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MEETING ON THE CONDITION OF THE BANKING SYSTEM IE.~RARYJ  N l 11S17  /Jr.  HEARINGS  111  BEFORE THE  COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE NINETY-FIFTH CONGRESS FIRST SESSION  ON OVERSIGHT ON THE CONDITION OF THE BANKING SYSTEM AND REVIEW OF GENERAL ACCOUNTING OFFICE REPORT TO CONGRESS ON A STUDY OF FEDERAL SUPERVISION OF STATE AND NATIONAL BANKS  MARCH 10 AND 11, 1977  Printed for the use of the Committee on Banking, Housing, and Urban Affairs   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  FIRST MEETING ON THE CONDITION OF THE BANKING SYSTEM  HEARINGS BEFORE THE  COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE NINETY-FIFTH CONGRESS FIRST SESSION ON  OVERSIGHT ON THE OONDITION OF THE BANKING SYSTEM AND REVIEW OF GENERAL ACCOUNTING OFFICE REPORT TO CONGRESS ON A STUDY OF FEDERAL SUPERVISION OF STATE AND NATIONAL BANKS  MA.ROH 10 AND 11, 1977  Printed for the use of the Committee on Banking, Housing, and Urban Affairs  U.S. GOVERNMENT PRINTING OFFICE 86-817 0   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  W ASffiNGTON : 1977  COMMITTEE ON BANKING, HOUSING, A.ND URBAN A.FFA.IRS WILLIAM PROXMIRE, Wisconsin, Chairman JOHN SPARKMAN, Alabama EDWARD W. BROOKE, Massachusetts HARRISON A. WILLIAMS, JR., New Jersey JOHN TOWER, Texas THOMAS J. McINTYRE, New Hampshire JAKE GARN, Utah ALAN CRANSTON, California H. JOHN HEINZ III, Pennsylvania ADLAI E. STEVENSON, Illinois RICHARD G. LUGAR, Indiana ROBERT MORGAN, North Carolina HARRISON SCHMITT, New Mexico DONALD W. RIEGLE, JR., Michigan PAULS. S4RBANES, Maryland KENNETH A. McLEAN, Sta!! Director   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  s.  ,JEREMIAH BUCKLEY, Minority Staff Director CHARLES L. MARINACCIO, Special Oounsel  (II)  CONTENTS LIST OF WITNESSES THURSDAY, MARCH  10 '.Page  Arthur F. Bums, Chairman, Federal Reserve Board, accompanied by Brenton Leavitt, Director, Division of Banking Supervision and Regulation____ ________________________________________________________ Robert F. Keller, Deputy Comptroller General, accompanied by Ellsworth H. Morse Jr., Assistant Comptroller, Fred Layton, and Donald Allen, BankingTaskForce_____________________________________________ FRIDAY, MARCH  33 150  11  Robert E. Barnett, Chairman, Federal Deposit Insurance Corporation, accompanied by John Early, Director, Division of Bank Supervision___ Robert Bloom, Acting Comptroller of the Currency, accompanied by H. Joe Selby, First Deputy Comptroller of Currency for Operations, and John Shockey, Chief CounseL____ __ __ _________________________ ____ Prof. Hyman Minsky, Washington University_________________________ Prof. Bernard Shull, Hunter College, City University of New York______ Prof. Joe Sinkey, University of Georgia______________________________  211 317 356 464 471  ADDITIONAL STATEMENTS AND DATA  Comptroller General of the United States: Comment11 on Federal Reserve System staff analysis of Comptroller General's testimony of February 1, 1977, on GAO study of "Federal Supervision of State and National Banks" _________________ _ Study of Federal _____________________________________________ supervision of State &nd national banks: Introduction _ Entry into the national banking system _____________________ _ Con versions of Charters-Changes in supervisory agencies _____ _ Bank examinations: 1971-75 _______________________________ _ Bank problems identified by examinations ___________________ _ Reporting practices: 1971-75 ______________________________ _ Efforts to improve bank examination ________________ -------Effectiveness of agencies in resolving problems_ - ---- __ -------An analysis of banks that failed in the last 5 years ___________ _ Examiner capability and independence _________________ -- __ -Potential for better interagency cooperation _________________ _ Scope and approach of GAO study ____________ - - - _- - _- - - - - - Letter dated January 14, 1977, from the Comptroller of the Currency, to the General Accounting Office ____________ _ Letter dated January 16, 1977, from the Chairman, Federal Reserve Board, to the General Accounting Office _______ _ Letter dated January 17, -1977, from the Chairman, Federal Deposit Insurance Corporation, to the General Accounting_ _____________________________________________ Office Survey of commercial bankers ____________________ -----Principal officials responsible for administering activities discussed in this report ______________________________ _   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  (III)  105  567 583 607 619 673  687  703 735 794 812 834 845 853  866 896 962  976  IV Comptroller of the Currency: Index to appendices of statement of Robert Bloom: Appendix A: Statistical data on national banks requiring special supervisory attention, submitted to Chairman Proxmire on Pare February 15, 1977 ______________________________________ _ 1105 Appendix B: 1. Graph on selected bank ratios, December 1972 through December1976 __________________________________ _ 1181 2. Table on selected ratios on foreign and domestic operations of all national banks __________________________ _ 1182 3. Table on__________________________________________ NBSS selected ratios for national bank peer_ groups 1184 Appendix C: 1. Sample NBSS bank performance report ________________ _ 1185 2. Glossary of NBSS significant ratios ___________________ _ 1199 3. Sample NBSS action control status report ______________ _ 1202 Letter to Chairman Proxmire concerning the record of conversions of of banks from the State to the national system and vice versa ______ _ 335 List of former employees showing number of years worked and subsequent employment ________________________________________ _ 351 Number of banks and assets gained or lost by the national banking system due to conversions ____________________________________ _ 337 Federal Deposit Insurance Corporation: General memorandum, October 1976, regarding priorities, frequency, and scope of examinations ____________________________________ _ 314 Memorandum to regional directors from John J. Early, Director, Division of Bank Supervision, concerning liquidity analysis _______ _ 281 Problem bank summary received by the committee in answer to Chairman Proxmire's letter of February 8, 1977 ________________ _ 1032 Reprint of address of Frank Wille, chairman, November 6, 1973, before the National Correspondent Banking Conference of the American Bankers Association _______________________________ _ 267 Federal Reserve Board: Information received in response to Chairman Proxmire's letter of November 15, 1976: Glossary ________________________________________________ _ 985 Definition of rating scheme used by the Federal Reserve ______ _ 988 Number of banks in each rating category, 1971-76 ____________ _ 992 Deposits of banks by rating category, 1971-76 _______________ _ 993 Movement of banks within rating categories, December 31, 1975 through June 30, 1976 __________________________________ _ 994 Emergency or unusual borrowings by member banks ______ _ 995 Capital composition and ratios ____________________________ _ 997 Classified assets __________________________________________ _ 999 Aggregate loans __________________________________________ _ 1000 Short-term liabilities ______________________________________ _ 1000 Investment securities _____________________________________ _ 1001 Other real estate ____________ ---- __________________ ---- ___ _ 1001 Standby letters of credit ___________________________________ _ 1001 Loans to officers, directors, employees and their interests ______ _ 1002 Actions taken under the Financial Institutions Supervisory Act of 1966 _______________________________________________ _ 1003 Alleged violations of law ___________________________________ _ 1019 Failed banks _____________________________________________ _ 1022 Mergers or acquisitions to avert failure ______________________ _ 1026 Letter from Brenton C. Leavitt, Division of Banking Supervision and Regulation, to the officer in charge of examinations at each Federal Reserve bank ______________________________________________ _ 79 Letter from Chairman Burns to Senator Proxmire concerning classifification of problem banks ___________________________________ _ 79 Reprint of an address by Arthur F. Burns, at the 12th annual meeting of the Society of American Business Writers, Washington, D.C., May 6, 1975 ________________________________________ -- -- -- -125 Staff analysis of testimony presented by Comptroller General before the House Committee on Banking, Finance, and Urban Affairs ____ _ 82   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  V  Library of Congress, Congressional Research Service, U.S. commercial banks: Selected data series illustrating the financial condition of the industry________________________________________________________ Minsky, Hyman P., Washington University, reprint of papers titled: "Financial Instability Revisited: The Economics of Disaster"________ "Suggestions for a Cash Flow-Oriented Bank Examination"__________ Sinkey, Joseph F., Jr., University of Georgia, reprint of papers titled: "Problem and Failed Banks, Bank Examinations and Early-Warning Systems: A Summary"--------------------------_____________ "The Bank-Examination Process and Major Issues in Banking: A survey_____________________________________________________   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Page  3  387 429  504 532  FIRST MEETING ON THE CONDITION OF THE BANKING SYSTEM THURSDAY, MARCH 10, 1977  U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington,D.0. The committee met at 10 a.m., in room 5302, Dirksen Senate Office Building, Senator William Proxmire ( chairman of the committee) presiding. Present: Senators Proxmire, Sparkman, Morgan, Tower, and Lugar.  OPENING STATEMENT OF CHAIRMAN PROXMIRE The CHAIRMAN. The committee will come to order. Chairman Burns, we welcome you as the opening witness in the first set of oversight hearings on the health of the banking system. You recommended these hearings as a matter of fact with considerable force, as you may recall. You recommended that this committee hold periodic oversight hearings twice each year in order to apprise ourselves of the condition of the banking system on a continuing basis. The events of the past 5 years have led to the most serious doubts since the depression years of the 1930's about the strength of our banks. In that time we have had the worst failures since the advent of the FDIC. These failures sent tremors throughout the financial community. The FDIC has changed the rules of the game very greatly. We now have deposits insured up to $40,000 and this made an immense difference, but we still have most serious problems. The recent history shows that I think that we are capable of averting a repeat of the 1930's. The GAO recently conducted an audit of how well the banking system is doing. By and large they established they have a long way to go to improve the job they are doing and Con~ress needs to establish a legislative framework within which the regulators can do their job more effectively. An examination of the banking system must go together with an examination of the regulatory process. We expect the regulators to insure a safe and sound banking system. The condition of t'he banking system is in my view in part a reflection of the performance of bank regulators, not entirely certainly but in part. Let's make no mistake about it-it is absolutely necessary to have a healthy banking system. Our domestic economy and the international economy cannot prosper without one. Now what are the facts1 Bank failures are running several times greater on the average during the past 5 years than they did for the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  (1)  2 previous 10. The number and size of problem banks has become a disturbing concern. Classified assets, reflecting underlying values, have exploded in recent years to over 100 percent of capital at national banks over $5 billion and 80 percent of capital at State member banks over $5 billion. The capitalization of our banks, particularly the large banks, is far too low. The percentage of total capital to total assets for national banks over $5 billion is 4.9 percent and 5 percent for State member banks in this category. The Federal Reserve baseline measure for capital adequacy has been suggested at 8 percent. The undercapitalization of these banks leaves them particularly vulnerable to recessions. Moreover, our banks hold $250 billion in foreign loans representing 20 percent of their loan portfolios. The percentage of such loans at the larger banks in some cases is over 50 percent of their loan portfolio, and many of these loans are to underdeveloped countries carrying high risks with their high earnings. We all hope we are on the verge of an economic recovery. An undercapitalized banking system and one heavily committed to foreign loans could seriously slow recovery or conceivably abort it. We need to take action to see that that doesn't take place. You're confronted, unfortunately, Dr. Burns, with a series of dilemmas. I'm sure you're much more aware of that than we are, but let me very quickly state them. For one thing, we wouldn't expect the Chairman of the Federal Reserve Board, particularly a mart of your great wisdom and judgment and experience, to come in and paint a dire and gloomy picture. That would obviously be counterproductive and self-fulfilling. At the same time, I know you will, as you always have, give us the facts straight and honestly and fully and I'm sure that you will do that for us this morning. In the second place, if we place a too conservative and restraining policy on the banks they will not provide industry with the capital that a strong recovery demands. If in the interest of concentrating our available bank capital here at home and minimizing risks, we discourage lending to the lesser developed countries, immense sources of funds for the poorer countries of the world are denied them and the professional expert supervision that private banking can provide, better than government in my judgment, will also be discouraged; In fact, banks are now lending $50 billion to LDC's which is a potentially serious problem in the soundness of our banks, but if we insist those loans be called or even not further expanded the effects on developing countries can be very discouraging indeed. The $250 billion I referred to in total of foreign loans made by our banks represents more than 20 percent of all loans outstanding. Indeed, our biggest banks are far more deeply enmeshed in this web. The five biggest banks had profits of 40 percent last year which came from overseas lending and such loans accounted for 78 percent of the 1976 profits of Chase Manhattan, The improvement in the economy in the past 2 years has also helped to provide some improvement in the safety and soundness of the banks, but that improvement still leaves a relatively a dangerous situation for many banks and an implication if we move into another recession our banking system would be in more serious trouble than it was a few years ago. [The charts referred to follow :]  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  3  THE LIBRARY OF CONGRESS CongYessional ReseaYch SeYvice  WASHINGTON, D.C. :IOJ40  U.S. COMMERCIAL BANKS: SELECTED DATA SERIES ILLUSTRATING THE FINANCIAL CONDITION OF THE INDUSTRY  Prepared for the Committee on Banking, Housing and Urban Affairs, United States Senate   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  by Roger S. White Analyst in Money and Banking Economics Division (in consultation with staff of the Conunittee) March 7, 1977  4 U.S. COMMERCIAL BANKS: SELECTED DATA SERIES ILLUSTRATING THE FINANCIAL CONDITION OF THE INDUSTRY  The series of graphs contained in this collected set depict recent trends in selected financial aspects of the commercial banking industry in the United States.  Data used for constructing the graphs was  obtained from special reports requested by the Senate Committee on Banking, Housing and Urban Affairs from the Board of Governors of the Federal Reserve System, the Comptroller of the Currency and the Federal Deposit Insurance Corporation.  Each agency reported data for banks  for which it has primary supervisory authority. Where possible, the graphs contain information for a series of years. groups.  In a number of cases, data is presented for selected bank size An effort has been made to use the same format in portraying  data from each agency.  Differences among the agency reports in infor-  mation supplied, however, has not made this possible in all cases.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  i  5 U.S. COMMERCIAL BANKS: SELECTED DATA SERIES ILLUSTRATING THE FINANCIAL CONDITION OF THE INDUSTRY FIGURES  FIGURE NUMBER  PROBLEM BANKS National problem banks (categories 3 and 4), number and deposits as a percent of deposits of all National banks, 1971-1976 ••••••  1  State inember problem banks (categories 3 and 4), number and deposits as a percent of deposits of all state member banks, 1971-1976  2  Insured nonmember problem banks, number and total deposits, 1976 and 1977 • •• • • • • • • • • • • • • • •• • • • • • • • • •• • • • • • • • • • • • • • • • • • • • • • • • • • • •  3  BANK FAILURES All insured banks failed or absorbed to avert failure, number and total assets, 1972-1976 ··••••·•······•••••·••··•··•··•••••·•·•••  4  National banks failed or absorbed to avert failure, number and total assets, 1972-1976 •·••··•••••··•·····•·•••·•··•·••···•···••  5  State member banks failed or absorbed to avert failure, number and total assets, 1972-1976 •··•··•••••••••·••··•·••·•·••·•·•·•••  6  Insured nonmember banks failed or absorbed to avert failure, number and total assets, 1972-1976 •·•·••·•·••·•······•····•····••••  7  CAPITALIZATION Total capital as a percent of total assets, National banks, selected size categories, 1971-1976 ••••••••••••••••••••••••••••••••••  8  Total capital as a percent of total assets, State member banks, selected size categories, 1971-1976 •·••·••••·•·•··•······••·••••  9  Total capital as a percent of total aasets, insured nonmember banks, selected size categories, 1971-1976 •·······•····•·••··•········• 10 Total capital as a percent of risk assets, National banks, selected size categories, 1971-1976 ····················•····•·•···••·•••·  11  Total capital as a percent of risk assets, State member banks, selected size categories, 1971-1976 ·••·••·•···•·•·•····•·•·•·•··  12  Total capital as a percent of risk assets, insured nonmember banks, selected size categories, 1971-1976 ·•··•··•·••···•·•·••··•••·•·•  13   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ii  6 QUALITY OF ASSETS RELATIVE TO CAPITAL  FIGURE NUMBER  Classified assets as a percent of gross capital funds, National banks, selected size categories, 1971-1976 •···•·•··•·•········  14  Classified assets as a percent of total capital, State member banks, selected size categories, 1971-1976 ···•·•·•·•·•·•••••••  15  Classified assets as a percent of total capital, insured nonmember banks, selected size categories, 1971-1976 ···••••·•·••·•••  16  Other loans especially mentioned as a percent of gross capital funds, National banks by size category, 1976 ·•·•··········•·••  17  Specially mentioned assets as a percent of total capital, insured nonmember banks by size category, 1976 ··•··•·•······•·•••····•  18  Total loans as a percent of total deposits for National banks, selected size categories, 1971-1976 •••••••••••••••••••••••••••  19  Total loans as a percent of total deposits for State member banks, selected size categories, 1971-1976 •·•·•·•·•••···•·•·••  20  Total loans as a percent of total deposits for insured nonmember banks, by size category, June 30, 1976 ••·····••··•·•····••··••  21  Dividends as a percent of net income, large banks controlled by bank holding companies, classed by agency affiliation of lead banks within individual holding companies, 1971-1975 ••·•••·•··  22  Real estate owned other than bank premises, National banks, selected size categories, 1971-1976 •••••••••••••••••••••••••••  23  Real estate owned other than bank premises, State member banks, selected size categories, 1971-1976 •••••••••••••••••••••••••••  24  Extensions of credit to directors, officers, employees and their interests, 1976 • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • •  25  Standby letters of credit by agency affiliation for selected size categories, June 30, 1976 •••••••••••••••••••••••••••••••••••••  26   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  iii  7 CRS-1  NATIONAL PROBLEM BANKS (CATEGORIES 3 AND 4), NUMBER AND DEPOSITS AS A PERCENT OF DEPOSITS OF ALL NATIONAL BANKS, 1971-1976' Perce,..nt;...__ _ _ _ _ _ _ _ _ _ _ _ _ _ _-.;;..;,Percent  40  40  30  30  20  20  10  10  o.___.____.____.____.____.____.__,o Number of Problem Banks  Number of Problem Banks  200  200  100  100  1w_._2_ _ 12m_.___1_w_._4__1_w_._s_ _ &n~s--o 0 .__1w_._1_ _ Year Data Source: Comptroller of the Currency.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  8 CRS-2  STATE MEMBER PROBLEM BANKS (CATEGORIES 3 AND 4), NUMBER AND DEPOSITS AS A PERCENT OF DEPOSITS OF ALL STATE MEMBER BANKS, 1971-1976 Percent  40  40  30  30  20  20  10  10  o.__.____._____.__ ____.___.___.___.o Number of Problem Banks  Number of Problem Banks  60  60  40  40  20  20  0---------....__ _.._____.__ ___.__ ___.___.o 1971  1972  1973  1974 Vear  Data Source: Board of Governors of the Federal Reserve System.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1975  1976  9 CRS-3  INSURED NONMEMBER PROBLEM BANKS, NUMBER AND TOTAL DEPOSITS, 1976 AND 1977  $ Billi,..o_n_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ $_,Blllion  .,.~ ., ., ., .,., ., ., ., .,  8  6  8  6  -·-·-·'  -----·--------  -■-·-·-·-·-· ,, ,,  4  ,,,, ,, ,,,,  4  Key: -  2  Serious Problem - Potential Payoff Banks  2  • - - Serious Problem Banks -•-• Other Problem Banks  o.__...,________.._________._ ___,o Number  Number  200 ._ 150 ._  -·-·-·-·-·-·-·-·-·-  ■---■-·-· -■-·-·-·  100 .._ 50 -  - 200 - 150 - 100  -------------------------·  - 50  0 ,___~l_ _ _ _ _ _ _~l_ _ _ _ _ _ _~l_ ___. 0 111n& 111n& 111m Date Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Federal Deposit Insurance Corporation.  10 CRS-4  ALL INSURED BANKS FAILED OR ABSORBED TO AVERT FAILURE, NUMBER AND TOTAL ASSETS, 1972-1976 Total Assets ($ Billion)  Total Assets ($ Billion)  4  4  3  3  2  2  1  1  o...__ _._____._____._____._____.__ __,o Number of Banks  Number of Banks  30  30  20  20  10  10  o,___......____....._____._____._____.__ _,o 1972  1973  1974  1975  Year Data Sources: Board of Governors of the Federal Reserve System   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Comptroller of the Currency Federal Deposit Insurance Corporation  1976  11 CRS-5  NATIONAL BANKS FAILED OR ABSORBED TO AVERT FAILURE, NUMBER AND TOTAL ASSETS, 1972-1976 Total Assets ($ billion)  Total Assets($ billion)  4  4  3  3  2  2  1  1  o-------___.____._____,____.__ __.o Number of Banks  Number of Banks  6  6  3  3  o-------___.____._____,____.__ __.o 1972  1973  1974 Year  Data Source:  Comptroller of the Currency.   86-817 0 - 77 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 2  1975  1976  12 CRS-6  STATE MEMBER BANKS FAILED OR ABSORBED TO AVERT FAILURE, NUMBER AND TOTAL ASSETS, 1972-1976 Total Assets ($ million)  Total Assets ($ million)  1000  1000  800  800  600  600  400  400  200  200  0L_J_  _::~.1...-!!!!!!!!~:::::.-_L_ __1__~0  Number of Banks  Number of Banks  2  2  1  1  1972  1973  1974  1975  Year Data Source: Board of Governors of The Federal Reserve System •.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1976  13 CRS-7  INSURED NONMEMBER BANKS FAILED OR ABSORBED TO AVERT FAILURE, NUMBER AND TOTAL ASSETS, 1972-1976 Total Assets ($ Million)  Total Assets ($ Million)  400  400  300  300  200  200  100  100  o~------~--------~-----------o Number of Banks  Number of Banks  20  20  10  10  o.__.__---'-_.____.____.____.___.o 1972  1973  1974 Year  Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Federal Deposit Insurance Corporation.  1975  1976  14 CRS-8  TOTAL CAPITAL AS A PERCENT OF TOTAL ASSETS, NATIONAL BANKS, SELECTED SIZE CATEGORIES, 1971-1976 Percent  Percent  8  -·· -·-· -■-·-· -·-·-·-·-· -■-·-·-· ----·-·-· ---·  ··-·-  7  ---------------------  8  7  6  6  5  5  4  4  3  3  Bank Deposit Size Categories:  2  2  Over $5 Billion • - - - -  $500 Million to $1 Billion  ■■-■-■- Under $100 Million  1  1  O 12/"J1fl1 12/"J1fl2 12/"J1fl3 12/"J1fl4 12/"J1fl5 6/.30fl6 O Year Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Comptroller of the Currency.  15 CRS-9  TOTAL CAPITAL AS A PERCENT OF TOTAL ASSETS, STATE MEMBER BANKS, SELECTED SIZE CATEGORIES, 1971-1976 Percent  9  Percent  ·-·-··... , , ,,...... ......... -------- -·-· --·___-·-·-·-·-·-·,...  ~,.___ ........... -•-•:;.-.:.  8  9  ......  8  7  7  6  6  5  5  4  4  3  3 Bank Deposit Size Categories:  2  ----··-·-·-  1  Over $5 Billion  2  $500 Million to $1 Billion Under $50 Million  1  O 12/31fl1 12/31fl2 12/31fl3 12/31fl4 12/31fl5 6/30fl6* O Year *Percentages lowered for 6/30/76 by changes arising from new reporting format. Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board of Governors of The Federal Reserve System  16  TOTAL CAPITAL AS A PERCENT OF TOTAL ASSETS, INSURED NONMEMBER BANKS, SELECTED SIZE CATEGORIES, 1971-1976 Percent  Percent  9  8  9  -·---~-·-·-·-·-·-·-·-· --·-·-·-■-·-·-·-· I  7  ---------  ------  8  7  6  6  5  5  4  4  3  3 Bank Deposit Size Categories:  2  Over $1 Billion ■ • • • •,  2  $500 Million to $1 Billion  ••••••• Under $100 Million  1  1  O 12/31fl1 12/31fl2 12/31fl3 12/31fl4 12/31fl5 6/30fl6 O Vear Data Source:  Federal Deposit Insurance Corporation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  17 CRS-11  TOTAL CAPITAL AS A PERCENT OF RISK ASSETS, NATIONAL BANKS, SELECTED SIZE CATEGORIES, 1971-1976 Percent  11  10  Percent  .............  ,.,·,.-  ·-·-·-·-·-·-·-·-·-·  -·-·-·-·  11 10  9  9  8  8  7  7  6  6  5  5  4  4  3  3 Bank Deposit Size Categories: - - - Over $5 BIiiion  2  - - - - - $500 Million to $1 Billion ••-•-•- Under $100 Million  1  2  1  O 12/31fl1 12/31fl2 12/31fl3 12/31fl4 12/31fl5 6/30fl6 O Year Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Comptroller of the Currency.  