The bank makes no loans, holds only U.S. Treasury securities or other securities guaranteed as to principal and in terest by the U.S. government or cash assets, and conducts basically a payments business only. All insured deposits in the failed bank are transferred to accounts in the Deposit In surance National Bank. Failures handled as DINBs are classified as deposit payoffs, since depositors can withdraw the amount of their deposits. This method is used only where no other banking facilities are available in a community, in the hope that local people will be encouraged to organize a permanent bank for themselves. The FDIC can, if it wishes, sell the business of the DINB by accepting bids to capitalize the bank. Financial aid. A bank may become insol vent before any actual default on obligations occurs. The FDIC is empowered to make long-term loans to a distressed bank if the FDIC and the chartering regulator agree that continuance of the insolvent bank is necessary to the economic well-being of the community or is desirable because the demise of the bank would bring about ex cessive concentration of banking resources. Such loans, coupled with close supervision and perhaps mandatory changes in operating personnel and procedures, can help restore a distressed bank to a sound condition. The most notable occurrence of this type of assistance involves the Bank of the Com monwealth of Detroit, which has received loans totaling $35.5 million from the FDIC. Reorganization. State banking laws and the National Bank Act provide that a failed bank can be reorganized, presumably with reduced capital and other liabilities to reflect the reduced market value of its assets. In tervention by the FDIC is not required. Reorganization is especially useful when Federal Reserve Bank of Chicago liquidation of the bank will result in large losses for all classes of creditors. To invoke such a procedure, therefore, requires the concurrence of creditors holding claims to a large fraction of the bank's nonequity liabilities, typically 75 or 80 percent. Of the five methods of disposing of failed banks, legal reorganization is used least frequently—virtually never. Financial aid is used more often to prevent actual failure than to dispose of a failed bank. Deposit Insurance National Banks are used infrequently and are really only an alternative means of paying off depositors. The great majority of failed banks are handled either by purchase and assump tion or direct payoff. The FDIC seemingly has gone through cycles in which it preferred first one method of dealing with failures and then another. From 1934 to 1944 both payoff and assumption methods were extensively used. Between 1945 and 1954, however, every bank failure was handled as a purchase and assumption transaction. Then, from 1955 through 1964, almost all failures were paid off. Since 1965 both payoffs and assumptions have been used. Data on numbers of bank failures are un derstated, just as numbers of business bankruptcies are also understated. Besides the possibility of financial aid from the FDIC to keep a distressed bank afloat, emergency mergers are sometimes consummated before the acquired bank actually fails. Occasionally, the merger takes place with the blessings of the federal bank regulatory agencies but without any financial assistance. The most prominent example of this occurred in 1975, when the Security National Bank of Hempstead, New York, was acquired by Chemical Bank. Had the merger not taken place, Security, with deposits of $1.3 billion and assets of $1.7 billion, would have become the second largest bank failure in U.S. history. In other cases, the FDIC has used direct financial assistance to facilitate mergers. In 1975 the FDIC assisted in the merging of a newly organized bank with the Palmer First National Bank and Trust Company of Sarasota, Florida, after receiving assurances 27 that such assistance was necessary to bring about the acquisition and to avert the failure of Palmer First National. These are but two in stances in w hich failures have been preempted by mergers. It is not known how many insolvencies have been prevented this way. Normally, the FDIC chooses the method that minimizes the loss to the insurance fund. The distribution as well as the total amount of losses to creditors are strongly influenced by the method chosen by the FDIC. It is possible that one method—usually deposit payoff— may result in a somewhat smaller loss to the insurance fund while generating much larger losses to other creditors than any alternative method. However, when a large bank fails, the FDIC is under great pressure to handle the case by a purchase and assumption. Although possibly more costly to the insurance fund, a purchase and assumption guarantees that depositors, whether fully insured or not, will suffer no losses. What do bank failures cost? Regardless of the distribution of losses among creditors, bank failures impose costs upon society. Resources must be devoted to what is essentially the unproductive task of disposing of the failed bank, collecting in terest and principal from the failed bank's assets, and compensating creditors of the failed bank—tasks performed by the receiver and by the FDIC as insurer. Labor and other resources may be idled if the bank's demise results in a lack of credit in the community. If the payoff route is chosen, deposits are not immediately available to depositors. Thus, there is an opportunity cost due to the tem porary sterilization of working capital. This cost does not arise in purchase and assump tion cases. Those resources that had been allocated to businesses that failed (i.e., to defaulting debtors of the failed bank) and that could have been channeled to more produc tive uses represent wealth that, aside from any liquidation value that may remain, is per manently lost to society. The potentially most important social cost of bank failures is that 28 they might lead to a rapid contraction of the money supply, possibly inducing a period of economic depression. This is the cost that is the primary concern of bank regulation and deposit insurance. Finally, chronic failures might lead to a loss of faith in the payments mechanism. If people become disenchanted with “ bank money/' they will be induced to hold more