18 CRS-12  TOTAL CAPITAL AS A PERCENT OF RISK ASSETS, STATE MEMBER BANKS, SELECTED SIZE CATEGORIES, 1971-1976  .---------------------------,Percent  Percent  12.5  ...  -------- -------- ---___, ,, ,------. ..........·-·-·-·-·-·-·-·-·-·-·-·-·-·-·-·  12.5  ;  10.0  ;  5.0  10.0  5.0  Bank Deposit Size Categories: - - - Over $5 Billion • - - - • $600 Million to $1 Billion  2.5  2.5  ••-•-•• Under $50 Million  O 12/31fl1 12/31fl2 12/31fl3 12/31fl4 12/31fl5 6/30fl6* O Year "Percentages lowered for 6/30/76 by changes arising from new reporting format. Data Source: Board of Governors of The Federal Reserve System.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  19 CRS-13  TOTAL CAPITAL AS A PERCENT OF RISK ASSETS, INSURED NONMEMBER BANKS, SELECTED SIZE CATEGORIES, 1971-1976 Percent  Percent  12  -........  12 ....  ·-·-·-·-·-·-·-·-·-·  -■-·-  ·-·-·-·-·  --------------·  10  10  8  8  6  6  4  4  2  Bank Deposit Size Categories:  2  - - - Over $1 Billion • - - - - $500 Million to $1 Billion ••-•-•• Under $100 Million  0 12131n1 12131m 12131n3 12131n4 12131ns &.tJOn& Year Data Source:  Federal Deposit Insurance Corporation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  0  20 CRS-14  CLASSIFIED ASSETS AS ~ PERCENT OF GROSS CAPITAL FUNDS, NATIONAL BANKS, SELECTED SIZE CATEGORIES, 1971-1916 Percent .-----------------------,  Percent  100  90  Bank Asset Size Categories:  100  - - - Over $5 Billion - - - - • $500 Million to $1 Billion ••-•-•• Under $100 Million  90  80  80  70  70  60  60  50  50  40  40  ------  30  20  ,, ,, ,, ,, ,,  -------,, -·-· -·-·-·-·-·-·-·-·-·-·-·-· -· ____ .....  __  10  30 20  -■-·-·-·10  o....___._____.___.._____._____._____._~o 1971  1972  1973  1974 Year  Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Comptroller of the Currency.  1975  1976  21 CRS-15  ClASSIFIED ASSETS AS A PERCENT OF TOTAL CAPITAL, STATE MEMBER BANKS, SELECTED SIZE CATEGORIES, 1971-1976 Perce,...n_t- - - - - - - - - - - - - - - - - - - - ~ P . . c . , e r c e n t  Bank Deposit Size Categories:  120  - - - Over $5 Billion • • - - • $500 Million to $1 Billion  120  ••-•-•• Under $50 Million  100  100  80  80  60  60  ,,,.,, ,,  40  ,,,,  ----------  20  ,, ,,,,  ~-·-·-·-·-·-·-·-·-·-·  ---·-·-·---·-·-  40  20  o._____.____..____.____._____.____.___,o 1971  1972  1973  1974 Year  • Data for 1976 are incomplete. Data Source: Board of Governors of The Federal Reserve System.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1975  1976*  22 CRS-16  CLASSIFIED ASSETS AS A PERCENT OF TOTAL CAPITAL INSURED NONMEMBER BANKS, SELECTED SIZE CATEGORIES, 1971-1976 Percent  Percent  Bank Deposit Size Categories: Over $1 Billion  60  $500 Million to $1 Billion  - - - - -  ••-•-•• Under $100 Million  50  40  I  30  , 20  ,  ,, ,/ , ,,...... ,, ,,,, ...........,  -·-·-·-  ■---■-■ -l-·  '  -·-·  I  I  I  I  I  I  I  ------  60  50  40  -·-·  ,·,· ,· ,·  ,.,•  10  I  I  I  I  I  I  I  30  20  10  0L-----L----1----'-----1----'-----'----'0 1971 1972 1973 1974 1975 1976 Year Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Federal Deposit Insurance Corporation.  23 CRS-17  OTHER LOANS ESPECIALLY MENTIONED AS A PERCENT OF GROSS CAPITAL FUNDS, NATIONAL BANKS BY SIZE CATEGORY, 1976 Percent  Percent  50._  1  - 50  lltBl1l  iilllll  40._  30 -  1  il l11  20 -  - 40  - 30  - 20  1111111 10 -  - 10  i!!ltl  :!:i:i:i:~:i:i:!:~:i:i:[: _ _ _ __J0 0L------~=...:.L-- J:i==L-._ $1 Billion Over to $5 Billion $5 Billion Deposit Size Category  Data Source:  Comptroller of the Currency.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  24 CRS-18  SPECIALLY MENTIONED ASSETS AS A PERCENT OF TOTAL CAPITAL INSURED NONMEMBER BANKS BY SIZE CATEGORY, 1976 Percent  Percent  - 30  25 .._  - 25  20 .._  - 20  15 .._  - 15  10 ,_  - 10  5 ,-..  -5  rlllll  ::::::_:l::_;:::_:::::'·='=: __ i=:::;::~:_._,:: __ i=:::;:: __ :::1::·i:::·;:::_:_::,::!::_i .. :::._:!.__ 1::i .. ::::._!_::_:::_i::_:;:.:i __ :,:::j::_·i .. ::_i=.::i :~: .. .. :.:  l:!ll:lll:lllllllilllll:l:llli -- - -- o.__....... .:.:.:.:.:="'---===.._--"'= ......=-.......;.:.:.:.:.=....__-~o Under $100 Million  $100 Million to $500 Million  $500 Million to $1 Billion  Deposit Size Category Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Federal Deposit Insurance Corporation.  $1 Billion to $5 Billion  25 CRS-19  TOTAL LOANS AS A PERCENT OF TOTAL DEPOSITS FOR NATIONAL BANKS, SELECTED SIZE CATEGORIES, 1971-1976 Percent  Percent  70  70  65  65  60  60  55  55 Bank Deposit Size Categories: - - - Over $5 Billion • - - - - $500 Million to $1 BIiiion ••-•-•• Under $100 Million  0 12131n1 12131m 12131n3 12131n4 12131ns &/30n& Year Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Comptroller of the Currency.  0  26 CRS-20  TOTAL LOANS AS A PERCENT OF TOTAL DEPOSITS FOR STATE MEMBER BANKS, SELECTED SIZE CATEGORIES, 1971-1976 Percent  Percent  70  70  65  65  60  60  ,.,.-· ,. ,.  55  -·-·-·-·-·-·-·-·-·-·-  -■-■-•-·'·  55 Bank Deposit Size Categories: - - - Over $6 Billion - - - - • $500 Million to $1 Billion •-•-•-• Under $50 Million  0 12131n1 12131n2 12131m 12131n4 12131ns &iJOn& 0 Year Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board of Governors of The Federal Reserve System.  27 CRS-21  TOTAL LOANS AS A PERCENT OF TOTAL DEPOSITS FOR INSURED NONMEMBER BANKS, BY SIZE CATEGORIES, JUNE 30, 1976 Percent  Percent  60 -  - 60  50-  - 50  40 -  - 40  30 ,-  - 30  20 ,-  - 20  10 -  - 10  0'--~~-.:.:.:.:.a""""~~'""'"~~,:,;,;,:,~-.:.,:.:.:.:,:"""""'"""'--'0 Under $100 Million $500 Million $1 Billion $100 MIiiion  to $600 Million  to $1 Billion  Deposit Size Category Data Source:  86-817 0 • 77 • 3   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Federal Deposit Insurance Corporation.  to $5 Billion  28 CRS-22  DIVIDENDS AS A PERCENT OF NET INCOME, LARGE BANKS CONTROLLED BY BANK HOLDING COMPANIES, CLASSED BY AGENCY AFFILIATION OF LEAD BANKS WITHIN INDIVIDUAL HOLDING COMPANIES, 1971-1975 Percent  Percent .-----------------------,  60  60  --- ------- ,,' ,,  ,,, ' ,,,..,,  50  ,. 50  40  40  .  --. .._  30  .....__·--.-·-·-·-·-·-·-·-·-..  20  30  20 Key: National Banks with - - - Deposits Over $6 Billion State Member Banks with - - - - - ■ Deposits Over $5 Billion Insured Nonmember Banks -•-•-•-• with Deposits Over $1 Billion  10  10  o...__ _.______._____.____.____.__ ___.o 1971  1972  1973  1974  Year Data Source:  Board of Governors of The Federal Reserve System.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1975  29 CRS-23  REAL ESTATE OWNED OTHER THAN BANK PREMISES, NATIONAL BANKS, SELECTED SIZE CATEGORIES, 1971-1976  $ Mill... io_n_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _--'$--.Million  Bank Deposit Size Categories:  350  - - - Over $5 Billion - - - - • $500 Million to $1 Billion ••-•-•• Under $100 Million  350  300  300  250  250  200  150  150  ,.,. , ,,, .,. ,,,, ,.  100  50  -·-  .-..{tttl'J  ,,  ---------------  ,  ,,  ,,  O 12/J1fl1 12/J1fl2 12/J1fl3 12/J1fl4 12/J1fl5 6iJOfl6 Year Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Comptroller of the Currency.  100  50  O  30 CRS-24  REAL ESTATE OWNED OTHER THAN BANK PREMISES, STATE MEMBER BANKS, SELECTED SIZE CATEGORIES, 1971-1976 $ Mill;:::io::.:.n_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _....;$:...:.;;Million  Bank Deposit Size Categories:  350  - - - Over $5 Billion  350  - - - - • $500 Million to $1 Billion  ••-•-•• Under $50 Million  300  300  250  250  200  200  150  150  100  100  50  ,,,,,  _-------J _____ ...,----------·-·-·-·-·-·-·· -·-·-·- -·-·-·-·Year Data Source:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board of Governors of The Federal Reserve System.  50  31 CRS-25  EXTENSION OF CREDIT TO DIRECTORS, OFFICERS, EMPLOYEES AND THEIR INTERESTS; 1976. Extensions ($ Billion)  Extensions ($ Billion)  $4.5 Billion  4 -  -4  3 -  -3  2 -  -2  1 -  -  1  $0.5 Billion  111111111111111111111111111111 O.__ __...................'----""""""""""'""'"~---"'"'"'"'"'"'"'"'"'""'"'""'...__........,O  State Member Banks National Banks (Problem Banks (with Deposits Over Only) $1 Billion Only)  Insured Nonmember Banks  *Data does not include extensions of credit to all controlling stockholders and their interests. Data Sources: Board of Governors of The Federal Reserve System.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Comptroller of the Currency. Federal Deposit Insurance Corporation.  32 CRS-26  STANDBY LETTERS OF CREDIT BY AGENCY AFFILIATION FOR SELECTED SIZE CATEGORIES, JUNE 30, 1976 $ Billion  Banking  $ Billion  National  State Member  Data Sources: Comptroller of the Currency. Board of Governors of The Federal Reserve System.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Federal Deposit Insurance Corporation.  Insured Member  33 The Chairman. I'd like to just spend another minute calling your attention to a series of charts developed by the Library of Congress. The one that we have posted here tell part of the problem. They indicate some degree of improvement, as we can see. The deposits of State member banks in the problem category obviously went up very sharply and still hasn't come down very much. The national problem banks, that is the national banks who are problem banks, went up very sharply, too, and has not come down greatly. But I would like to call your attention also to the fact that insured, nonmember problem banks, the number in total deposits, 1976 and 1977-that's chart 3 which you have before you-shows a steady increase, virtually no improvement. Chart 7, insured nonmember banks failed or absorbed to avert failure, the number in total assets 1972 to 1976, that's on a rising scale with enormous increase between 1972 or even the bad year in 1973, it's gone far above that. It's doubled over the 1973 losses. The number of banks has also increased and seems to continue to increase. Chart 14 indicates that classified assets as a percentage of gross capital funds for national banks has continued to go up with no improvement. In 1976, the latest. year for the biggest banks, it's well above 100 percent; that is, the banks over $5 billion in size. Chart 16 indicates that classified assets as a percentage of total capital insured nonmember banks, there's again a continually bad story right. up to 1976. Chart 17, other loans, specially mentioned, as a percentage of gross capital funds, these I take it are loans that are considered questionable or at least subject to special mention-they now constitute more than 50 percent of the capital of the big banks; that is, the banks with $5 billion or more in assets. There are other very disturbing indications here, including an immense increase in the real estate owned other than· bank premises by banks suggesting that the effects of the REIT investments are still to be felt. At any rate, the overall picture is one that has disturbed not only members of this committee but members of the press and other Members of Congress, and I think it's most timely that you come before us to give us your reactions. · STATEMENT OF ARTHUR F. BUitNS, CHAIRMAN, FEDERAL RESERVE BOARD, ACCOMPANIED BY BRENTON C. LEAVITT, DIRECTOR, DIVISION OF BANKING SUPERVISION AND REGULATION Mr. B:cmNs. Thank you very much, Mr. Chairman. Before I plunge into my testimony let me make a few remarks. First, I have been accustomed over the years to testify by myself, but I'm departing from custom today. I have with me Mr. Leavitt, whom I would like to introduce to you now. Mr. Leavitt is the Director of our Division of Supervision and Regulation. He was an examiner in the State of Wyoming for some 5 years and he's been with the Federal Reserve for some 25 years since then. He's a great authority on supervisory problems and, therefore, I'm going to depend very heavily on him-   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  34 as I think the committee will have to-since his knowledge is far more extensive in this area than my own. My second remark concerns these charts, some of which I recognize but o_ne or two of which I don't. I would like the privilege of commentmg on these charts for the record after this meeting. The CHAIRMAN. Very good. We would be happy to have that. [Dr. Burns submitted the attached letter for inclusion in the record at this point.] CHAIRMAN OF THE BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM, Hon.  Washington, D.C., March 29, 1977. WILLIAM PROXMIRE,  Chairman, Committee on Banking, Ho-using, and, Urban Affairs, U.S. Senate, Washington, D.C.  DEAR MR. CHAIRMAN : At the March 10 hearing on the State of the Banking System there were displayed certain charts that had been prepared by the Congressional Research Service of the Library of Congress. At the outset of the hearing I asked for, and you graciously granted, the privilege of submitting comments on those charts for the record. However, the points that I had intended to make were covered adequately during the hearing, in responses by Mr. Leavitt and myself to questions of Committee members. _Accordingly, I find it unnecessary to submit any comments on the charts for the record. Sincerely yours, ARTHUR F. BURNS.  Mr. BuRNS. Finally, my testimony is long, and I'm really torn between two desires. One is to read the whole report to you; this is the first meeting of this kind, and I think that my report is well balanced. On the other hand, I hesitate to take all the time that is necessary to read a report of 28 pages. Therefore, I will cut down my report severely now. I do hope that every member of the committee will take the time later on to read my statement in its entirety; as I've indicated, I think it's a we.ll-balanced presentation. The CHAIRMAN. I will do my best to call that to the attention of the committee. Mr. BURNS. Turning to my report, let me say Mr. Chairman, that I attach very special importance to this meeting at which I shall be reporting to you, on behalf of the Board of Governors, on the condition of the banking system. As you indicated, Mr. Chairman, this hearing is the first of its kind. It's the outgrowth of our shared judgment-your com~ittee's ju~gment and the Board's judgment-that there ought to exist an official forum for an objective and systematic review of our banking system. Several years ago, it would have been difficult to generate broad interest in the kind of review that this committee is now initiating. The reason, obviously, is that from the standpoint of the public the Nation's banking system was adjusting well to the general growth of the economy. During the 1960's, our commercial bankers progressively shed much of the caution that had carried over from the Great Depression and-freed, as they came to be of some of the restraints imposed on them-they began to do things that were impressively creative. That history of change during the 1960's is reasonably well known, and I shall not dwell on it. In brief, what bankers did was to reach out for new business far more aggressively than they had formerly. To that end, they devised many highly ingenious new techniques for gathering deposits and making loans. Consumers and businessmen were clearly pleased by the enlarged range of banking services and by  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  35 the more intense competition among financial institutions across our land. But there's another side to the ledger. As often happens with evolutionary change that is essentially constructive, the pendulum swung too far too quickly. Excited by the profit gains which the drive for growth yielded in the 1960's, a good many bankers paid less heed than they should have to traditional canons of banking prudence. Most importantly, the growth of loans and investments in the banking system proceeded much more rapidly than did additions to the base of equity capital. Commercial bank assets increased at an average annual rate of 9 percent during the 1960's and at the even more rapid rate of 15 percent in the first 3 years of the 1970's. The consequence of this hard push for banking growth was that, by the end of 1973, equity capital was equivalent to only about 6½ percent of total bank assets, which was down sharply from the 9 percent registered at the end of 1960. That thinning of the capital cushion would have been reason enough for some uneasiness about banking trends as we moved into the 1970's, but there were other reasons as well. Of key importance was the particular way in which the growth of banking assets was achieved. The 1960's witnessed the birth and rapid spread of so-called liability management by banks-a technique that in practice involved heavy reliance on borrowd funds, often short-dated volatile funds, to accommo~te loan requests of banking customers. Unease about banking was also accentuated by the fact that, in addition to the rapid growth of loans, commercial banks proceeded with a rapid buildup of commitments to their customers to make additional loans in the future. A suspicion, moreover, that banks had to some extent compromised previous standards of asset quality in their drive for growth added to concern in the early 1970's. So, too, did realization that the holding company device had carried bankers into terrain that was relatively unfamiliar to them. Finally, the advent of widespread floating of currencies across the world produced keen awareness that many of the Nation's larger banks, by virtue of their international involvement, had become exposed to additional risks. Such uneasiness as existed in the public mind with respect to banking trends remained relatively mild, however, until 1974. The failure of the U.S. National Bank of San Diego in October 1973, followed as it was in 1974 by the well advertised difficulties of Franklin National Bank and Bankhaus Herstatt, both ending in failures, transformed what was incipient unease into serious apprehension. The public concern which arose in 1973 and 1976 about banking has moderated since then. But it still lingers on in some degree, having been nurtured by a succession of troubling events and revelations. Financial strains associated with the extraordinary jump in oil prices, involving as they did huge borrowing by oil-deficit nations, have contributed to unease about the health of banking. So, too, has the severity of the recent recession, which triggered a number of large business bankruptcies entailing some well publicized loan losses for banks and which exposed other financial weaknesses in our economy. Events such as these have at times made for nervousness about the condition of banking, and. this situation may not change quickly. A number of the problems impinging on banks-for example, those relat-   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  36 ing to international oil financing and those having to do with New York City-are almost certain to keep coming back into the headlines. Then, too, loan losses and loan problems in practice often continue months or even years after a recession in economic activity has ended. ,ve have to keep that in mind. Today, acting on behalf of the Federal Reserve Board, I am neverthe less very pleased to report to you that our analysis of the banking situation leads to the conclusion that the Nation's banking system has passed well beyond the worst of its recent difficulties and is in fact regaining strength steadily. This is the product of several factorsamong them, corrective actions taken by the banks on their own initiative, supervisory pressure for better performance, and the recovery which is now under way in our national economy. All of the widely used measures of bank-capital position have shown definite improvement since 1974, reflecting a combination of much slower growth in banking activity and also sizeable additions to the capital resources of our banks. Loans and investments of commercial banks have increased at an annual rate of about 5½ percent during the past 2 years, which is only about a third of the pace that prevailed in the opening years of this decade. Meanwhile, in order to bolster their capital, our banks have succeeded in raising substantial sums in the longer term debt market, and they have also added to their equity base both by stepping up sales of new stock and by continuing to pursue rather conservative dividend policies. The ratio of bank equity to total assets which I mentioned earlier as havin~ fallen to 6½ percent by the end of 1973 has recorded no si~ificant deterioration since then. On the contrary. it tended to stablize in 1974, then improved modestly in 1975, and modestly again through the middle of 1976, when the ratio of bank equity to total assets approached 7 percent. We have no later comprehensive information. The growth of bank assets has not merely slowed down, but-as is typical in strength-rebuilding phases of the kind now proceedingthere also has been a decided improvement in the composition of newly acquired bank assets. Between the end of 1974 and the close of 1976, commercial banks added enormously to their holdings of U.S. Government securities. In all, they added about $47 billion during this 2-year stretch. This emphasis on liQuid assets has strengthened very significantly the general quality of bank asset positions. Moreover, in view of the chastening experience so many banks have had, bank loan officers have typically of late been exercising greater care in extending new credit to their customers. Besides the improvement in the composition of assets, there has been a diminished emphasis by banks on accommodating expansion of their portfolios by relvin!!' on short-term borrowed funds. The total of socalled managed liabilities of large banks declined between the end of 1974 and the end of 1976, in spite of the fact that a substantial rise occurred in the overall liabilities of these large banks. The relative dependence on borrowed funds that are potentially very volatile has thus decreased. As I noted earlier, it would be unrealistic, even with the improvement that is now occurring in asset quality, to expect a rapid change in the loan loss experience of commercial banks. For some time, banks will continue to wrestle with the legacy of loans that turned sour   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  37 during the recession. Complete information on loan loss experience is not yet available for 1976, but such data as we do have indicate a flattening tendency in the net loan losses of commercial banks, measured as a percentage of loans. That is an encouraging change from 1975, when loan losses climbed very sharply. The same stabilizing tendencies are evident with regard to banks classified by the banking agencies of our Government as being in the "problem" category. Let me point out that when a bank is placed in such a category-that is, when it is described as a problem bank-this simply means that the bank requires special supervisory attention. It means no more than that. The number of such banks increased sharply in 1974 and 1975, but since then it has remained substantially unchanged. It should be recognized-and this is a very important fact-that the so-called problem banks represent only a small percentage of the total number of commercial banks in our country-in fact, less than 5 percent even at the worst readings of recent years. And, of course, the number of banks that actually failed is, indeed, a tiny percentage of so-called problem banks. In the difficult period from 1973 through 1976, there were only 39 bank failures in our country and most of the failing institutions were quite small. As a rule, the supervisory agencies were able to arrange takeovers of the failed institutions by healthy banks. Very few banks were liquidated, so that services to customers were generally uninterrupted, and losses to depositors on uninsured balances were quite minimal. We, at the Federal Reserve Board, expect the gradual improvement that is underway in the condition of the banking system to continue. Our anticipation that the general economy will expand at a good rate during 1977 and on into next year is, of course, critical to this judgment. But other quite important reasons also suggest further strengthening in the banking situation. By no means the least of these reasons is the sobered mood of bankers. The difficulties that bankers have recently experienced have significantly altered the psychological framework within which banking decisions are made. Liability management no longer seems quite so wondrous to many bankers, and there is clearly a new degree 0£ appreciation that commitments to lend ought not to be undertaken lightly. Having learned the hard way that the business cycle is, after all, still very much alive, most bankers are likely-for some time, at leastto apply stricter standards than they did a few years ago in making their credit judgments. Not only bankers, but also their customers, are in a more sober mood and this likewise, bodes well for progress toward a healthier banking industry. Business managers in particular stung by their own discovery that the busines cycle is not yet dead and that huge risks are entailed in enlarging balance-sheet totals through short-term borrowings-have been hard at work putting their houses in order. They have sold sizable amounts of both long-term bonds and equity secm'l.ties, and they have used the proceeds of these sales largely to reduce short-term indebteqness to banks and to increase their liquid assets. These developments, together with the continuing improvement of corporate earnings, certainly should result in fewer new bad-loan problems for our banks and also should help progressively in cleaning up existing problems.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  38 I can, moreover, assure this committee that the Federal Reserve Board will make every effort to see to it that the current trend toward a strengthened banking situation continues. The Board, in its regulatory and supervisory actions, is adhering basically to the cautionary thrust that was formally initiated in the spring of 19'73. There has been no significant departure in our "go-slow" policy toward expansion of bank holding company activities. The list of activities generally permissible for these companies has not been expanded since early 19'74, and the Board has recently determnied that two requested activities-one of them being the acquisition of savings and loan associations-will simply not be permitted. Individual bank holding companies have been allowed to expand into new areas '()nly when the Board has been satisfied with their financial condition and with their managerial capabilities. In some instances where applications for expansion have been approved, the authority to proceed with expansion has been made conditional by the Board on improvement in the applicant's capital position. The Board intends to continue using such leverage in the interest of assuring further improvement in the condition of the banking system. The capabilities of the Federal Reserve to exercise a constructive influence on banker attitudes and actions are numerous. Perhaps of greatest significance is the fact that the examination and the supervisory process is being strgenthened by our expanded and more timely surveillance, thereby enhancing our ability to identify banking problems and to respond to them at an early stage. Let me point out that the conclusion of the Federal Reserve Board that the condition of the banking system is improving does not mean that we are taking anything for granted or that we see no problems. The wiser attitude that now appears to prevail among bankers needs to be tested as the expansion in economic activity proceeds. Memorieshowever painful-can sometimes be very short. In spite of the steady improvement in real estate markets, we, at the Board, are not at all complacent about the involvement of banks and bank-holding companies in real estate investment trusts. Many of these trusts have avoided bankruptcy only because of the forbearance of creditors, and from the strained and often touchy relationships that inevitably exist in such a situation, sudden flareups of trouble are always possible. This situation obviously demands close attention, with the prospect that it will be a long while before the messy problems in the REIT area are resolved. Much the same is true of the financial difficulties of New York City in which the New York banks have such a substantial stake. The working assumption must be that a solution calming to financin.l markets will be devised, but simple prudence demands that the Federal Reserve System, because of its great responsibility for containing shocks to financial markets, be alert to any sudden untoward turn in that troublesome New York City situation. Another area of concern with respect to the soundness of our banks is the continued attrition in Federal Reserve membership. Over the past 8 years a total of 42'7 member banks have withdrawn from the System and an additional 91 have left as a result of mergers. '.J'hese banks. have left mainly because of the high cost of the nonmterest-earmng reserves that they are required to hold as members  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  39 of the Federal Reserve. Not a few of the banks that dropped out of the System, being financially weak, :faced a desperate need to cut costs and improve profits. At present, 60 percent of insured commercial banks, accounting for about 25 percent of total outstanding deposits, are outside the Federal Reserve System. Unless the trend toward nonmembership is reversed, the soundness of the banking system will be jeopardized by the :fact that so many banks will not have direct access to the Federal Reserve discount window. This is a problem that warrants priority attention by this committee and by the full Congress. The Board also would like to see this committee :focus as soon as it reasonably can on gaps that continue to exist in the supervisory powers of the bank regulatory agencies. On January 31 the Board, as you know, forwarded to this committee a regulatory reform bill that we believe would contribute materially to better bank supervision. Our draft bill proposes the creation of a statutory interagency bank examination council that would establish uniform standards and procedures for Federal examination of banks. The bill would also place statutory limits on loans to insiders. In addition, we see a need for change in existing cease-and-desist authority. At present, the Board cannot remove any bank or bank holding company officer for anything less than a showing of personal dishonesty. We believe that authority for removal, of course with appropriate safeguards, should extend as well to gross managerial negligence. The bill that we have proposed would also permit out-of-State acquisition of large banks in danger of failure. When adverse developments trigger deposit losses that seriously weaken a bank, it may be necessary in the public interest to combine the weakened institution with a larger and stronger bank. As you know, this recently occurred in New York and California, where large in-State banks were available to acquire the problem banks involved. Had institutions of the size of Franklin National or U.S. National failed in certain other States, no in-State bank would have been large enough to acquire them. In such circumstances, the ability to arrange acquisitions across State boundaries would become truly urgent. These specific legislative changes would be helpful. From a broader perspective, we at the Board believe it is vital to make membership in the Federal Reserve more attractive, and also to subject foreign banks in our country to the same Federal rules and regulations that apply to domestic banks. To strengthen the banking system, we urge adoption by Congress of legislation on foreign banking such as the House of Representatives passed la.st year. Mr. Chairman and members of the committee, I have dwelt thus far on the condition of the banking system in relation to the activities that banks carry on in our domestic markets. A proper assessment of banking must take into account also the role of our banks abroad. That role has expanded enormously, and the pace of growth has been especially rapid in the last several years. The indebtedness of foreigners to U.S. banks and their foreign branches rose annually during the past 3 years by about 20 percent. It is important m this connection, however, to recognize that most of the expansion in the :foreign lending of our banks has been made possible by funds that the foreign branches or banks were able to raise abroad.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  40 As the world economy keeps getting bigger, some year-to-year increase in the international loan portfolios of U.S. banks is a normal occurrence. But the recent pace of bank lending to foreigners goes beyond anything that can be explained in terms of the growth of either world economic activity or international trade. In addition, it reflects three developments : first, the enormous rise of financing needs around the world that was caused by the quintupling of oil prices; second, the willingness of American banks to respond to these financing needs; and third, the growth of multinational corporations and the internationalization of banking through the Euro-currency markets. The sharp increase of oil prices did not in and of itself give rise to a need for financing activity of the kind that American banks have been engaged in. Theoretically at least, the OPEC group, recognizing the severe payments imbalances they had caused, could themselves have become bankers on a major scale. We know, of course, that they largely avoided the route of extending credit directly to the countries that were buyers of their oil, but instead funneled their huge surpluses into a variety of financial assets-chiefly bank deposits. They thereby shifted the banking opportunity-and with it, o:f course, the burden of credit evaluation-to others, which meant mainly the large American and European banks that the OPEC group used as deposito.ries. The fact that things might have happened otherwise is something we should not :forget, because in the years immediately aheadif serious oil-related payments imbalances persist-it may yet be necessary to urge upon the OPEC group a far more active role as bankers than they have been willing thus :far to play. American banks, as is well known, responded along with banks in other countries to the recycling challenge, serving since 1974 a very substantial intermedia,ry role between the OPEC group and the countries whose external payments had deteriorated because of OPEC pricing. The sharp increase of oil prices, to say nothing of the worldwide recession, caused extensive_ dislocations in the world economy; but much more serious difficulties would have occurred if commercial banks here and elsewhere had not acted as they did. There simply was no official mechanism in place in 1974 that could have coped with recycling of funds on the vast scale that then became necessary. The supportive role that American and other commercial banks played in this situation thus prevented financial strains from cumulating dangerously, and this role continues even now. Certainly, our export trade and the general economy have been helped-and are being helped-by banking's role in international lending. This is not to say, however, that there have been no excesses or that expansion .of international lending by American banks can continue at an undiminished pace. Even though losses on foreign loans have been small-indeed, relatively smaller than on domestic loans-the Federal Reserve Board is concerned about the enlarged risk exposure of our banks. · The rapid expansion of credit to the non-oil "less developed countries warrants particularly close attention. The total indebtedness of such countries to American banks alone approximated $45 billion at the end of 1976. These countries also owe substantial sums to foreign   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  41 banks, official institutions, and others. The fact that the aggregate external indebtedness of these countries may run to something like $180 billion has been well publicized. Of course, total debt figures-and more importantly the interest charges flowing from them-need to be viewed in the context of the levels of production and exports of the nonoil LDC's. Looked at in this f!tshion, these debt figures are decidedly less worrisome. Nevertheless, the ratio of the external debt to exports and also the ratio of the external interest burden to exports have deteriorated for most nonoil LDC's in recent years, although some stabilizing tendencies did emerge in 1976. In some countries, such ratios have reached levels which justify serious concern and which point to the need for determined stabilization policies in these countries. In the absence of such policies, difficulties may be encountered in rolling over the existing debt, and difficulties may be encountered in borrowing to meet new requirements. This situation demands a heightened sense of caution on the part of our banks in managing their international loan portfolios, and such caution does in fact appear to be emerging. Here, too, though, the Board will be watchful of developments. As part of a broader effort to improve knowledge of international lending activities, we at the Board are currently engaged in a joint project with other central banks to obtain a more accurate size and maturity pro.file of the indebtedness to banks of individual countries. Data of this type should prove very useful to bankers as they proceed to evaluate credit requests by foreigners. The Federal Reserve has communicated its intent to be both helpful ·to banks and watchful of their activities. The latter point is currently being signaled, for example, by an informal survey that we have underway of bank practices in defining, monitoring, and controlling risk in international lending.• . The Board's judgment about the condition of the international loan portfolios of American banks is not easily summarized. We have been concerned with the rapidity of the rise in foreign lending, and we believe that here and there a slowing must occur-to rates of growth, generally, that are consonant with expansion of the debtservicing capabilities of individual borrowing countries. Such slowing, it should be appreciated, may well involve some problems for the international economy, since the structural payments imbalances that have occasioned such heavy bank lending to foreign countries are not going to disappear rapidly. The inference is clear that a strong cooperative effort is more than ever necessary-involving official international agencies, the group of 10 countries, OPEC, the nonoil LDC's and the private banks. Unless we succeed in devising sound financial alternatives, serious strains in the world economy may develop. ·In closing, let me say that I am sensitive to the fact that the statement I have made this morning by no means reviews the condition of our banking system as fully as would be desirable. Some of the matters I have touched on are extremely complex and that inherently creates risks that relatively brief treatment may give rise to misunderstandings. I particularly hope that the emphasis I have placed on the need for caution in credit extension will not be misunderstood. In banking,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  42 as in other pursuits, a fine line exists between being too cautious and not being cautious enough. You called attention to this, Mr. Chairman, when you spoke of several dilemmas that we face. At the Federal Reserve Board, we certainly do not want caution to be overdone in the sense of having our bankers be unresponsive to the needs of creditworthy borrowers, either at home or abroad. Nor do we as supervisors, despite our obligation to be watchful, seek to substitute our judgments for those of online bankers in deciding who should get credit. We have neither the capacity nor the desire to play such a role. The legitimate credit needs of our citizens and our businesses must be met if our economy-and indeed the world economy-is to prosper. It is precisely for that reason that the Federal Reserve is pursuing a policy of adding steadily to our banking system's resources, and yet doing so on a scale that will not reignite the fires of inflation. Our banks are in a good position to serve the needs of their communities. They have been extending impressive amounts of credit to consumers, to farmers, and to those in need of mortgage credit. As the demand for business credit strengthens, that too will be reasonably accommodated. I hope that in dwelling- on other considerations this morning, I have created no misimpress1ons about this critical matter. Thank you very much, Mr. Chairman. [ Complete statement follows:]   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  43 Statement by  Arthur F. Burns  Chairman, Board of Governors of the Federal Reserve System  As you know, Mr. Chairman, I attach special importance to this meeting today at which I shall report to you, on behalf of the Board of Governors, on the condition of the banking system. This. hearing, the first of its kind for this Committee, is an outgrowth of our shared judgment -- the Committee's and the Board's -- that there ought to exist an official forum for objective and systematic review of our banking system. Certainly from the Board's standpoint, there has been a regrettable lack of balance at times in the past several years in• public discussion of banking matters.  It is our _hope, which  I am sure you share, that hearings of this kind will contribute to better understanding of the performance of the Nation's banking system and in so doing will bring individual banking pr.oblems into better perspective. A few years ago it would have been difficult to generate broad inttorest in the kind of review this Committee is now initiating.  The reason, obviously, is that from the standpoint  of the public the Nation's banking system was adjusting well to the general growth of the economy.  During the decade of the  1960 1 s, bankers progressively shed much of the caution that had carried over from the great Depression and -- freed, as   86-817 0 • 77 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  • 4  44 they came to be, of some of the restraints imposed on them -they began to do things that were impressively creative. That history of change during the I960's is reasonably well known, and I need .not dwell on it.  In brief, what bankers  did was to reach out for new business far more aggressively than they had formerly.  To that end, they devised new techniques  many highly ingenious -- for gathering deposits and making loans. They opened offices at a rate much more rapid than the growth of the Nation's population, and increasingly extended their operations to new geographic areas and functions.  Banks that  previously served only local markets sought to become regional in scope; regional banks moved to establish a national presence; and our Nation's largest banks looked more and more to opportunities abroad. As long as such growth was outwardly free of signs of strain -- as it generally was for more than a decade the development met with broad approval.  Complaints were  few -- except, of course, from banking's competitors, who were understandably unenthusiastic about banking's new display of entrepreneurial energy and talent.  Consumers and business-  men could only be pleased by the enlarged range of banking services and the more intense competition among financial institutions.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  45 There is, however, another side to the ledger.  As often  happens with evolutionary change that is essentially constructive, the pendulum swung too far too quickly.  Excited by the profit  gains which the drive for growth yielded in the I960's, a good many bankers paid less heed than they should have to traditional canons of banking prudence. Most importantly, the growth of loans and investments in the banking system proceeded much more rapidly than did additions to the base of equity capital. Commercial bank assets increased at an average annual rate of 9 per cent in the decade of the 1960 1 s and at the even more rapid rate of 15 per cent in the first three years of the 1970's.  In both periods, the rate  of growth of bank assets appreciably exceeded the growth in the dollar value of the Nation's production -- a fact indicative of the determined efforts banks were making to enlarge their share of total financing activity. The consequence of the hard push for growth was that, by the end of 1973, equity capital was equivalent to only about 6-1/Z per cent of total bank assets -- down sharply from 9 per cent at the end of 1960,  Moreover, the equity capital of banks  had been leveraged by some parent holding companies which used funds raised in debt markets to increase equity investment in their subsidiary banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  46 That thinning of the capital cushion would have been reason enough for some uneasiness about banking trends as we moved into the 1970' s. well.  But there were other reasons as  Of key importance was the particular way in which  asset growth was achieved.  The 1960's witnessed the birth  and rapid spread of so-called liability management by banks a technique that in practice involved heavy reliance on borrowed funds, often very short-dated funds, to accommodate loan requests.  Thus, uneasiness was engendered not only by the  rapid expansion of assets relative to equity but also because that expansion rested so heavily on volatile resources. The unease was accentuated by the fact that, in addition to the rapid growth of loans, commercial banks proceeded with a rapid build-up of commitments to their customers to make additional loans in the future.  A suspicion, moreover, that  banks had to some extent compromised previous standards of asset quality in their drive for growth added to concern in the early 1970's.  So, too, did realization that the holding-company  device had carried bankers into terrain that was relatively unfamiliar.  Finally, the advent of widespread floating of  currencies produced keen awareness that many of the Nation's   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  47 larger banks, by virtue of their international involvement, had become exposed to additional risks.  In sum, as the decade  of the 1970's began, apprehension was emerging -- and this was not confined to banking regulators - - that the innovations and developments of the 1960 1 s, welcome as they were in many respects, posed some formidable challenges. Such uneasiness as existed in the public mind with respect to trends in banking remained relatively mild, however, until 1974.  The failure of U. S. National of San Diego in  October 1973, followed some months later by the well-advertised difficulties of Franklin National -and Bankhaus Herstatt, both ending in failures, transformed the incipient unease into serious apprehension.  Indeed, for the first time since the 1930's major  doubts began to be voiced here and there about the soundness of our Nation's, and indeed the world's, banking system. The unhappy closing in our country of two large banks U. S. National and Franklin National -- was handled by the regulatory authorities in a manner that caused a minimum of disturbance to their customers and no loss at all to their depositors. Even so, public concern about banking continued.  In fact, it still  lingers on in some degree, having been nurtured since 1974 by a succession of troubling events and revelations.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  48 Financial strains associated with the quantum jump in oil prices -- involving as they did huge borrowing by oil-deficit nations -- have contributed to unease about the health of banking. So too has the severity of the recent recession -- itself the product of an inflationary environment that fostered widespread speculation.  The slump in business activity triggered a number  of major business bankruptcies entailing some well-publicized loan losses for banks.  The recession, moreover, laid bare  the financial weakness of many real estate investment trusts, which, as is well known, are heavily in debt to our Nation's banks. And the recession also played a part in exposing New. York City's financial difficulties, thus bringing to acute national consciousness the risk exposure of commercial banks -particularly, but by no means exclusively, the large New York banks -- to the vicissitudes of municipal finances. All of these events have at times made for nervousness about the condition of banking, and that situation may not change quickly.I A number of the problems impinging on banks -- for example, those related to international oil financing and those having to do with New York City -- are almost certain to keep   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  49 coming back into the headlines,  Then, too, loan losses and  loan problems often continue months or even years after a recession in economic activity has ended,  The recent recession  ill:iuninated the bad credits, indeed to a large extent caused them, but considerable time will be required for troubled debtors to work out their financial difficulties,  Hence, the  total amounts of questionable loans, and the number of banks classified as problem banks because of a sizable volume of such loans, may not diminish rapidly even in an upbeat economy. We ought to expect that and not be surprised by such disclosures, On behalf of the Federal Reserve, I am pleased to report that our analysis leads to the conclusion that the Nation's banking system has passed well beyond the worst of its recent difficulties and is in fact regaining strength steadily.  This is  the product of several influences -- among them, corrective actions taken by the banks on their own initiative, supervisory pressure  for better performance, and the recovery that is  underway in the general economy.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  50 All of the widely used measures of bank-capital position have shown definite improvement since 1974, reflecting a combination of much slower growth in banking activity and sizable additions to capital resources.  Total loans and  investments of commercial banks have increased at an annual rate of approximately 5-1 /Z per cent during the past two years, only about a third of the pace that prevailed in the opening years of this deca,de,  A major part of the slowdown reflects,  of course, the subsidence of credit needs occasioned by the state of the economy and the increased reliance of business firms on public debt markets.  But there also has become  discernible a greater sense of caution and selectivity on the part of bankers in extending credit.  Meanwhile, in order to bolster  their capital, banks have raised substantial sums in the longerterm debt market, and they have also added to their equity base both by stepping up sales of new stock and by continuing to pursue conservative dividend policies. Fortunately, our Nation's banks have enjoyed relatively good profits, in part because of a new cost-consciousness that has manifested itself not just in go-slow policies affecting the scope of operations but in some instances also in personnel   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  51 reductions - - something that until recently was wholly uncharacteristic of the banking industry.  Earnings of banks  have been big enough, taken in the aggregate, to absorb the large -loan losses that have occurred in lagged response to the recession and yet permit moderate gains in net income. This performance of profits has been a key factor, of course, in enabling banks to strengthen their capital position by retaining a large part of earnings.  It is also worth noting  that in many of the larger banks, profits have been bolstered by exceptional income gains growing out of international activities. The ratio of bank equity to total assets that I mentioned earlier as having fallen to 6-1 /2 per cent at the end of 1973 recorded no significant deterioration thereafter,  It tended to  stabilize in 1974, then improved modestly in 1975, and modestly again through the middle of 1976, when it approached 7 per cent. Other available measures of the status of bank capital - - those that take debt capital into account as well as equity and which focus on risk assets rather than total assets -- show either equal or greater strengthening.  