currency. The fact that most money is presently held in the form of de mand deposits at commercial banks indicates that people generally prefer this form of money. Thus, the occurrence of a situation in which people are driven by uncertainty to hold more currency and less demand deposits than usual would impose a social cost. Even when bank failures do not result in net losses to society, they bring about transfers of wealth among individuals. Wealth has been transferred from creditors of banks—stockholders, other investors, and sometimes uninsured depositors—to debtors of banks—those whose failures to repay their borrowings brought about the insolvency. Under theoretically ideal conditions— accounting practices that correspond exactly with economic and financial theory and in stantaneous liquidation of a failed business— the dollar amount of wealth transfers from bank creditors to bank debtors will exceed the overall cost to society. This is true because bank debtors receive a net benefit from the amounts they borrowed and never repaid. Under real-world conditions, the estimates will likely diverge even farther. The major creditors of failed insured banks, in dollar terms, are depositors, the FDIC, bondholders, and stockholders. Estimating losses to these creditors will give a good indication of the up per bound of the cost to society from bank failures. Depositors. According to FDIC data,7 99.6 percent of the amount of deposits in banks failing from 1934 to 1976 has been paid or made available to depositors. Since in deposit assumption cases all deposits are im mediately available, losses to depositors arise only in deposit payoff cases. The vast majority 7A n n u a l R e p o r t o f t h e F e d e r a l D e p o s it In s u r a n c e C o r p o r a t i o n , 7976, tables 125 and 127. Economic Perspectives of deposits in paid-off banks has already been made available to depositors, mostly by direct payments from the FDIC (i.e., a demand deposit in another bank), but partly through offset against outstanding loans, through security or preference, or through the proceeds of asset liquidation. The FDIC ex pects eventually to repay about 96 percent of deposits in failed banks handled as deposit payoffs, leaving a loss of less than $20 million over the entire 1934-76 period. Thus, even though large deposits are not fully covered by deposit insurance, depositors of insured banks cannot be said to have sustained major losses from bank failures. On the other hand, losses in the form of opportunity costs (interest foregone while deposits are un available) may be quite large but are extreme ly difficult to calculate. FDIC. The Federal Deposit Insurance Corporation estimates that, based upon all its activities undertaken to protect depositors of failed banks, its total loss from banks failing between 1934 and 1976 will be just over $285 million. This loss covers not only dis bursements in payoff and assumption cases but also amounts advanced to protect assets, net losses on purchases of assets from operating banks, defaulted principal on loans made to operating banks to avert failure, and other similar expenditures. Thus, it is obvious that federal deposit insurance operates to shift the burden of risk from depositors to the Federal Deposit Insurance Corporation's in surance fund. Bondholders. Long-term capital notes and debentures are securities that have become relatively popular only in recent years. Thus, most losses to bondholders have occurred in the decade of the 1970s. Stockholders. Recoveries by stock holders are infrequent. The FDIC last publish ed a study of stockholder recoveries in its 1958 Annual Report. The overall finding was that in only 91 out of a total of 436 failures did stockholders recover any part of their investment. The method used by the FDIC to dispose of the bank influences the likelihood of recoveries by stockholders. Stockholder Federal Reserve Bank of Chicago recoveries are less likely in payoff cases because the class of general creditors is augmented by uninsured depositors. In purchase and assumption cases stockholders have on occasion received stock in the con tinuing bank, especially when two failing in stitutions were merged into a single sound bank or when a failing bank was merged into a newly chartered bank. In a few other scattered cases, stockholders of assumed banks also recovered a small fraction of their investment. It would appear that everyone seems to come out at least as well off when the deposit assumption route is chosen as when the FDIC pays off depositors directly. If so, why does the FDIC ev§r use the payoff method? There are several reasons. An assuming bank requires indemnification against legal actions that may arise as a result of the closing of a bank. In certain cases the uncertainty sur rounding a bank failure may be so great that such indemnification could prove expensive in terms of legal and court costs. In unit bank ing states finding a suitable merger partner can be quite difficult since the failed bank cannot be operated as a branch. Thus, the assuming bank, if it were not newly chartered, would have to be quite close by. Then, too, the FDIC could estimate that the total cost of paying off depositors could be less than arrranging a merger. Even in the assumption cases, the FDIC is saddled with some assets of the failed bank, normally the worst credit risks. Negotiation costs can be avoided if the FDIC takes over the entire portfolio. And all the purchase bids received by the Corpora tion could turn out to be negative numbers! Basically, while the FDIC was instituted to protect depositors in case of bank failures, it has a responsiblity to dispose of failed banks with minimum cost to itself. Estimating losses in the 1970s Losses are incurred by depositors only in payoff cases. Some failures handled as payoffs in the 1970s have involved banks whose depositors were fully insured. In other payoff cases, the percentage recovery by general 29 holding companies' assets, in all probability those holding companies will also file for bankruptcy. Because some of the holding companies themselves had long-term bonds outstanding, it is reasonable to assume that holders of those bonds will suffer losses. Since they are as yet unknown, these losses are not included