In particular, the ratio of total  capital -- that is, equity plus subordinated debt - - to risk assets rose by more than a full percentage point between the end of   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  52 1974 and mid-1976, when it reached IO. Z per cent.  Significantly,  this improvement in bank capital positions has occurred for all size classes of banks, from the smallest to the biggest. The growth of bank assets has not merely slowed, but -as is typical in strength-rebuilding phases of the kind now proceeding - - there has been a decided improvement in the composition of newly acquired bank assets.  Between the end  of 1974 and the end of 1976, commercial banks added enormously to their holdings of U. S. government securities - - in all, about $47 billion.  This emphasis on liquid assets has strengthened  the general quality of bank asset positions,  Moreover, in view  of the chastening experience so many banks have had, loan officers have typically been exercising greater care in exten•g new credit. Besides the improvement in asset composition, there has been a diminished emphasis by banks on accommodating expansion of their portfolios by relying on short-term borrowed funds,  The total of so-called managed liabilities of large banks  declined between December 1974 and December 1976, despite a substantial rise in the over-all liabilities of these banks. The relative dependence on borrowed funds that are potentially   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  53 very volatile has thus decreased.  At present, the average  ratio of managed liabilities to the total assets of. large banks is some six percentage points below the high recorded in the summer of 1974. As I stated earlier, it would be unrealistic, even with the improvement now occurring in asset quality, to expect a rapid change in the loan-loss experience of banks.  Banks for  some time will continue to wrestle with the legacy of loans that turned sour during the recession.  Complete information on loan-  loss experience is not yet available for 1976.  But such data as  we do have indicate a flattening tendency in the net loan losses of commercial banks, measured as a percentage of loans. That is an encouraging change from 1975, when loan losses climbed sharply.  Strengthening the impression that a turn for  the better has occurred is the fact that during 1976 a decline was recorded in the proportion of past due loans of National banks.  Moreover, preliminary data for 1976 on bank assets  classified by bank examiners as substandard or worse also suggest that the dollar amount of classified loans is no longer rising.  Thus, some signs of improvenient in bank loan experience  have appeared, and these should multiply as expansion of the economy continues and gives support to the financial position of bank customers.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  54 Essentially the same stabilizing tendencies are evident with regard to banks classified by banking agencies as being in the "problem" category.  When a bank is placed in such a  category, this simply means that it requires special supervisory attention.  The number of such banks increased sharply  in 1974 and 1975, but it has since then remained substantially unchanged.  For purposes of evaluation, it is important to  bear in mind that the composition of these lists changes frequently as difficulties are identified by the regulators and resolved by the institutions.  Thus, no inference of a lack of  progress in overcoming specific problems should be drawn from the recent relative stability in the over-all number of banks on such lists.  In particular, the recent stability of  numbers does not mean that there is a set of chronic "hardcore" cases that defy remedy.  We should, moreover, keep  in mind the fact that the overwhelming majority of our commercial banks do not require special supervisory attention. The so-called problem banks represent only a small percentage of the total number of commercial banks in the United States -- less than 5 per cent even at the worst readings of recent years.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  And, of course, the number of banks that  55 actually fail is a small percentage of so-called problem banks. The incidence of failure in the banking industry is, indeed, very much smaller than in other lines of business.  In the  difficult period from 1973 through 1976, there were only 39 bank failures in the United States and most failing institutions were relatively small.  As a rule, the supervisory agencies  were able to arrange takeovers of the failed institutions by healthy banks.  Few were liquidated; thus services to customers  were generally uninterrupted, and losses to depositors on uninsured balances were minimal. The Federal Reserve Board expects the gradual improvement that is under way in the condition of the banking system to continue.  Our anticipation that the general economy  will expand at a good rate during 1977 and on into next year is, of course, critical to that judgment.  But other important  reasons also suggest further strengthening in the banking situation. By no means the least of these is the sobered mood of bankers.  The difficulty experienced by some banks in issuing  certificates of deposit at times during 1974 or 1975 has clearly left its mark.  So has the embarrassment that certain institutions  suffered in having to pay a premium rate on their certificates of deposit.  Fresh is the memory, also, of the cost and strain   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  56 many banks experienced in making good on liberally-granted commitments to extend credit,  Such things as these, combined  with the shock of heavy loan losses, appear to have significantly altered the psychological framework within which banking decisions are made,  Liability management no longer seems  quite so wondrous to many bankers, and there is clearly a new degree of appreciation that commit:Inents to lend ought not to be undertaken lightly.  Having learned the hard way  that the business cycle is, after all, very much alive, most bankers are likely for a time to apply stricter standards than they did a few years ago in making credit judgments.  All in  all, the banking industry is exhibiting considerable caution, which extends both to the traditional range of banking operations and to the nonbanking activities of holding companies,  This  should help to clear up old problems and avoid new ones. Not only bankers, but also their customers, are in a more sober mood and this, likewise, bodes well for progress towards a healthier banking industry,  Business managers in  particular -- stung by their own discovery that the business cycle is not yet dead and that huge risks are entailed in enlarging balance-sheet totals through short-term borrowings   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  57 have been hard at work putting their houses in order.  They  have sold sizable amounts of both long-term bonds and equity securities and have used the proceeds of these sales largely to reduce short-term bank debt and increase their liquid asl!ets.  Those developments, together with the continuing  improvement of corporate earnings, certainly ought to result in fewer new bad-loan problems for banks and also should help progressively in cleaning up existing problems. I can, moreover, assure this Committee that the Federal Reserve Board will make every effort to see to it that the current trend toward a strengthened banking situation continues, The Board in its regulatory and supervis_ory actions is adhering basically to the cautionary thrust that was formally initiated in the spring of 1973, There has been no significant departure, for instance, in our "go-slow" policy toward expansion of bank holding company activities,  The list of activities generally permissible  for these companies has not been expanded since early 1974, and the Board has recently determined that two requested activities are not to be permitted,  Individual companies have  been allowed to expand into new areas only when the Board has   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  58 been satisfied with their financial condition and managerial capabilities.  On the other hand, companies whose asset  composition, capital, or liquidity raises doubts, ought by now to know that the Board will be extremely skeptical of proposals that divert financial or managerial resources to new undertakings.  Partly as a result of pointed denial of  various applications to undertake new investments - - through which the Board has signalled to the market its "go-slow" policy - - the number of requests filed with the Federal Reserve has sharply diminished in the past two years.  Moreover, in  some instances in which applications for expansion have been approved, the authority to proceed has been made conditional on improvement of the applicant's capital base. The Board intends to continue using such leverage in the interest of assuring further improvement in the condition of the banking system.  The capabilities of the Federal Reserve  to exercise a constructive influence on banker attitudes and actions are numerous, even though our power to deal with certain problem areas is inadequate.  Perhaps of greatest  significance is the fact that the examination and supervisory process is being strengthened by expanded and more timely   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  59 surveillance, thereby enhancing our ability to identify problems and to respond to them at an early stage.  Parallel develop-  ments to strengthen monitoring and follow-through capabilities are under way in the office of the Comptroller of the Currency and at the Federal Deposit Insurance Corporation.  Coordination  of efforts among the three agencies.is, of course frequent. The conclusion of the Federal Reserve Board that the condition of the banking system is improving does not mean that we are taking anything for granted or that we see no problems.  The wiser attitude that now appears to prevail  among bankers needs to be tested as the expansion in economic activity proceeds.  Memories - - however painful - - can  sometimes be short.  Should we find that the lessons of the  recent past -- concerning capital adequacy, excessive reliance on volatile funds, or expansion into unfamiliar areas -- are no longer generally respected by bankers, the Board will be ready to take whatever action seems appropriate. Nor, even now, despite steady improvement in real estate markets, do we have any complacency about the involvement of banks and bank-holding companies in real estate investment trusts (REITs).  86-817 0 • 77 • 5   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Many of these trusts have avoided  60 bankruptcy only because of the forbearance of creditors, and from the strained and often touchy relationships that inevitably exist in such a situation sudden flare-ups of trouble are always possible.  A number of REITs face a significant  increase of maturing medium-term debt later this year and in 1978.  This situation demands close attention, with the  prospect that more REIT-related losses lie ahead for banks and that it will be a long while before the messy problems in that area have been resolved. Much the same is true of the financial difficulties of New York City in which the New York banks have such a substantial stake.  The working assumption must be that a  solution calming to financial markets will be devised, but simple prudence demands that the Federal Reserve System, because of its responsibility for containing shocks to financial markets, be alert to any sudden untoward turn in that troublesome situation. Another area of concern with respect to the soundness of our banking system is the continued attrition in Federal Reserve membership. In 1976, 46 banks chose to give up membership and 8 banks left the System as a result of mergers with nonmembers.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Over the past eight years a total of 427 member  61 banks have withdrawn from the System, and an additional 91 have left as a result of merger.  These banks have left mainly  because of the high cost of the non-interest earning reserves that they are required to hold as members of the Federal Reserve.  Not a few of the banks that dropped out of the  System, being financially weak, faced a desperate need to cut costs and improve profits.  At present 60 per cent of  insured commercial banks, accounting for about 25 per cent of deposits, are outside the Federal Reserve System. Unless the trend toward nonmembership is reversed, the soundness of the banking system will be jeopardized by the fact that so many banks will not have direct access to the Federal Reserve discount window.  The availability of the  discount window -- as was demonstrated dramatically in 1974 is an important element contributing to the stability of our banking system.  There should be no assumption that cor-  respondent banks will always be able to afford assistance to nonmembers.  This is a problem that warrants priority  attention by this Committee and the full Congress.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  62 The Board also would like to see this Committee focus as soon as it reasonably can on gaps that continue to exist in the supervisory powers of the agencies that regulate banks. On January 31 of this year, the Board, as you know, forwarded to this Committee a regulatory reform bill that we believe would contribute materially to better bank supervision. Our draft bill proposes, among other things, the creation of a statutory inter-agency bank examination council that would establish uniform standards and procedures for Federal exaniination of banks.  The bill would also place statutory limits  on loans to insiders. As the Committee is aware, problems with insider loans have been a major contributing factor in a number of bank failures.  In addition, we see a need for change  in existing "cease and desist" authority. At present the Board cannot remove bank or bank holding company officers for _anything less than a showing of personal dishonesty. We believe that authority for removal, with appropriate safeguards, ought to extend as well to gross managerial negligence. The bill we have proposed would also permit out-ofState acquisition of large banks in danger of failure.  When  adverse developments. trigger deposit losses that seriously   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  63 weaken a bank, it may be necessary in the public interest to combine the weakened institution with a larger and stronger bank.  As you know, this recently occurred in New York and  California, wher~ large in-State banks were available to acquire the problem banks involved.  Had institutions of the  size of Franklin National or U.S. National failed in certain other States, no in-State bank would have been large enough to acquire them.  In such circumstances, the ability to arrange  acquisitions across State boundaries would become urgent. These specific legislative changes would be helpful. From a broader perspective, it is vital to make membership in the Federal Reserve more attractive -- perhaps by providing for lower reserve requirements or allowing the System to pay interest on the reserve balances that member banks maintain. Moreover, in view of the expanding presence of foreign banks in the United States -- with assets here that now exceed $75 billion -- the Board believes it important to subject foreign banks to the same Federal rules and regulations that apply to domestic banks.  To strengthen our banking syste.m, we  therefore urge adoption by Congress of legislation on foreign banking such as the House of Representatives passed last year.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  64 I have dwelt thus far on the condition of the banking system in relation to the activities that banks carry on in our domestic markets.  A proper assessment must take into  account as well the role of our banks abroad.  That role has  expanded enormously, and the pace of growth has been especially fast in the last several years.  The indebtedness of foreigners  to U.S. banks and their foreign branches rose annually during the past three years by about 20 per cent.  It is important to  recognize in this connection that most of the expansion in foreign lending by our banks has been made possible by funds raised abroad. As the world economy keeps getting bigger, some year-to-year increase in the international loan portfolios of U.S. banks is a normal occurrence.  But the recent pace of  bank lending to foreigners goes beyond anything that can be explained in terms of the growth of either world economic activity or international trade.  In addition, it reflects three  developments: first, the enormous rise of financing needs around the world that was occasioned by the quintupling of oil prices; second, the willingness of American banks to  respond to those financing needs; third, the growth of multinational corporations and the internationalization of banking through the Euro-currency markets.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  65 The sharp increase of oil prices did not in and of itself give rise to a need for financing activity of the kind American banks have been engaged in,  Theoretically at least, the OPEC  group, recognizing the severe payments imbalances they had caused, could themselves have become bankers on a major scale.  We know, of course, that they largely avoided the  route of extending credit directly to the countries that were buyers of their oil, but instead funneled their huge surpluses into a variety of financial assets -- chiefly bank deposits. They thereby shifted the banking opportunity -- and with it, of course, the burden of credit evaluation -- to others, which meant mainly the large American and European banks that the OPEC group used as depositories.  The fact that things might  have happened otherwise is somethi1:1g we should not forget, since in the years immediately ahead -- if serious oil-related payments imbalances persist -- it may yet be necessary to urge upon the OPEC group a much more active role as bankers than they have so far played. American banks, as is well known, responded along with other banks to the "recycling"· challenge, serving since 1974 a very substantial intermediary role between the OPEC   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  66 group and the countries whose external payments had deteriorated because of OPEC pricing.  The fact that loan demand  within the United States was relatively weak in 1975 and 1976 undoubtedly has been a factor helping to sustain an unusually high rate of foreign lending activity by our banks. The sharp increase of oil prices, to say nothing of the world-wide recession, caused extensive dislocations in the world economy; but much more serious difficulties would have occurred if commercial banks here and elsewhere had not acted as they did.  There simply was no official mechanism  in place in 1974 that could have coped with recycling of funds on the vast scale that then became necessary.  The supportive  role that American and other commercial banks played in this situation thus prevented financial strains from cumulating dangerously, and this role continues even now.  Certainly,  our export trade and the general economy have been helped -and are being helped -- by banking's role in international lending. This is not to say there have been no excesses or that expansion of international lending by American banks can continue at an undiminished pace.  Even though losses on foreign  loans have been small - - indeed, relatively smaller than on domestic loans -- the Federal Reserve Board is concerned   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  67 about the enlarged risk exposure of our banks.  I personally  have voiced apprehension about various aspects of these international lending activities in both private and public discussion. The rapid expansion of credit to the non-oil "less d-eveloped" countries (LD9's) warrants particularly close attention.  The total indebtedness of such countries to American  banks alone approximated $45 billion at the end of 1976.  These  countries also owe substantial sums to foreign banks, official insitutions, and others.  The fact that the aggregate external  indebtedness of these countries may run to something like $180 billion has been well-publicized. Of course, total debt figures -- and more importantly the interest charges flowing from them -- need to be viewed in the context of the levels of production and exports of the nonoil LDC's. worrisome.  Looked at in those terms, they are decidedly less Nevertheless, the ratio of the external debt to  exports and also the ratio of the external interest burden to exports have deteriorated for most non-oil LDC' s in recent years, although some stabilizing tendencies did emerge in  1976.  In some countries, such ratios have reached levels  which justify serious concern and which point to the need for   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  68 determined stabilization policies.  In the absence of such  policies, difficulties may be encountered in rolling over existing debt or borrowing to meet new requirements. This situation demands a heightened sense of caution on the part of our banks in managing their international loan portfolios, and such caution does in fact appear to be emerging. Here, too, though, the Board will be watchful of developments. As part of a broader effort to improve knowledge of international lending activities, we are currently engaged in a joint project with other central banks to obtain a more accurate size and maturity profile of the indebtedness to banks of individual countries.  Such data should prove useful to bankers as they  proceed to evaluate credit requests by foreigners.  The Board  has communicated its intent to be both helpful to banks and watchful of their activities.  The latter point is currently  being signaled, for exaznple, by an informal survey of bank practices in defining, monitoring, and controlling risk in international lending, The Board's judgment about the condition of the inter national loan portfolios of American banks is not easily summarized.  We have been concerned with the rapidity of  the rise in foreign lending, and we believe that here and there   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  69 a slowing must occur -- to rates of growth, generally, that are consonant with expansion of the debt-servicing capabilities of individual borrowing countries.  Such slowing, it should be  appreciated, may well involve some problems for the international economy, since the structural payments imbalances that have occasioned such heavy bank lending to foreign countries are not going to disappear rapidly.  The inference  is clear that a strong cooperative effort is more than ever necessary -- involving, among others, official international agencies, the Group of Ten countries, OPEC, the non-oil LDC's, and the private banks.  Unless we succeed in devising  sound financial alternatives, serious strains in the world economy may develop. In closing, let me say that I am sensitive to the fact that the statement I have made this morning -- despite its length -- by no means reviews the condition of our banking  system. as fully as would be desirable.  Some of the matters  I have touched on are extremely complex and that inherently creates risks that relatively brief treatment may give rise to mi sunder standings.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  70 I particularly hope that the emphasis I have placed on the need for caution in credit extension will not be misunderstood, In banking, as in other pursuits, a fine line exists between being too cautious and not being cautious enough.  At the Federal  Reserve Board, we certainly do not want caution to be overdone in the sense of having our bankers be unresponsive to the needs of creditworthy borrowers, either at home or abroad.  Nor do  we as supervisors, despite our obligation to be watchful, seek to substitute our judgments for those of on-line bankers in deciding who should get credit,  We have neither the capacity  nor the desire to play such a role. The legitimate credit needs of our citizens and our businesses must be met if our economy - - and indeed the world economy -- is to prosper,  It is precisely for that reason that  the Federal Reserve is pursuing a policy of adding steadily to our banking system's resources, and yet doing so on a scale that will not reignite the fires of inflation.  Our banks are in  a good position to serve the needs of their communities.  They  have been extending impressive amounts of credit to consumers, to farmers, and to those in need of mortgage credit. As the demand for business credit strengthens, that too will be reasonably accommodated.  I hope that in dwelling on other  considerations this morning, I have created no misimpressions about this critical matter,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  71 The CHAIRMAN. Thank you very much, Chairman Burns, for an excellent statement, most impressive and certainly well balanced. At the same time, I have a feeling, as I'm sure you must have too, that we have very, very serious and difficult problems ahead of us if we're going to achieve the kind of sound banking system that we want to achieve. For example, you say, in referring to the soundness of the banking system: I'm pleased to report that our analysis leads to the conclusion that the Nation's banking system has passed well beyond the worst of its recent difficulties and is in fact regaining strength steadily. ·  And later you reaffirm that, but then you say : Our anticipation that the general economy will expand at a good rate during 1977 and on into next year is, ·of course, critical to that judgment.  Of course, one of the important elements of a sound banking system is that it should be able tQ $tand and stand firmly in the event of a serious recession. In my judgment, if the last recession continued on through most of 1975 we might have had some far more serious banking problems. We had some anyway but they would have been far more serious. And I'm concerned, as I'm sure you are, 1about what happens if we do have a recession. Clearly, in my view, if we don't, if the business cycle does not-as you say, it may have been repealed, but it has not been, and I agree with you-but if we continue under prosperous conditions, we probably won't have very much difficulty with our banks. What kind of action can we take-can the Federal Reserve Board take to provide greater protection ·against the problems of a serious recession of the kind we had in 1975 or maybe even more serious 1 Mr. BURNS. The Federal Reserve, in and of itself, cannot prevent recessions, and it would be a great mistake to assume that we have the power to do so. If our Federal Government pursues loose financial policies, and if our private businesses embark on speculative ventures on a massive scale-as they did during the period from 1965 to 1973, encouraged in large part by the great outpouring of Federal moneythen I don't see how we at the Federal Reserve Board can do anything except to moderate the recession that would follow. We couldn't stop it. The CHAIRMAN. Well, I'm not talking about-of course, I agree with that. My question was badly stated. I certainly didn't mean to imply there was 1anything the Federal Reserve Boa,rd can do to avert a recession if we have one. I'm not even so sure that the Congress can do a great deal. We can do something, but I don't think we can prevent it. As long as we have a free enterprise system we're going to have a business cycle. As long as we have a business cycle we are going to have downs as well as ups. What I'm concerned about is what steps we can take to reduce the number of problem banks. You say on page 12 the number is no worse than it was in 1974 or 1975 and it seems to me in view of the recovery that's rather a gloomy situation. If the situation hasn't improved considerably in 2 years of recovery, I'm concerned that the banking system is not as sound as it ought to be or in the kind of shape it ought to be to resist the downturn of the business cycle. Mr. BuRNS. As I pointed out, loan losses are recognized with a lag, and the lag is quite significant; tha,t is always the case. But I would like to put the posi,tion of the banking system in somewhat better perspective. We have had a serious recession, as all of us know, and the  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  72 ability of the banking system to ride through this storm with so few bank failures is, I think, a remarkable achievement. Obviously, I would have liked it better if we had had no failures. But we have to be cautious. If our banks are going to serve the credit needs of this economy, they will have to take some risks; and when banks take risks, as they should now and then, there will be bank failures here and there. We have had very few bank failures, and on those unfortunate occasions t!he bank regulatory authorities were able to manage matters in a fashion which caused very few ripples on the economic or fi.ll'ancial scene. I think this is a great achievement, -and I should say that the main credit belongs to the Congress because of the banking legislation that it passed during the 1930's. The ba.nk regulatory agencies can t1ake a little credit too, but the main credit belongs to the Congress. The CHAIRMAN. Well, let me see if I can perceive whether or not you would feel that there's been ,a change in the last 5 years as compared to the situation 15 years ago that it's more than a cyclical problem, that it's a problem of some deterioration •at least in the basic soundness of our banks. The GAO reported that over a 5-year period the character of problem banks has changed. Whereas in 1971 there were 352 problem banks, 13 of which had deposits over $100 million, by 1975 there were 607 problem banks, 90 of which had deposits of over $100 million. Doesn't that diata suggest that the problems regulatory agencies have to cope with have changed in character and indeed gotten worse in the past 5 years 1 Mr. BURNS. They 'have gotten worse, yes. But we are still dealing with a very small percentage of banks, and the regulatory authorities have stepped up their efforts. The CHAIRMAN. Well, let me point out further that until 1973 the percentage of all national and State member :bank assets in the problem categories were under 4 percent, but since 1974 those categories have gone up to over 30 percent of such assets and wouldn't you agree that that represents ,a rather serious problem? The agencies should make every effort to use their power to reduce the number of problem banks. Mr. BURNS. There's no question about that. The CHAIRMAN. In your October 1974 speech, you pointed to a number of factors which explained the uneasiness about banking. These were declining capital ratios, aggressive liability management, deteriorating asset quality. You further stated that increases in doubtful loans is of consequence because it raises questions about bank solvency and the maintenance of solvency is closely related to capital adequacy. Since these factors are all considered in determining which banks are problem banks, isn't the size and number of such banks an indication of the health of the banking system? Mr. BURNS. It tells you something about the health of the banking system. If I told you how many people had cancer in our country I'd be telling you something about the health of the American population, but I also ought to tell you how many people do not have cancer. The CHAIRMAN. That's right. That's why I pointed out that we had an increase from 4 percent to 30 percent. So the situation has been very sharply changed. If I were told that the number of people having cancer had-proportionate .number of people having cancer in this country had gone up eightfold, I think that would be an indication that the health of the American had seriously deteriorated in an important respect.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  73 Mr. BuRNS. I can't quarrel with what you say, but I do want to interpret a comment you m~e. I cannot emphasize too strongly that when we speak of problem banks, we are simply speaking of banks that deserve-in our judgment or in the judgment of other bank regulatory 1authorities-special ,attention. That doesn't mean that these banks are weak banks; it doesn't mean that th~y are headed for failure. It means merely that we are doing our job and are watching these banks more closely for reasons that we consider advisable. The CHAIRMAN. Well, I think the definition of problem banks is crucial and critical and for that reason, no. 1, we ought to have a uniform criteria for defining problem banks by the three agencies as recommended by the General Accounting Office. We don't have that at the present time, as I understand it. So it's a shifting unsure definition. Mr. BURNS. And it will always be that because so much depends inevitably on judgmentr----On the judgment of bank examiners and bank regulators. The CHAIRMAN. Well, my time is about up but let me ask one further question along that line. With respect to the shifting definition of problem banks, it seems to shift particularly when the situation gets worse. Last year the committee discovered when the number of problem banks increased in numbers and size to a number of real concern, we discovered the Comptroller changed his definition. We also find the Fedeval Reserve no longer considers other loans specially mentionedthat's the words used-in assessing the equality of assets held by banks. Data on these loans were not presented by the Federal Reserve, but in national banks that were over $5 billion in assets, specifically mentioned loans were 55 perce?,t <;>f capital liast year. Thus, it would seem that such loans would be s1gmficant for the large State member banks  too.  Mr. BURNS. I don't think we have changed our definition. I think it's simply a matter of looking at one set of categories at one time and another set of categories at ,another time. However, I may be mistaken, and I want to tum this question over to Mr. Leavitt. . Mr. LEAVITT. As you noted, Senator, we did make the change with respect to the category of specially mentioned loans. Previously, we had added one-half of such loans to other loans that were classified "substandard" or "loss" in arriving at a part of the grade which we ultimately assigned to a bank. The change was not triggered by a desire to make the banks look better. We made the change because for some time I had been concerned about adding specially mentioned loanswhich are often placed in that category for highly technical reasonsto loans for which there is a question about the credit quality. Other than this small technical change, I would say we have made no change; I think the fact that the Federal Reserve's number of problem banks has increased during this period of time would verify that statement. The CHAIRMAN. You say that technical change would not have affected it, if you had not made that change you would not have had more problem banks i Mr. LEAVITT. If we had followed the rating system rigidly our classification would have resulted in more problem hanks. But we give our examiners and supervisors flexibility. · The CHAIRMAN. Would you provide us with the number of problem hanks you would have if you hadn't changed that definition~   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  74 Mr. LEAVITT. You'd have to allow us the flexibility that we 1:1,llow our examiners. While our criteria suggests that a bank's assets should be ra,ted as A, B, C, or D according to the percentage relationship between criticized assets and capital, we do not interpret those percentages rigidly; we give the examiner flexibility in deciding whether or not to place the bank's assets in an A, B, C, or D category. The CHAIRMAN. Senator Sparkman. Senator SPARKMAN. I'll be glad if you would just continue but I will take a minute or two, not very much. Let me say I have enjoyed very much the discussion and your presentation, Dr. Burns. Would I be right in coming to the conclusion from your statement that we are on pretty much an even keel now? Mr BURNS. As far as the condition of the banking system is concerned? Senator SPARKMAN. Yes. Mr. BuRNS. No; I think the condition of banking is on an improving trend. Senator SPARKMAN. But not a declining one? Mr. BuRNS. Oh, no. Senator SPARKMAN. Now you referred to certain legislation that has been proposed in recent years. I don't remember when it was. Was it last year? Mr. BuRNs. We proposed legislation 2 years ago and once again last year, and we are doing so once more this year. I hope that this committee will seriously consider the legislation that we propose; I think it would go some distance in improving the supervisory process. The CHAIRMAN. Would the Senator yield? Senator SPARKMAN. Yes. The CHAIRMAN. The committee reported that legislation favorably and I wholeheartedly support it, but ,ve reported it and were unable to get it enacted, but it was excellent legisaltion. Senator SPARKMAN. Let me just say I think this is a very fine and to me a rather reassuring presentation that you have made to us. Thank you, Mr. Chairman. The CHAIRMAN. Senator Tower. Senator TowER. I would like to join the chairman and Senator Sparkman in applauding this report. I think it's a very comprehensive report, a very good one. It raises a number of questions and answers a great deal. Dr. Burns, I don't know whether this figure is manageable or not, but I'm curious to know what percentage of the petrodollars recycled in the United States are represented by our oil deficit or is there any way to determine that? Mr. BURNS. I think that the amount of recycled petrodollars is very much larger than our oil deficit. I'm quite sure our staff can go a considerable distance in providing a factual answer to your question. Senator TowER. I was sure that it would be larger because the economies of Western Europe were not capable of recycling the petrodollars that we were capable of rf?cycling. I would be interested in the disposition of those petrodollars particularly as they affect the banking community. Mr. BURNS. I will supply information for the record that is directed specifically to your question.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  75 [Dr. Burns submitted the following information for inclusion in the record at this point:] In the 3 years 1974--76, U.S. merchandise imports from the OPEC countries, consisting almost entirely of oil, came to about $61 billion. U.S. merchandise exports to OPEC countries were $30 billion, so that our trade deficit with these countries was $31 billion. !According to Federal Reserve staff estimates, in 1974--76 OPEC investments in ,the United States came to about $34 billion-an amount equal to about onefourth of OPEC'•s 3-year 1surplus, estimated at $140 billion. A:bout $25 billion of the $34 billion was invested in relatively liquid form-Le., bank deposits (including CD's) and government and private securities. (The remainder consisted principally of prepayments for imports, debt repayments, and real estate purchases.) In addttion, the OPEC countries have also placed large amounts of fund'S with foreign branches of U.S. banks; a't the end of 1976, these branches held about $17 billion of deposits from OPEC countries. While corresponding data are not available prior to September 1975, it is presumed that almost all of the $17 billion was received after oil prices were increased in late 1973.  Senator TowER. Thank you. On page 21 of your statement you said, "It's vital to make membership in the Federal Reserve more attractive, perhaps by providing for lower reserve requirements or allowing the system to pay interest on reserve balances that member banks maintain." I wrote you a letter not long ago suggesting that very issue be looked intg and I'm delighted to see your response to that. Can you expand on that or comment further on it? Mr. BuRNS. Yes. We at the Federal Reserve are now working with some of the leaders in the banking field and in the Congress, and with the members of congressional staffs, in developing a bill designed to deal with a range of problems in this area. The main purpose of the legislation will be to extend NOW accounts which at present are confined to the New England States, across the country. The banking system has been moving in that direction on its own-that is, it is paying interest to an increasing degree on balances that effectively serve the purpose of demand deposits-and it has been moved further in that direction by regulatory changes and legislative c'hanges at the State and Federal levels. Under the bill that we're working on, NOW accounts would be made available to individuals, but not to corporations and not to nonprofit organizations-although in New England nonprofit organizations are eligible for NOW accounts. Interest would be paid on NOW accounts, and that of course means an addition to costs for our banks. Therefore, I trust that the legislation being worked on will allow the banks a period of perhaps two years in which to develop their plans for introducing service charges and to develop their plans for advertising, for computer programing, and the like. As to the interest rates paid, there is an interest rate ceiling of 5 percent at the present time on NOW accounts in New England. There is no differential in the ceiling rate on NOW accounts at commercial banks and thrift institutions. I think that the interest rate ceiling shoul<l be lower than 5 percent, but I also think that interest rate ceilings should be discontinued after a few :vears. Such a provision may be included in the legislation now being drafted. To deal further with the difficult problem of costs and earnings of commercial banks, we feel that it would be desirable to start paying interest, at a modest rate, on the reserves that are kept by banks with the Federal Reserve. These are very substantial sums, and banks now   86-817 0 - 77 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  6  76 earn nothing on them; that is why so many banks have been leaving the System. I have learned, much to my discomfiture, that a disproportionate number of the banks in New England that have left the System are weak banks or problem banks. They have left the System because of the financial problems they face and because that is a way of saving on costs and bolstering their earnings somewhat. These are the very banks that need most the insurance policy that is furnished by the discount window. As banks leave the Federal Reserve, I think we are developing underlying problems in our banking system. These are some of the considerations that we have in mind in working on the draft legislation. I have gone beyond your question, Senator, but, I wanted to indicate the setting within which we are now thinking of paying interest on reserve requirements. We are considering this in connection with broader legislation, in which the several pieces would fit together. Senator TOWER. You discuss the matter of subjecting foreign banks to the same rules and regulations applied to domestic banks and you made some comments on the increase in the loan portfolios of U.S. banks doing business abroad. To what extent are regional American banks, those that are outside of the major money centers, participating in international lending? Mr. BURNS. They are participating to some extent. I don't have the figures with me; possibly Mr. Leavitt can answer that. Mr. LEAVITT. I do not have the figures either, Senator. I would say that the bulk of the foreign lending that is done by regional banks takes the form of a participation in a syndicate loan that's put together by the major money market banks either in New York or on the west coast. There is also a small amount of· lending directly to Mexican borrowers by banks situated in the State of Texas, but I do not have any particular numbers in mind. Mr. BURNS. My impression, Mr. Leavitt, is that the largest 50 or so banks account for the great bulk of the foreign lending. Is that correct i Mr. LEAVITT. That's by far and away correct; it is these larger banks that would be making the syndicated loans in which the smaller regional banks are participants. Senator TowER. What do you perceive the proper role would be in international lending for these regional banks in the future? Mr. BuRNS. I expe0t the regional banks to extend their participation. Some perhaps have gone too far now, but over the long run I think many of these regional banks will grow, in time becoming national banks and later becoming international banks. That's the way in which our own economy and the world economy have been developing, and I think our banking system will adjust to what is happening in the economy at large. I would expect regional banks in your State of Texas 10 or 20 years from now to play a significantly larger role in international lending than they play at the present time. Senator TowER. Thank you very much, Dr. Burns and Mr. Leavitt. The CHAIRMAN. Senator Lugar. Senator LUGAR. Dr. Burns, I'd like to follow through on some of the international implications of what you have said today. You pointed out that essentially the OPEC countries give away the opportunities of banking but also the potential dangers of credit evaluation. Two pages later in your testimony you mentioned that at least one  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  77 aspect of this may be that as much as $45 billion of loans through American banks have been made to LDC's, and that is a part of maybe $180 billion in loans extended worldwide. The question I want to raise is this one. Granted that the Federal Reserve Board is following this very closely and that there has been considerable prudence by banks in this country, we appear to be heading toward a north and south conversation in international negotiations with great pressure from the Saudis for us to be even more liberal in return for their not raising the price of oil any faster than they have done. You at the Federal Reserve are monitoring all this and having an interest in foreign policy and so forth, but not having very much control over this. What sort of a scenario follows this as a part of our international diplomacy? Does it become imperative for the United States or U.S. banks to extend quite a bit more credit. What if the problems of LDC's are increased as OPEC oil becomes more and more expensive and the OPEC countries do not read your testimony and do not get more into banking and, in fact, are perfectly willing to shift almost all of this banking and credit extension to us and ask us to do a great deal more of it? Now I don't think that's unlikely to be the case, but at least that would be a part of their push. So I suppose what I'm asking you is this: Granted that you might not have control over what is conceded there, what sort of additonal prudence is required in terms of domestict banking regulations over which you do have some say? Granted that you pointed out that things are moving not only toward an even keel but in answer to Senator Sparkman toward a greater health and that equities are being built up, that liability management diminished and all these sorts of things. Do we have to look for a greater safety margin in anticipation of the world situation that I think is clearly going to be upon us? Mr. BURNS. You raised a very important question; I touched on it in my testimony. When the OPEC group began raising the price of oil in the latter part of 1973-eventually quintupling or sextupling the price-they in effect declared economic warfare on the industrial world. The industrial world did not respond; we were substantially passive. I think that was unfortunate. I said at the time that forces were being released in the world that were likely to prove literally unmanageable, and that sentiment was shared by a good many at the time. But then many bankers and students of banking became complacent, and we began 'hearing more and more about the wonderful performance of the private banking system in recycling these funds and about how the problem had been solved by our private financial system. I didn't believe a word of it then, and I don't now. What was happening was simply that the loans were piling up as the surpluses grew. The banks got the money and the banks extended the loans. But this couldn't go on; corrective action had to be taken. Some corrective steps have been taken, but not nearly enough. Now that a number of the oil importing countries are in financial trouble, they will have to take much stronger internal measures to deal with the inflation that was caused in large part by the pricing policies of OPEC. I think also that our banks simply cannot continue recycling on the scale that they have been doing. It would be unfor-   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  78 tunate if they withdrew entirely; in fact, we would have a crisis if they did. I don't think they are going to do it and they shouldn't do it. At the same time, I would be deeply concerned if our commercial banks continued lending abroad at the recent rate particularly to the LDC's but not exclusively so; !"'sometimes wonder which countries belong in the LDC category. Our banks must not continue increasing their outstanding foreign loans at the rate at which they have been doing so. There is, however, a limit to the measures that the oil deficit countries can take, and I believe that new financial devices will have to come into play to tide us over. I think the time has definitely come for OPEC to discharge its responsibility; they released major financial troubles for the rest of the world and they have to play a part in solving these problems. I believe that there is increasing recognition on the part of the leaders in Saudi Arabia and in other countries in the OPEC group that they will have to do this. The International Monetary Fund is now engaged in very sensitive conversations designed to help solve this problem. They are in steady communication with us and I think mechanisms will be worked out to tide the world over this problem. I hope this country will play a part; we have to. The other major industrial countries will have to as well. But the time has come for OPEC to play a major role, too. They have a choice: they can become bankers or they can cut the price of oil by 50 percent. Senator LUGAR. Dr. Burns, I agree that they should do these things. I am hopeful we will be better in negotiating with them or more persuasive in that respect. But in the meanwhile, what is your judgment as to American private banks having $45 billion of loans to L.D.Cs and maybe some increase, in view of the fact that these loans inevitably get into foreign policy situations? Without trying to play the Devil's advocate for this point of view, are there not problems in private banks being engaged in these sorts of loaning activities as opposed to the U.S. Government that eventually might have to face the predicament of massive defaults, or at least changes in governments in favor of people who simply do not recognize these loans? Are these loans, in other words, much the same in a sense as lendlease, or other sort of arrangements, in which we have helped other countries in dire straits, granted these are peacetime as opposed to wartime loans but are they not almost government-to-government loansi Dr. BURNS. I have been talking about loans by commercial banks, and my report today is confined to them. These loans have been made on a business basis, and I think that, by and large, they will turn out to be good loans. But the pace has been too fast. Our bankers are well aware of this, and I expect the pace of bank lending abroad to slow down. I also think that governments will play a larger role, through the International Monetary Fund if not otherwise. And I think that OPEC has to join the international community in helping to solve the problem that OPEC itself, in very large part, has caused. Senator LUGAR. Thank you. The CHAIRMAN. I have so many questions here, Dr. Burns, and we do have another witness, but I will be as quick as I can.