in Table 2 but could easily exceed $100 million. Losses to the four major categories of creditors of failed banks totaled over $673 million for the seven years, according to the estimates in Table 2. Of this sum 60 percent represents losses to stockholders and another 31 percent represents losses to the FDIC. Depositors' losses are less than 1 percent of the total amount lost. Thus, it appears that federal deposit insurance accomplishes its major goal: insulating depositors from loss in the case of bank failure. Losses to debtholders, insignificant be fore 1973, are beginning to take on sizable proportions. This reflects both the increasing popularity of debt capital and the greater size of the banks that have failed in recent times. Since 1973 nearly 9 percent of total losses have been incurred by holders of capital notes and debentures. Franklin National Bank of New York had an especially large volume of capital notes outstanding, accounting for the large loss to bondholders in 1974. Losses to the FDIC tend to be con siderably larger than losses to depositors ex cept in the years in which the deposit payoff creditors (and therefore that of uninsured depositors) is known. In those payoff cases where the ultimate status of depositors' recoveries is not known, losses to depositors are estimated at 3V2 percent of total deposits. This figure is slightly higher than historical average losses in payoff cases. Losses to bondholders are estimated from information supplied by the Federal Deposit Insurance Corporation. The assump tion is made that bondholders of failed banks will lose the entire principal amount of their investments. No component is included for lost interest. Losses to the FDIC are the Corporation's estimates. Losses to stockholders are the most dif ficult to estimate. The ratio of the market value of common stock to the book value of equity for banks and bank holding companies whose equities are widely traded can be formed and applied to the book value of equity for banks that failed. Applying the ratio to book value of equity two years before failure should correct for the large losses sustained by failing banks prior to their clos ing. The assumption is made that stockholders lose the entire amount of their investment in banks that fail. Data on stockholders' equity are taken from the December Report of Con dition two years prior to failure. Several banks failing in recent years have been owned by bank holding companies. Since the banks comprised the bulk of the Table 2 Estimated losses d u e to ban k failures Disposition: Year Number of failures Deposit payoff Purchase and assumption Estimated losses to creditors Depositors Debtholders Stockholders FDIC Total (t h o u s a n d s ) 1970 1971 1972 1973 1974 1975 1976 Total 7 6 1 6 4 13 16 4 5 1 3 0 3 _3 3 1 0 3 4 10 13 $ 585 3,541 713 0 0 1,138 649 $ $ $ $ 53 19 34 $6,626 $54,246 $402,193 $210,762 $673,827 30 0 0 0 15,000 29,600 2,600 7,038 8,572 31,124 1,863 56,097 167,243 49,103 88,191 825 1,215 4,000 150,269 4,100 35,045 15,308 9,982 35,880 6,576 221,366 200,951 87,886 111,186 Economic Perspectives technique was relied upon most heavily. Thus, in 1970 and 1971 losses to depositors ex ceeded losses to the FDIC. The FDIC’s largest expected loss resulted from failures in 1973. Interestingly, the FDIC's losses expected from 1974 failures, including Franklin National Bank, should be quite small, while losses to stockholders will be extremely large. Thus, despite public and legislative con cern that an inordinately large number of banks have failed in recent years and that society has paid a heavy price in lost wealth, the evidence shows that bank failures are still relatively rare events and losses are borne, not by depositors, but by capital investors and the federal deposit insurance fund. Since insured banks themselves contribute insurance premiums out of their earnings, one can justifiably conclude that the banking system is fully capable of safeguarding the stock of bank money against all but the most drastic contingencies. Protecting against such ex treme contingencies, however, is properly the province of monetary and fiscal policy. Moreover, that losses in bankruptcies be borne by capital investors is fitting. Indeed, stockholders and bondholders should be ful ly aware of the risks they take in making in vestments in banks or in any other firm. Since they enjoy whatever return their investment brings, they should properly bear the risks. Summary • Two important legal distinctions sep arate bank failures from other business failures. In banking, the chartering authority, which is neither a creditor of nor an investor DigitizedFederal for FRASER R e s e r v e Bank of Chicago in a bank, is empowered to declare the firm insolvent; in other businesses, only creditors or the firm itself can initiate bankruptcy proceedings. While but two means of resolv ing a bankruptcy proceeding are available for most businesses, five methods can be used in banking. The two most commonly used methods are deposit payoff (liquidation) and purchase and assumption (merger into a sound institution). • Deposit insurance operates to reduce the number of bank failures and to minimize the financial impact of failures on small depositors. The FDIC accomplishes this by in serting itself in the legal proceedings between depositors and the failed bank, substituting a guaranteed reimbursement of the insured amount of an account for an uncertain claim against the assets of the failed bank. • Because of its prominent role in dispos ing of a failed bank, the FDIC is typically ap pointed receiver. The Corporation then serves in two roles: as guarantor of deposits, the FDIC is potentially a general creditor of the failed bank; as receiver, the FDIC is responsible for evaluating assets and liabilities and validating claims and preferences. • Bank failures generate costs, part of which can be thought of as wealth transfers and part of which represent net wealth losses to society. Wealth is transferred from creditors of banks to debtors of banks. • Estimates of losses to creditors of banks that failed from 1970 to 1976 reveal that stockholders and the Federal Deposit In surance Corporation bear the brunt of the costs, accounting for 91 percent of all losses sustained. 37
@FedFRASER