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  79 On the point I was making when I finished by questioning, would you recalculate the number of problem banks for the committee, using the "other loans especially mentioned" category, including those loans where credit-worthiness is a factor, but leaving out the technical classifications? Could you do that? Dr. BURNS. Surely. [Dr. Burns submitted the attached letter for inclusion in the record at this point :] CHAIBMAN OF THE BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM, Washington, D.C., April 18, 1977. Hon. WILLIAM PROxMmE, Chairman, Committee on Banking, Housing and Urban Affairs, U.S. Senat.e, Washington, D.C.  DEAB MB. CH.AmMAN: I am pleased to respond to the request that you made during my appearance before your Committee on March 10 concerning the classification of problem banks. You noted during the hearing that the Federal Reserve had changed its criteria for "rating" the financial condition of State member banks by eliminating consideration of "other loans specially mentioned" by bank examiners. You requested that the Federal Reserve recalculate the number of problem banks for the Committee, using the prior category of other loans specially me·ntioned. The technical change in question was made by the Board's Division of Banking Supervision and Regulation on May 9, 1975. The letter outlining our instructions relating to this change is attached for your information. As I indicated duri'ng my testimony, any rating of the financial condition of banking institutions necessarily involves the subjective judgment of individuals who are expert in such matters. Moreover, since the "composite rating" properly includes consideration of all factors pertinent to a bank's fi'nancial condition, we anticJpated that the technical change in the criteria would not result in significant shifts of banks among rating categories. Subsequent to my testimony on March 10, all Reserve Banks were requested to review the most recent examination of State member banks in their respective districts to determine whether any additional banks would have been classified as so-called problem banks if no change in the rating methad had been made. All twelve of the Federal Reserve Banks reported that, upon reexamination of their ratings, no State member bank would be moved from a non-problem to a problem status. We believe, therefore, that the data concerning the ratings of State member banks submitted to you prior to my testimony are complete and would not be changed by reversing the amendment in our instructions relating to other loans in the specially mentioned category. I appreciate the opportunity to make this information available. Sincerely yours, ARTHUR F. BURNS. Attachment. BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, Washington, D.C., May 9, 1975.  TO THE OFFICER IN CHARGE OF EXAMINATIONS AT EACH FEDERAL RESERVE  BANK  This amends the method by which the quality of asset factor is computed for the purposes of determining the asset rating as set forth in the uniform system for rating commercial activities of member banks. Under existing procedures, 50 percent of other loans specially mentioned is added to classified assets in the calculation used in determining the asset quality factor. Inasmuch as there appears to be little uniformity among Reserve Banks or among bank examiners in the use of the specially mentioned category, the inclusion of loans so criticized for rating purposes tends to distort the actual asset rating of many banks. Therefore, for purposes of determining asset rating only, the 50 per cent of specially mentioned loans should no longer be included in the calculation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  80 All other aspects of the uniform system for rating commercial activities of member banks remain unchanged. BRENTON c:LEAVITT.  The CHAIRMAN. Now I want to come back to that fascinating OPEC problem. But before that, I am still very much concerned with the fundamental outlook for our banks. You would agree, I am sure, that capitalization is an essential measure of soundness, that if a bank has adequate capital, obviously if we went. into rough times, loans turned bad, the capital could absorb that. If they are thinly capitalized when we run into bad times, they obviously cannot. Two baseline standards used by the Federal Reserve for determin'ing capital adequacy are total capital as a percentage of total assets, and total capi-tal as a percentage of risk assets. The percentages, I un.derstand, would suggest something like 8 and 10 as a standard. In light of these baseline standards, do you agree that the banking system as a whole is not adequately capitalized? Dr. BURNS. I would say that a good many of our banks are not adequately capitalized; that is my judgment. Do you share that, Mr. Leavitt? Mr. LEAVITr. I share that judgment. And I would say that we take advantage of many opportunities to get banks to increase their capitalization in the form of subordinated debt capital-or even in the form of equity capital, when banks can raise money in that way. The CHAIRMAN. In answering my question, you modified the question. My question was whether the banking system as a whole is undercapitalized. You say many of our banks are. Would you go as far as to say yes in answer to my question, or would you say that it is too gross a generalization? 'Dr. BURNS. If you want a yes or no answer, I will give it to you. The CHAIRMAN. I want one. Dr. BuRNS. Then the answer is yes. But I hope you will now permit me to interpret the "yes." The CHAIRMAN. As you interpret it, let me add a point. Isn't is particularly true that the large banks, the banks with assets of more than $5 billion, are particularly undercapitalized? Dr. BURNS. I am not going to answer questions like that with a yes or no. I did it once, but I am not going to do it again. The CHAIRMAN. Well, you did it once. All banks are undercapitalized, and the big banks have far less capitalization than the smaller banks, something like 5 percent? Dr. BURNS. Yes; but big banks are able to diversify their risks in a way and to a degree, that small banks cannot. And therefore, his~ torically-no matter how far back you go-you will probably find that big banks have lower capital-to-asset ratios than smaller ba.nks. Second, by and large, big banks are better managed. The CHAIRMAN. Well, accepting that, would you still feel that the level of 5 percentDr. BURNS. I still would be more comfortable if some of our bigger banks had larger capitalization, definitely. We work at that steadily with them. The CHAIRMAN. Some years ago I recall, I think it was rather recently, as a matter of fact, 2 or 3 years ago, Dr. Burns, in response to   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  81 a question I asked, you indicated that the Federal Reserve as a· I recall it would not permit a very large bank to fail, because of the catastrophic effect it would have on the economy. That is, you are in a position to, the Federal Reserve Board, I should say, is in a :position to prevent a failure, as you did, or at least the kind of devastatmg failure we would have had with the Franklin National Bank if you had not stepped in. Do you still share that view, that you will not permit a very large bank to fail, you would step in, if necessary? Dr. BURNS. Well, you know Franklin National did fail; and U.S. National of San Diego did fail. In each of these cases, when we saw that the bank was bound to fail, we tried to arrange a takeover that would leave undisturbed the commercial relations between the customers of the bank and the bank itself, under its new ownership. The CHAIRMAN. So no depositors would lose money. Dr. BURNS. So depositors would not lose money. If we run into similar difficulties in the future, we will be guided by the same principle. We don't want to see .dislocations to communities or to the Nation through the losing of large banks. But while that is very much a matter of concern to us, we can be and .will be quite ruthless with bank management if necessary. We are concerned about depositors; we are concerned about customers of banks. When the mana.gers have not done their duty properly; we have little sympathy with them, and we will do nothing to save their necks. I believe that every banker in the country understands that fully. The CHAIRMAN, Let me just spend a minute or two more of the capital adequacy of the large banks. · The percentage of classified assets-that is, assets of a substandard doubtful or loss nature-to capital at national banks over $5 billion is over 100 percent. For State member banks in 1976, based on incom7 plete data, it appears to be around 80 percent. These percentages are much much higher, by two or three times, than :for medium and smaller banks. Doesn't this data suggest that in absolute terms the capital problem may be worse than appears on the surface; and that the leverage of the bigger banks is greater than meets the eye? The quality of assets may explain the high earnings of the large banks since their higher risk portfolios probably carry higher earnings but weaker underlying values. Dr. BURNS. Some of our larger banks shared the euphoria of much of the business community during the late 1960's and early 1970's and, in the process, they bec;ame loaded down with weak loans, including in particular questionable real estate.loans. Our smaller and mediumsized banks avoided risks of that kind to a larger degree . .As for your repeated question, I can only give you my repeated answer: I would feel more comfortable if the capital position of a number of our larger banks were stronger. We are working at that constantly with them. The CHAIRMAN. The General Accounting Office's findings respecting the Federal Reserve's supervision of bank holding companies gives me great concern.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  82 You mentioned the bank holding companies briefly, I think you had one or two sentences about it in your excellent statement. Congress placed the responsibility on the Fed to regulate all bank holding companies, which incidentally control two-thirds of all banking assets and deposits. The Fed in turn has delegated substantial authority over bank holding companies to the Federal Reserve banks whose directors in many cases are banks regulated by the Reserve Banks. The main criticisms of GAO were: (1) Federal Reserve Bank standards varied from district to district; (2) No effective monitoring system was in effect at the Board for overseeing the Federal Reserve Banks; and (3) Federal Reserve Banks did not normally conduct simultaneous holding company and bank examinations. What concerns me is the GAO finding of lack of control by the Board over the Reserve Banks. This has great potential for harm. Shouldn't the Fed set in place an effective management system over the Reserve Banks in cases like this? Dr. BURNS. I am going to let Mr. Leavitt answer that question. But I do want to say this: in the judgment of our staff, and also, I believe, in the judgment of the Board, some of the criticisms by the General Accounting Office are not soundly based. With your permission, I would like to submit for the record a critique prepared by our, staff of Mr. Staats' recent testimony on the GAO study. May I do that? The CHAIRMAN. Yes, indeed. [Dr. Burns submitted the ·attached letter and staff critique for inclusion in the record at this point. The GAO comments follow:] CHAIRMAN OF THE BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM, Hon. WILLIAM PROXMIRE,  Washington, D.C., March 24, 1977.  Chairman, Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C.  DEAR MR. CHAIRMAN : When I appeared before your Committee on March 10 to discuss the condition of the banking system, you agreed to my suggestion that a staff critique of Comptroller General Staats' recent testimony concerning the GAO report on Federal supervision of state and national banks be submitted for the record. I am pleased to attach a copy of this staff critique and would appreciate your circulating it to your colleagues on the Committee on Banking, Housing and Urban Affairs. With best regards, Sincerely yours, ARTHUR F. BURNS. Enclosure.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  83 March, 1977  STAFF ANALYSIS OF TESTIMONY PRESENTED BY COMPTROLLER GENERAL ELMER B, STAATS . ON FEBRUARY 1, 19 77, BEFORE THE COMMERCE, CONSUMER AND MONETARY AFFAIRS SUBCOMMITTEE OF THE COMMITTEE ON GOVERNMENT OPERATIONS  AND THE FINANCIAL INSTITUTIONS SUPERVISION, REGULATION AND INSURANCE SUBCOMMITTEE OF THE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS The following is an analysis of the major points contained in Comptroller General Staats' testimony on the General Accounting Office Study of Federal Supervision of State and National Banks.  Mr. Staats'  direct comments or summary of them appear first, followed by Board staff views. INTRODUCTION AND BACKGROUND GAO View In the first four pages of his testimo~y, Mr. Staats outlines the events leading up to the GAO study, the agreements between the GAO and the agencies and the objectives of the study. The GAO reviewed examination reports and correspondence files for a general sample of 600 banks, 294 problem banks and 30 failed  banks.  The information contained in the examination reports was  taken as a "given" by the GAO since the agreement provided that they would not examine banks but would accept the facts found by the examiners for the three agencies.  The GAO study focused on  whether bank examinations are sufficient to identify banks which 'are likely to run into problems and whether supervisory agencies follow through on their findings to see that corrective actions are taken.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  84 Federal Reserve Staff Comment GAO's assessment of supervisory performance was largely based on written information contained in the Board's files.  Only a relatively  small sample of Reserve Bank files was reviewed,  The GAO is not likely  to have seen the entire record with respect to a  number of banks since  Reserve Bank files often contain more complete information concerning follow-up action.  Moreover, the GAO would have been unaware of corrective  actions taken such as counseling with respect to proposed expansion applications since  such actions are often not reduced to writing and are  not contained in the record. The methodology employed by the GAO in reviewing the banks in its sample also undoubtedly resulted in some distortions in findings and misinterpretations of examiner intent.  To facilitate review of such a  large sample of banks, the GAO designed a "data collection instrument'! (''DCI") which was used to pick up key pieces of information contained in the examination reports.  The information on the DCI was designed so  that it could be coded and reduced to a form suitable for computer processing. One of the major shortcomings inherent in this approach was the use of code words on the DCI to note examiner criticisms.  If the examiner was critical  of certain elements of the bank, but did not use precise phrases or words that corresppnded to the code words ?n the DCI, the GAO would not pick up the criticism and/or might misinterpret it.  For example, if an examiner  criticized loan procedures but did not use phrases to make it clear that by doing so he was being critical of management, the GAO would fail to note a criticism of management.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Such procedures undoubtedl~ led to the  85 following conclusion contained in the GAO report: ",,,Surprisingly, far fewer banks were cited for ineffective management than were criticized for the related problems of inadequate internal routines and'controls and violations of laws and regulations ••• " FAILED BANKS GAO View The GAO reviewed 30 of the 42 bank failures that occurred between January 1971 and June 1976 and concluded the following: 1.  In the main, failures were caused by practices followed by the banks' managers--14 were related to self-serving loan practices, 8 were due to fraud, and 8 were caused by general loan mismanagement.  2.  The examiners identified the problems well in advance of the failures in most instances.  3;  The agencies relied on informal persuasive techniques and did !!2J:. take formal legal measures against these banks often enough.  Federal Reserve Staff Comment Only two of the failed banks were under the supervision of the Federal Reserve. $15  Tri-City Bank, Warren, Michigan (deposits approximately  million); State Bank of Clearing, Chicago, Illinois (deposits $60  million). Tri-City Bank fai1ed on September 27, 1974,  At the time of its  failure, Tri-City was operating under a cease and desist order issued by the Board on June 30, 1971,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  more than three years before its failure,  86 Tri-City Benk's management did not cooperate with the regulatory agencies in resolving the bank's problems despite the fact that it was operating  under very close supervisory scrutiny and a restrictive cease and desist order,  Replacement of management might have helped to preserve this bank;  however, we did not believe the statutory findings necessary for removal action could be shown,  The Board's proposed change in cease and desist  statutes to permit removal on the grounds of gross negligence might have been helpful in this case, '.I.be failure.of State Bank of Clearing was principally caused by construction loans that turned sour with the sharp downturn in the real estate market,  The bank's situation worsened when its chief executive  officer, who dominated the bank, was killed in an automobile accident, Once the problems in the bank were identified, however, succeeding active management cooperated with the supervisory authorities,  It is questionable  that a cease and desist order, which is used primarily as a tool for dealing with recalcitrant management, would have proved useful in this case.  ADEQUACY OF SCOPE OF EXAMINATIONS GAO View The following is a summary of the GAO findings in this area, together with our comments concerning those findings, 1, agencies,  Examination procedures were similar among the three The major emphasis of the agencies' examination efforts  was on evaluating quality of assets, adequacy of capital and quality of management,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  87 2.  Examinations· placed g1·eat emphasis on analyzing the bank's  condition at the time of the examination and did not address underlying causes of problems such as poor policies or weak controls. 3.  Banks are examined on a rigid frequency requirement.  GAO believes that the number of times a bank is examined should not be based on rigid requirements but rather on the agencies' assessment of an evaluation of the bank's soundness, policies, etc. 4. _Examination reports showed that examiners only rarely cited violations of consumer laws and regulations.  '.lhe GAO reports  that the agencies acknowledge that they have not aggressively monitored consumer protection law compliance and that they have begun revising their approaches.  The GAO notes that the agencies are gearing up  their enforcement program. Federal Reserve Staff Comment 1.  We agree that the examination procedures followed by the three  agencies are much alike and agree with the GAO's assessment concerning the major emphasis of examination efforts.  * 2.  *  *  It is unclear from a review of the G\O report as to what facts  support this conclusion or what analysis was made that led to the conclusion. The following is a statement contained in the report that may pertain to  Mr. Staats' conclusion:  " ••• Examiners often did not criticize a bank's  policies until the problems had already developed.  For example, inadequate  loan policies were not cited by examiners unless the banks had classified loan problems, as shown by data cited for either problem in our general and problem samples combined ••• "   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  88 In other words, it appears that because the GAO found no criticism of loan policies in examination reports of banks that had no loan problems, the GAO concluded that examiners did not address the underlying causes of problems. We believe the conclusion of the GAO is erroneous and that present procedures do identify the cause of problems.  For example,  analysis of the loan portfolio as presently conducted by examiners reveals:  (1) the risk-taking propensity of management; _(2) the quality  of the administration of the portfolio; and (3) the ability of management to cope with problems when they arise.  Based on findings  as a result  of such analyses, the supervisor is readily able t_9 identify those institutions and/or particular operations within an institution that are likely to cause problems.  Moreover, weaknesses in policies and  procedures are often discussed by the examiner with management and not cited in the formal report, particularly when there are no.serious problems. The GAO recommendations in this area place considerable emphasis on examiner analysis of loan policies.  We believe written loan policies  are helpful and Federal Reserve examiners encourage banks to adopt them.  Such policies, however, are necessarily general in nature and provide only a basic framework within which the loan officer operates. not insure that good loans will always be made.  They do  The making of sound loans  is largely dependent upon the credit judgment of the lender which is exercised on a case-by-case basis.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  lhus, analysis of the major loans in  89 the banks's portfolio is perhaps the best method for gauging the soundness of lending policies and procedures. GAO also suggests that examiners should detect buildups of concentrations of credit in certain sectors and should criticize banks for inadequate diversification.  Effective risk diversification is not  always possible to achieve since many banks serve markets dominated by one industry, e.g., agricultural area9.  Furthermore, some banking  institutions develop particular expertise in or have an histo~cal relationship with certain industries and, therefore, tend to have extensive business dealings with those industries.  lhese factors make it difficult  for some banks to achieve effective di~ersification.  Nevertheless,  examiners do urge diversification of risk and are particularly sensitive to concentrations of credit. lhe statement made by the GAO that examiners rarely criticize loan policies until they criticize a large volume of loans also seems to suggest that bank examiners should possess better anticipatory powers than bank management possess.  In all likelihood, the recent experience  that some banks encountered with REITs contributed to this observation, To suggest that examiners should be able to anticipate events such as  the collapse of the real estate market in the mid-1970 1 s is expecting examiners to be very perceptive indeed.  Of course, there was evidence  of some unsound lending practices in connection with REITs which the examiners perhapslhould have recognized. It is in the area of lending policies that the GAO comes dangerously-close to suggesting that supervisory agencies should participate   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  90 in the management of the bank and should engage in de facto allocation of credit in order to achieve diversification of risk.  Neither of these  roles is proper for a bank ~egulatory agency.  * 3,  *  *  It is the Board's policy to examine all State-member banks  annually; to examine all problem banks a minimum of once each six months; to exami~e ·any bank following a change in ownership or control; to examine any bank in which there has been a dramatic shift in assets or liabilities  as reflected in. financial reports.  With respect to frequency requirements  for examinations, we believe that it is necessary to examine all banks, including those institutions that are not believed to have significant or potential  problems, within a set time frame.  lbe set frequency schedule  for examinations is necessary to assure that those banks believed to be in good condition are, in fact, in good condition.  However, the scope of the  examination of such banks need not be as exhaustive as the scope for banks with known problems or potential problems.  For this reason, the Federal  Reserve developed an "Asset Quality and Management Performance Examination" to be used for examination of banks thought to be relatively free of major problems.  If this limited ~cope examination detects major changes or  deterioration, a full scale examination is commenced.  Such procedures  give us flexibility, while at the same time assuring that problems are not overlooked,  * 4.  * *  lbe Federal Reserve has had the major responsibility for drafting  companion r~gulations for the surging growth of legislation that has taken   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  91 place over the past two years.  '!he Board's newly organized Division of  Consumer Affairs is working closely with the other agencies and has formed a task force to develop methods to enforce the newly enacted consumer credit  laws.  A cadre of examination specialists is being trained to concentrate on  inspection for compliance with consumer protection statutes.  Two schools on  consumer regulations were conducted in 1976 and four are planned for 1977. In addition, examination manuals that deal with the full array of consumer regulations have recently been prepared.  A new examination report form  dealing exclusively with this area has been developed and is expected to be in use in the near future.  In short, prior to the GAO study, we had been  moving ahe.ad vigorously to insure implementation of thes<! new laws. USE OF STATE EXAMINATIONS GAO View  Mr. Staats noted that both the FDIC and FRS are conducting limited experimental programs to determine if they can rely more on the work of State examiners instead of examining independently ·in those states.  '!he Federal Reserve has been conducting such an  experiment in the State of Indiana.  Mr. Staats stated:  " •• ~We  believe that the agencies should expand these programs to as many states as possible.  Of course, the qua,lity of State examinations  must be taken into consideration in such a program.,." Federal Reserve Staff Comment As far as  we  could determine, the GAO made no substantive  evaluation of the results of the experimental programs being conducted by the Federal Reserve and the FDIC to support its recommendation that  86-817 0 - 77 - 7   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  92 the programs be expanded,  It is our understanding that the programs being  conducted by the FDIC at the time of the GAO audit have now been terminated, In at least one instance, the termination was in response to a request by the State authorities that FDIC resume active participation in examinations, Although staff recognizes the necessity of eliminating unnecessary duplication, as a matter of policy we have some difficulty with the concept of withdrawal of active participation by the System in the examination of banks for.which the Federal Reserve has statutory supervisory responsibilities, Moreover, it should be noted that in those states where the Federal Reserve conducts concurrent or joint examinations with the State authorities, duties are normally divided between the State examiners and Federal Reserve examiners in a manner  de ■igned  to minimize the duplication of effort, EXAMINATION REPORT FORMAT  GAO View  Mr, Staats stated that reports of examination were not effectively communicating the examination results to the banks because: 1,  ",,,Many problems and criticisms were stated in the  confidential section of the report but not disclosed to the banks,,," 2,  The examiners generally did not recommend h.!!!t the bank  could correct -problems, Federal  Re ■ erve  Staff occa■ionally  Staff Comment believe■  there  i■  1ome merit to the criticism that  place c0111111ent1 in the confidential  appear in the open   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ■ action  ■action  of the examination report.  examiner■  that should probably  Federal Reserve examiners  93 are encouraged to place important criticisms in the open section of the report in order that they are brought to the attention of the bank's board of directors. lhe examination report review procedures followed by the System are designed to insure that the findings of the examiner are clearly and concisely conveyed to the bank.  If the reviewer notes important findings in the confidential  section, he may include them in the letter transmitting the examination report to the bank.  Occasionally, officials at the Reserve Banlcs discuss the  examiner's findings directly with the bank's management.  In short, there are  a number of ways by which the System communicates with State-member banks.  lhe  fact that the GAO noted instances when they believed that examiners' confidential comments should have appeared in the open section of the report hardly supports the sweeping conclusion that reports of examination were not effectively communicating the examination's results to the banks.  *  *  *  We believe that it is the responsibility of the examiner to identify the problems and recommend corrective action.  In the majority of cases,  determination of the precise remedial action is more properly the perogative of management. BANK HOLDING COMPANIES  GAO View With respect to the supervision of bank holding companies,  Mr. Staats stated:  " ••• Many of the banks in our samples were  eontrolled by bank holding companies.  While we did not review the  Federal Reserve's overall regulation of banlc holding companies, did check on the problems in our sample banks which were related   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  we  94 to holding companies.  We found that 22 of 344 banks had problems  caused by their holding companies.  In most of these cases, the  holding companies' actions were not uncovered until problems had been identified by the banks.  As you are aware, we were limited by the  study agreement to reviewing only the supervisory aspects of holding companies which contributed to problems of affiliated banks in our samples ••• " Federal Reserve Staff Comment lhere were limited instances in which bank holding companies were found to have caused problems in the subsidiary banks.  Out of the sample  of 344 which were affiliated with bank holding companies, there were 22 banks in which the report stated that the problems were caused by the parent holding company.  lhis constitutes 6.5 per cent of the sample banks affiliated  with bank holding companies.  However, the Board's examination of the parent  bank holding company in each of these instances demonstrates that, in fact, the actions of only five holding companies could be said to have caused any serious problem in the subsidiary banks. With respect to the 22 companies, the GAO also concluded that inspection of the bank holding company by the Federal Reserve did not uncover the problems until they had already surfaced in bank examination reports. Our review of t:i)e 22 bank holding companies revealed that problems in over two-thirds of the companies were predominately bank problems as opposed to problems caused by the parent holding company or nonbank subsidiaries,  In  these cases, it is unrealistic to postulate that a bank holding company inspection could have detected problems in subsidiary banks prior to their surfacing in bank examination reports.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  95 EFFECTIVENESS OF AGENCIES IN RESOLVING PROBLEMS GAO View  Mr. Staats made two major points in this area. 1.  lbey WP.re:  Su?Srvisors were not properly informing the banks' boards  of directors of problems frond during examination.  lbe GAO found  that the agencies met with directors in less than ten per cent of the banks in their sample and reco111111ended that meetings be held with directors in connection with every examination. 2.  Informal actions to correct problems were used most of the  time and formal actions were seldom used.  Mr. Staats stated:  " ••• Even  though the same types of problems existed from one examination to another, the agencies did not often change the type of enforcement actions used or intensify the use of an enforcement action to get the problems corrected.  For example, from 1971 'through 1975, the agencies  made limited use of written agreements and cease and desist orders-probably their most effective tools ••• " Federal Reserve Staff Co111111ent lbe long-standing policy of the Federal Reserve is to meet with the board of directors in connection with the examination.of every problem bank. Admittedly, however, this policy has not always been followed as closely as it should have been by the Reserve Banks.  In July 1975, the Board, in a  policy directive concerning follow-up procedures in connection with problem banks, reaffirmed the policy with respect to oeetings with directors.  Since  that time, the Reserve Banks have been closely following this policy.  It  should be noted that meetings with senior management of the bank are held in connection with every examination.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  96 In order to insure that directors are aware of the findings of the examiner, the Federal Reserve requires that the directors review the report and that such review be noted in the minutes of a meeting by the board of directors.  Additionally, in some instances, directors are required  to approve the bank's reply to the examination report. In general, we have some difficulty with the GAO reco11111endations that director's meetings be held in connection with every examination for two  reasons,  First, such meetings tend to become routine and thus lose some  of their effectiveness as a vehicle for obtaining corrective action when  serious problems arise,  Second, they are an unnecessary inconvenience and  expense to the bank and its directors as well as to the supervisory agencies when findings are routine and can be effectively communicated to the board through reports and letters,  *  *  *  Although we have substantially increased the usage of cease and desist authority--and there were undoubtedly some instances in the past where we could have used it and did not--such action does not necessarily represent the supervisors most effective tool.  '!here are a number of reasons why cease  and desist is not always the most effective method for seeking correction. 'lhese include: 1,  If management is cooperating with bank supervisors toward  the resolution of apparent problems, the Board will, at times, forestall formal cease and desist action and await the results of this cooperation before resorting to coercion.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  97 2.  Banking institutions registered with the SEC normally take  the position that such orders are material and must be disclosed.  Disclosure  that the U.S. Government has cited a banking institution for unsafe and unsound banking practices could cause that institution severe funding problems, particularly if it were operating in the money markets.  Such  a development would be counter-productive to efforts to restore the bank to a sound condition. 3.  It is possible for uncooperative management to delay  implementation of the corrective action being sought for months and perhaps years by extensive use of both the administrative and judicial appeal process. 4.  Some problems do not lend themselves to solution by cease  and desist action. example.  A problem bank in need of additional capital is an  In such situations, the bank may not be able to raise capital  in the market for two reasons.  First, the bank might be required to  disclose its financial condition in considerable detail.in prospectuses filed with the SEC.  Such disclosure would likely make it impossible or  too expensive to raise additional capital. would not likely support new capital.  Second, the bank's earnings  Under such circumstances, the  issuance of a cease and desist order requiring additional capital, when such action was not possible, would constitute a somewhat meaningless 1/ exercise,-  !/  Of course, a cease and desist order could be issued to provide for preservation of capital through elimination or reduction in dividends and/or reauction in operating expenses such as salaries.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  98 5.  We presently have no authority to remove management for  anything less than personal dishonesty.  The majority of the Board's  problems with management fall, rather, into the category of incompetence or negligence. In its discussion of the effectiveness of the agencies in resolving problems, the GAO cited one case study involving a problem State-member bank.  The following represent the salient facts in this  case: In a July 1974 examination report, the Federal Reserve examiner, in the confidential section said the bank had a capital deficiency.  The  transmittal letter forwarding the examination report to the bank's board of directors cited the capital deficiency and requested a $1 million injec~ion of new capital.  The June 1975 examination  report revealed increases in classified assets; the bank was placed in a problem status.  The  transmittal letter emphasized the need for strict adherence to the bank's recently strengthened lending policy and requested monthly progress reports.  A meeting was held with the bank's board  of directors to discuss the loan situation.  The  February 1976 examination revealed a more favorable condition.  The $1 million additional capital had  .been added and the volume of classified assets had   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  99 declined.  Following a meeting with the board of  directors held in connection with the February examination, the bank was removed from the problem list. With respect to this case study, the GAO said: " ••• The same problems have been in evidence for almost 2 years, yet the FRS had little success in using informal enforcement action to get the problems corrected ••• " Staff would submit that, GA.O's conclusions notwithstanding, this case represents an excellent example of effective bank supervision that resulted in timely correction of problems.  The GAO seems to be suggesting that  cease and desist action should have been taken in this case.  We believe  the problems were effectively resolved using informal supervisory methods. In connection with corrections of problem situations, it should be noted that far more important than the issuance of cease and desist orders have been the numerous instances in which Federal Reserve personnel have advised holding companies to defer expansionary programs.  The with-  holding of supervisory approval needed by bank holding companies that seek to engage in additional activities or, in some cases, to expand their present operation has proven to be a most effective supervisory tool. actions went unnoticed by the GAO. PROBLEM BANKS  GAO View  Mr. Staats states:  " ••• All of us have read a great deal in  recent months about the agencies' lists of problem banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  In  Such  100 our study, we analyzed those lists in detail to see how long banks remained in problem status and how the agencies dealt with those banks,"  ''During the 5-year period ending December 31, 1975, a total of 1,532 connnercial banks were on the agencies' problem bank lists, Fifty-five per cent of those banks were returned to nonproblem status by December 31, 1975,  Although most of the banks returned  to nonproblem status in two years or less, 24 per cent remained problem banks over two years.  We found that some banks were considered  to be problems for longer than five years ••• " Federal Reserve Staff Comment The majority of banks on problem lists are institutions that have experienced some difficulties and were identified as needing more than the usual degree of supervisory attention and monitoring.  Supervisory  performance should not be measured by the number of institutions that the supervisor believes warrant close attention and/or the length of time such attention is given,  That may also be a measure of the supervisor's alertness,  In addition, it should be recognized that there &re banking institutions-fortunately not many--that are only marginally successful businesses, but that provide essential services to their communities,  If the supervisors  believe they can work closely with the bank and safely let it continue, lileymay find it necessary to maintain close scrutiny for a number of years. We believe this is a responsible policy that is in the public interest,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  101 NEW LEGISLATIOI GAO View Mr. Staats supported the request by the superviso-ry agencies  for additional statutory authority to remove a bank official whose acts stem from either personal dishonesty or gross negligence and  to assess civil penalities against banks and/or individual officers for specific violations. Federal Reserve Staff Connnent In addition to the requested additional authority mentioned by Mr. Staats, the Board has also proposed statutory limits on loans to insiders and authority to permit the acquisition of a large failing bank by an out-of-State institution.  We believe this additional  authority is also in the public interest. EFFORTS TO IMPROVE EXAMINATIONPROCEDURES GAO View  Mr. Staats noted the Federal Reserve's adoption of limitedscope examination procedures for banks thought to be relatively free  from major problems.  It was quite clear, however, that the GAO was  most favorably impressed by the new procedures adopted by the  Comptroller.  With respect to these procedures, Mr. Staats stated:  " ••• 'lbe Comptroller of the Currency has developed detailed examination procedures which place greater emphasis on early identification of weaknesses in bank policies, practices, procedures, controls, and audit.  If the Comptroller can effectively influence the banks to   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  102 correct these weaknesses promptly, many of the types of problems now being disclosed by the traditional examination approach may be prevented or, if they occur, corrected before they develop to the point of seriously threatening the.soundness of the bank,,," He further stated:  ";,,Neither we nor the agency were able  to fully evaluam the practical problems that may be encountered in impl~menting the new procedures, such as the resource implications and the usefulness of the procedures to all types of banks,  Undoubtedly,  many practical problems will be encountered and further refinement of the process will be necessary,  But, we feel that this new approach  can be a big step forward and the three agencies should jointly test and evaluate the approach .. ," Federal Reserve Staff Comment We believe that the GAO arrived at a number of. erroneous conclusions and/or failed to fully understand some aspects of the present examination practices and procedures,  Mr, Staats believed that the new  procedures adopted by the Comptroller can be a big step forward,  As far  as we could determine, the GAO made no in-depth analysis of these new procedures in order to ascertain whether or not such procedures will accomplish their stated goals,  Since the new procedures have not been  fully tested, the GAO was, in essence, comparing written goals with an operating system whose failures could be viewed with the advantage of hindsight, We believe the procedures used by the Federal Reserve have proven their effectiveness, thus we are not inclined to abandon them for new,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  103 not yet fully tested techniques.  Of course, we continually review,  update and improve our examination practices.  In this connection, the  Comptroller has been most cooperative in sharing his new systems with us and we fully intend to use whatever benefits may be derived from the Comptroller's efforts in this area.  INTERAGENCY COORDINATION GAO View  Mr. Staats recognized that there was some coordination among the regulatory agencies; however, he stated there was no mechanism for the three agencies to combine their forces in undertaking significant new initiatives to improve the bank supervisory process or in resolving problems common to the three agencies.  Mr. Staats  " ••• We believe that a better mechanism is needed to insurl!  said:  effective interagency coordination.  We believe that the Congress  should enact legislation establishing such a mechanism and give consideration to identifying those areas where it feels effective interagency  coordination is essential ••• "  Federal Reserve Staff Comment The Interagency Coordinating Committee recently established a Bank Examination Council consisting of the directors. of supervision from  each agency.  This Council is designed to improve coordination and cooperation  among the agencies. In addition, the Board recently forwarded to Congress a proposed bill which would create an Examination Council by statute.  lhis Council  would establish mandatory uniform standards and procedures for Federal   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  104 examination of bank~ as well as uniform reporting systems and conduct joint schools for examiners.  lbe Board strongly supports such legislation and  believes a proposal along those lines could accomplish most of the objectives set out in the report's recommendatiai.s in the examina~ion area.  BANKERS' VIEWS OF THE REGULATORS GAO View lbe final section of Mr. Sta,ts' testimony deals with the results of a· survey the GAO conducted.  As part of their study, the GAO sent  questionnaires to 1,600 banks, of which 90 per cent responded. of the more interesting results of that survey follows: 1.  90 per cent of the respondents felt that elimination of bank regulation entirely would be detrimental.  2.  88 per cent felt elimination.of bank examinations would be detrimental.  3.  S8 per cent indicated they supported the present  4.  lbe competence of the examiners for the three  system of three bank regulatory agencies.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  regulatory agencies was rated very favorably.  Some  105  COMPTROLLER GENERAL OF' THE UNITED STATES WASHINGTON, D.C. 111941  B-118535  APR 2 , 1977  The Honorable William Proxmire Chairman, Committee on Banking, Housing and Urban Affairs United States Senate Dear Mr. Chairman: When Chairman Burns of the Federal Reserve Board appeared before your committee on March 10, 1977, he offered to submit for the record, a critique of my February 1 testimony concerning our report on the Federal Supervision of State and National Banks. This testimony was given before the Commerce, Consumer and Monetary Affairs Subcommittee of the House Committee on Government Operations and the Financial Institutions Supervision, Regulation and Insurance Subcommittee of the House Committee on Banking, Finance and Urban Affairs. The critique is in addition to the Federal Reserve's comments on the report itself, which were included as an appendix to the report. We have reviewed the Federal Reserve's critique, and we do have some comments on it. I would like to request that our comments be made a part of the hearing record. I have enclosed copies of both the critique and our comments.  Comptroller General of the United States  Enclosures   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  106 GAO COMMENTS ON FEDERAL RESERVE SYSTEM STAFF ANALYSIS OF COMPTROLLER GENERAL 1 S TESTIMONY OF FEBRUARY 1, 1977, ON GAO STUDY OF FEDERAL SUPERVISION OF STATE AND NATIONAL BANKS The staff of the Board of Governors of the Federal Reserve System (FRS) has made an analysis of the Comptroller General's February 1, 1977, testimony before the Commerce, Consumer and Monetary Affairs Subcommittee of the House Committee on Government Operations and the Financial Institutions Supervision, Regulation and Insurance Subcommittee of the House Committee on Banking, Finance and Urban Affairs.  The .FRS analysis and related  GAO comments are summarized below. INTRODUCTION AND BACKGROUND FRS analysis The FRS is concerned that we focused our review on records kept at the Board's Washington, D,C., headquarters.  It feels  that some actions taken by Federal Reserve Banks either have not been documented or that the documentation was not available in Washington.  Therefore, it is concerned that we did not see  the entire record on some banks. The FRS believes our use of automated analysis of bank examination reports through a Data Collection Instrument (DCI) did not allow us to evaluate nuances in examiners' comments. Therefore, we may have missed some comments intended to criticize a bank's management.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  107 GAO comment During our study we visited Federal Reserve Banks in addition to performing work at the Board of Governors in Washington, D.C. Although not all correspondence for every bank is available in Washington, we were told by officials both there.and at the Federal Reserve Banks that pertinent items, especially concerning significant bank problems, would be available at the Board· headquarters. In fact, we did review some bank cases at the appropriate Federal Reserve Banks and in our study of failed banks we even had Reserve Banks ship their files to Washington, D.C. We are c_onfident that we were able to obtain the information necessary to conduct an appropriate study. We reduced information from examination reports to coding for the DCI after qualified auditors had studied the reports and made judgments about what they read.  Their work was reviewed  by supervisory auditors. We tried to be as fair as possible in deciding if examiners were actually criticizing a bank's management.  It is  possible that we might have missed some criticisms aimed at managers by the examiners, but overall we observed a lack of direct criticism of bank management practices by the regulatory agencies. FAILED BANKS FRS analysis The FRS analysis states:  86•817 0 - 77 - 8   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  108 "Only two of the failed banks were under the supervision of the Federal Reserve.  Tri-City Bank, Warren, Michigan  (deposits approximately $15 million); State Bank of Clearing, Chicago, Illinois (deposits $60 million). "Tri-City Bank failed on September 27, 1974.  At the time  of its failure, Tri-City was operating under a cease and desist order issued by the Board on June 30, 1971, more than 3 years before its failure.  Tri-City Bank's management did not cooper-  ate with the regulatory agencies in resolving the bank's problems despite the fact that it was operating under very close supervisory scrutiny and a restrictive cease and desist order. Replacement of management might have helpe~ to preserv~ this bank; however, we did not believe the statutory findings necessary for removal action could be shown.  The Board's  proposed change in cease and desist statutes to permit.removal on the grounds of gross negligence might have been helpful in this case. "The failur•~f State Bank of Clearing was principally caused by construction loans that turned sour with the-sharp downturn in the real estate market.  The bank's situation  worsened when its chief executive officer, who dominated the bank, was killed in an automobile accident.  Once the problems  in the bank were identified, however, succeeding active manage-• ment cooperated with the supervisory authorities.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  It is  109 questionable that a cease and desist order, which is used primarily as a tool for dealing with recalcitrant management, would have proved useful in this case." GAO comment In keeping with the spirit of our agreement not to disclose information on specific banks, we do not wish to discuss in any detail the circumstances surrounding these· two.  However,  since the issue was raised by the FRS, we offer the following general observations: 1.  In spite of the FRS explanation of events at TriCity Bank, we feel that the agency could have been more vigorous in its enforcement actions.  2.  While the picture on the State Bank of Clearing was still clouded at the time of our study, its problems stemmed from more than just a downturn in the·real estate market.  After the bank cl-osed, regulators  began investigating the possibilities of self-dealing and conspiracy at the bank. we do agree, though, that additional legal powers, such as those now being requested, might have helped the FRS deal with these cases. ADEQUACY OF SCOPE OF EXAMINATIONS FRS analysis The FRS analysis was presented in four parts:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  110 1.  The FRS agreed that all three agencies' examination proceaures are alike and that GAO's assessment of the major emphasis of examinations is correct.  2.  The FRS states it is not clear from our report why we conclude that examiners don't place enough emphasis on causes of potential ban~ problems such as poor policies or weak controls, and it disagrees with our conclusion.  The FRS stated that a bank's poli-  cies, even if written, are very general, anyway, and loan management depends on the credi~ judgment of the lender.  The FRS states, "Thus, analysis of the major  loans in the bank's portfolio is perhaps the best method for gauging the soundness of lending policies and procedures," The FRS believes its examiners do watch out for poor policies, such as unnecessary overconcentration of assets.  It also points out that in some markets, dom-  inated by one industry, some lack of risk diversification is unavoidable.  The FRS feels we expect too  much of the examiners--that they should not be expected to anticipate events such as the declines in real estate markets that caused problems in many banks that overconcentrated in those markets.  It also feels  we come close to "suggesting that supervisory agencies   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  111 should participate in the management of banks ••• • in our suggestion that examiners take a harder look at a bank's lending policies. 3.  The FRS believes all banks, regardless of condition, should be examined on a regular basis to make sure their conditions do not deteriorate.  The FRS believes  its limited scope examinations offer it sufficient flexibility to avoid unnecessary work in banks in good condition. 4.  The FRS points out that it is moving in the area of consumer affairs and started to do so even before the GAO study.  GAO comment The basic premise of the FRS comment in part 2 is its statement, "Thus, analysis of the major loans in the ~ank's portfolio is perhaps the best method for-gauging the soundness of lending policies and procedures.• We.only partly agree. The analysis of the loans is the best method to gauge the results of those policies, but by the time the loans are made, it is too late. For example, the Comptroller of the Currency's new examination approach emphasizes a review of a bank's policies in much greater depth than does the traditional approach (which FRS admits is similar in all three agencies).  As we pointed  out on pages 7-9 and 7-10 of our report, a test of the new   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  112 procedures at one bank uncovered numerous bank policy and control deficiencies that had not been uncovered during the previous traditional examination.  There had been no change in  management at the bank between examinations, nor had the bank's resources grown substantially.  So the new examination proce-  dures discovered bank policy problems the old procedures had missed, and the examinations were conducted only 6 months apart. We are not s~ggesting as the FRS analysis implies, that examiners be able to anticipate events, such as real estate problems that put REITs in trouble.  However, we do feel that  examiners should criticize managers who overconcentrate in real estate loans because these managers are not adequately diversifying their risks.  We noticed a tendency by the agencies not  to criticize these policies in open comments in their reports or in correspondence with the banks until after the loans started going bad. We also believe it is important for the agencies to strike a balance betweerr the soundness of banks and the potential for excessively interfering with bank management.  The Comptroller  General was quite explicit.about this in his testimony. From part 3 of its analysis above, it appears that we and the FRS agree on the basic need to concentrate efforts on banks with known problems or potential problems. Although not speaking for the FRS, Chairman Barnett of FDIC stated in November 1976 that his agency spent too much time   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  113 on the soundest banks, and our recommendation that the agencies base their examinations on evaluations of banks' controls, policies, and procedures was addressed to all three agencies. The requirement to examine all banks on a specified frequency could be augmented by using computerized monitoring systems now being developed by each agency. As far as consumer compliance is concerned (part 4 above), we did note the increased efforts in this area by all three agencies in the past year or two. The point was that, until recently, they have not put sufficient emphasis on consumer affairs. USE OF STATE EXAMINATIONS FRS analysis The FRS analysis states: "As far as we could determine, the GAO made no substantive evaluation of the results of the exp~imental programs being conducted by the Federal Reserve and the FDIC to support its recommendation. that the programs be expanded.  It is our  understanding that the programs being ·conducted· by the POIC at the time of the GAO audit have now been terminated.  In at  least one instance, the termination was in response to a request by the State authorities that FDIC resume active participation in examinations. "Although staff recognizes the necessity of eliminating unnecessary duplication, as a matter of policy we have some dffficulty with the concept of withdrawal of active participation   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  114 by the System in the examination of banks for which the Federal Reserve has statutory supervisory responsibilities.  Moreover,  it should be noted that in those states where the Federal Reserve conducts concurrent or joint examinations with the State authorities, duties are normally divided between the State examiners and Federal Reserve examiner~ in a manner designed to minimize the duplication of effort." GAO comment It's true that the demands of our study did not allow us the time to evaluate the experimental State programs as fully as we would have liked.  Our only point was that the agencies  should rely as much as possible on State-work to reduce, not eliminate, Federal super~isory involvement.  Our recommendation  to use State examinations was not.directed to particular programs but to the concept of increased use of State work meeting acceptable standards. EXAMINATION REPORT FORMAT FRS analysis The FRS agrees that sometimes its examiners place comments in the confidential section of examination reports that should appear in the open section, but it does not believe this is sufficient reason to conclude that the reports do not effectively communicate results of examination to bank officials.  The  F.RS mentions a variet"y of ways, including meetings and letters   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  115 transmitting reports to the banks, used to communicate problems.  The FRS also stated 'that while examiners are supposed  to identify problems in banks and recommend corrective action, bank managers must determine the precise remedial steps to be taken. GAO comment Our conclusion that examiners aren't communicating effec~ tively is not based solely on what they put in the confidential sections of their reports versus what they put in open sections. We reviewed records of all types of communications--transmittal letters, correspondence, and meetings.  We concluded the com-  munications to the banks--especially to the boards of-directors-were often inadequate to clearly get problems corrected. We understand that the banks' managers are responsible for the precise remedial actions taken to correct their problems. But often we found that examiners after developing evidence of a serious problem in a bank, merely stated in general terms that management s·hould solve it.  The FRS Manual of Examination  Procedures states "Bank management is aware of the unique experience of examiners  • and the opportunity to benefit  from this experience ••  We feel that examiners can better  impart this experience by making more specific recommendations in their reports.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  116 BANK HOLDING COMPANIES FRS analysis The FRS analysis stated: "There were limited instances in which bank holding companies were found to have caused problems in .the subsidiary banks.  Out of the sample of 344 which were affiliated with  bank holding companies, there were 22 banks in which the report stated that the problems were caused by the parent holding company.  This constitutes 6.5 percent of the sample banks  affiliated with bank holding companies.  However, the Board's  examination of the parent bank holding company in each of these instances demonstrates that, in fact; the action~ of only five holding companies could be said to have caused any serious problem in the subsidiary banks. "With respect to the 22 companies, the GAO also concluded that inspection of the bank holding company by the Federal' Reserve did not uncover the problems until they had alreaay surfaced in bank examination reports.  Our review of the 22  bank holding companies revealed that problems in over twothirds of the companies were predominantely bank problems as opposed to problems caused by the parent holding company or nonbank subsidiaries.  In these cases, it is unrealistic to  postulate that a bank holding company inspection could have detected problems in subsidiary banks prior to their surfacing in bank examination reports.•   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  117 GAO comment Our study was limited by restrictions placed on us by the FRS.  However, we found that the FRS examiners themselves  believed that in the 22 banks in question--controlled by 20 different holding companies--problems were caused by inept or ineffective management in their holding companies such as overexpansion, unsound operations of non-bank subsidiaries, and unpaid real estate loans. we agree that the problems reported by the examiners. were centered in the banks, but the ~--according to FRS examiners--were clearly centered in the holding companies. We feel, therefore, that better inspections of those holding companies could have detected the causes and perhaps prevented the problems.  Therefore, we reco.mmended several steps to  strengthen FRS holding company supervision, based on more onsite inspections. EFFECTIVENESS OF AGENCIES IN RESOLVING·PROBLEMS FRS analysis The FRS agrees that meetings with a bank's board of directors are important, and it do.es require directors to at least review examination reports.  But the FRS believes it would be  •an unnecessary inconvenience and expense to the bank" to meet with directors after every examination if no serious problems are found.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  118 The FRS gives several reasons why cease and desist orders are not always the best means to get corrective action from banks.  Specifically, public disclosure of pending orders would  inhibit the bank's ability to raise capital.  The FRS also  points out difficulties under current law in removin~ bank officials. The FRS comments on one of our case studies (presented on pages 8-28 through 8-31 of our report).  The FRS believes,  contrary to our observations, that the case demonstrates effective supervision and timely correction of problems.  It feels  cease and desist authority would have been ineffective in this case. Finally, the FRS states that their control over holding company expansion is an effective _supervisory tool, one which went "unnoticed by the GAO." GAO comment Officials at all three agencies told us they believe many bank directors do not become sufficiently involved with their banks' operations.  The FDIC states that this lack of involve-  ment is a common occurrence in banks that fail.  In light of  this, and in light of the ultimate responsibility th, director~ have for bank oeprations, perhaps it is worth some expense and "inconvenienc~• to ensure that the directors become involved and know what is happening in their banks.  Moreover, our  recommendation was that.the examiners meet with either the board of directors   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  £I  the bank's audit or examining committee.  119 Certainly some circumstances cannot be handled with cease and desist oraers.  That is why we support iegislation to  augment these powers. As to the effect of publicizing unsafe and unsound practices, this addresses the larger question of baiancing a bank's soundness against investors' rights to obtain adequate information about businesses in which they invest.  This question  is clearly one for the Congress, the industry, and the regulators to resolve. Notwithstanding the FRS comments on the case study, our review disclosed little improvement in the bank's condition  over the 2 years we looked at.  we did not ~uggest in Qur report  {pages 8-28 through 8-31) that a cease and desist order would have been the specifically appropiiate remedy; our purpose was to demonstrate that, informal methods are not al ways successful in influencing a bank to resolve its problems. The FRS actions with regard to holding company expansions would have been of· interest to us.  However, during our study,  the FRS did not permit us to reyiew holding companies in general, and that is why many actions involving them went "unnoticed" by us. PROBLEM BANKS FRS analysis The FRS cautions against using problem lists to judge supervisory performance.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  It states the lists can indicate  120 alertness by the regulatory agencies.  It also states that  some banks remain on the problem list for a long time because they are only marginally successful businesses; but, if they are needed by their communities, the supervisory agencies try to work with them to keep them open. GAO comment The FRS analysis is reasonable, but we do not know how many of the 24 percent of the banks that remained on the problem lists over 2 years were the "marginally-successfulbut-necessary-to-the-community" banks referred to.  It is only  logical to question the status of the banks on problem lists for a long time; many of the banks that failed were lo~g-time problems, too. EFFORTS TO IMPROVE EXAMINATION PROCEDURES FRS analysis The FRS does not believe we fully understand current examination procedures, nor does it believe we made an indepth study of the new procedures being developed by the Office of the Comptroller of the Currency.  The FRS is not  inclined to abandon its current procedures for new, not yet fully tested techniques, but it is willing to use whatever benefits  ■ar  efforts to  be derived from the Comptroller of the Currency's  i■prove   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  procedures.  121 GAO comment We did study the Comptroller's new procedures, and we reviewed the results of tests made at some national banks. Ten banks had been tested by the time of our review.  Our  report did not recommend that FRS and FDIC abandon all· of their current procedures.  Instead, we recommended that all  three agencies work tegether to evaluate the new approach of the Comptroller of the Currency. What impressed us about the new procedures was that they emphasize a systematic review of a bank's policies, routines and controls to spot weaknesses that might adversely affect the bank.  As we mentioned earlier, such a review in one  test bank turned up problems that traditional examination methods had missed.  While FRS and FDIC do make a review of  a bank's procedures and controls, it is not as systematic or extensive as the new approach of the Comptroller of the Currency. I-NTERAGENCY COORDINATION FRS analysis The FRS mentioned a subgroup recently established by the Interagency Coordinating Committee to improve coordination and cooperation among the agencies. GAO comment The group mentioned by the FRS was proposed after our work had, been completed.  We are pleased that the FRS also believes  that better coordination is desirable.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  122 Dr. BURNS. Thank you very much. I will turn the question over to Mr. Leavitt. Mr. LEAVI'IT. With respect to the first of the GAO's criticisms of our oversight of bank holding companies, while there is some variation in the application of examination standards among the Federal Reserve Banks, that variation is not nearly so great as might appear. Clearly the Federal Reserve Board sets policies for Federal Reserve Banks, even though the Federal Reserve Banks have certain freedom within these broad policies. For example, the Federal Reserve Board has established a schedule for the various Federnl Reserve Banks to adhere to in the examination of bank holding companies. The schedule requires that all bank holding companies that have known problems be examined first, and that all major bank holding companies be examined within a 3-year cycle. With respect to monitoring, the Federal Reserve Board staff has several ways in which we monitor the activities of the Federal Reserve Bank Examination Departments. There is frequent-and I mean day-by-day-contact between members of the Board's Division of Bank Supervision and Regulation and members of the Federal Reserve Bank Examination Departments on various types of questions. Also, we write letters to the Federal Reserve Ba.nks to inform them of Board policies or to interpret Board policies as best we can for their guida.nce. Finally, with respect to coordination of examina.tions of banks and holding companies, we sometimes examine the holding company at the same time as we do the bank. But we have not felt that they necessarily had to be examined at the same time; they are different corporations, different entities. The holding company's investment in the. bank is evidenced by its ownership of stock in the bank, and we look at the holding company as a separate entity. If we also want to examine the bank we would normally do so at a different time. The CHAmMAN. Mr. Leavitt, there was a disturbing element here in the GAO criticism of your operation. You are the head of the Division of Banking Supervision and Regulation, is that correct j Mr. LEAVITT. That is correct. The CHAIBMAN. It said the Division employees have not completely monitored the Federal Reserve Board supervisory activities. For instance, they had no system, such as status reports, to keep track of the number of holding companies inspected, and to insure that all holding companies with closely monitored subsidia.ry ba.nks or leveraging nonbanking subsidiaries had been inspected. They also said they were limited by the Federal Reserve in their access to information, they weren't a.llowed to have everything that they felt was desirnble. They stated on page 12-1 "Access to holding companies was limited to those banks in the sample selections that were found to have holding company problems." Now in view of the dominant position bank holding- companies play in banking and nonbanking industries, would you be agreeable to a full Genernl Accounting Office audit of bank holding compa.nies, similar to the audit conducted by GAO on banks i Mr. LEAVITT. That would be a question for Dr. Burns. The CHAIBMAN. All right. Dr. BURNS. That is a question that I am not prepared to answer at the present time.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  lr.23 The CHAIRMAN. All right, sir. We will be in touch and perhaps you can think it over and let us know when you can. I would appreciate that. I just have a couple of other questions that I would like to get into. I am afraid I am going to have to ask for the record questions about the OPEC situation, fascinating as that is. But I do want to ask about at least one of the consequences of the testimony we have heard this morning that occurs to me. As you know, your strong right arm, I guess he was your right arm for a while, he has been in the Federal Reserve for a long time, Governor Robertson, made a recommendation for consolidating the bank examination into a single agency, and I thought so highly of that suggestion by Governor Robertson, that I introduced legislation to do that. You have had similar, but different, notions of how we can improve bank regulation. The GAO examined a number of matters involving switching charters from State members to national, and found that one bank was receiving special supervisory attention when it converted, and it also found when other banks converted they obtained more favorable consideration for requests for branches, mergers, or other structural changes. In your speech in October 1974 in Hawaii, you discussed competition in laxity, and you said: "Even viewed in the most favorable light, the present system is conducive to subtle competition among regulatory authorities, sometimes to relax constraints, sometimes to delay corrective measures. I need not explain to bankers the well-understood fact that regulatory agencies are sometimes played off against one another. * * * The danger of continuing as we have in the past should be apparent to all objective observers. * * * I must say to you I am inclined to think the most serious obstacle to improving the regulation and supervision of banks is the structure of the regulatory apparatus." Now in light of your views, do you feel that a single regulatory agency-it would eliminate this kind of competition-a single regulator would be most desirable, or do you think some other system would be more desirable? Dr. BuRNS. A single regulator means you would have a monopoly in the regulatory area, and therefore you would not have any competition; that goes without saying. The CHAIRMAN. Well, eliminate competition in laxity, that is right. That is what we have in virtually every other regulatory operation, including the SEC and so forth. Dr. BuRNS. It would eliminate competition in laxity. It would also eliminate competition in excellence. The CHAIRMAN. We don't have to worry too much about that, apparently. Dr. BURNS. Yes, you do. If you knew more about it, you would worry about the elimination of that competition. The CHAIRMAN. Maybe. I would like to hear about some excellence. Dr. BuRNS. If you really would like to hear that, why don't Y?U give me the opportunity to sit down for a stretch of time and I will fill the room with music.   https://fraser.stlouisfed.org • 77 • Federal Reserve Bank86-817 of St.0Louis  9  124 The CHAIRMAN. Well, I am sure you would. But I would like to hear some facts, too. Dr. BURNS. These facts would resound musically in your ears. Senator, you quoted from the GAO report; the number of instances of competition in laxity that the Comptroller turned up was very, very small. I must say that when I made that speech in Hawaii I was in an angry mood. I was there to talk seriously to the bankers; I traveled several thousand miles to warn them about some of their misdeeds. I wasn't there to praise them. A more balanced account would have noted that there has b~n a great deal of competition in excellence. As far as we at th~ Fed'eral Reserve are concerned, we have never competed in laxity. Neither you nor anyone else will ever come forward with a single instance of that, at least during the past 7 years when I have presided over the Federal Reserve System. The CHAIRMAN. Dr. Bums, you know my very high regard for you and for the Federal Reserve Board generally. But the fact is I think we have to judge regulatory bodies and results. And the fact is that all the data and details we can see over here on both sides of the room, and even more devastating information we have on the enfeeblement of our banking system, the fact that they are not as sound as they should be, indicates that regulation has not been as vigorous or as effective or as strong as it should be. Maybe it has been accommodating to the bankers in many ways, maybe it has done some good things, I am sure, for the country. But I just don't, in view of the situation we have now, and it has deterioriated in the last 3 or 4 or 5 years, I don't see how we can be smug or complacent about it. I think we ought to change a system that is not working. Dr. BURNS. Your picture is so overdrawn, Senator. Let's not talk about smugness or complacency. These are matters that we in the Federal Reserve Board work on literally day and night, and most conscientiously. I gave a speech about 2 years ago---I am going to send it to youin which I interpreted the speculative wave that occurred in this country starting in the mid 1960's. The business world went on a binge, and bankers, living in that environment, participated in it to some degree. As I read the record, in spite of this speculative binge, in spite of the severe recession that followed, our banking system has come through quite well. We have had some failures, yes. But the fact that we have had some failures does not mean that our hanks are unsound, nor does is mean that the regulatory authorities have done their job poorly. We could have a banking system in our country in which no bank would ever fail, because no bank would ever take any risk. The standard to apply is not zero failures; we must always keep that in mind. [It was requested that the following appear in the record:]   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  125 Reprint of an address by Arthur F. Burns, at the Twelfth Annual Meeting'of the Society of American Business Writers, Washington, n.c., May 6, 1975  I am glad to meet with this distinguished group of business and financial journalists in a leisurely setting.  As  a policymaker, I feel I have much in common with the members of your profession.  Both you and I must be alert to every twist  and nuance of the changing economic scene.  Both you and I must  keep busy searching the business skies for some clues to the economic future.  I find this aspect of my work exciting and  intriguing, as I am sure you do.  But it does involve a certain  risk for both of us. Sharing -- as we do -- the problem of continually meeting deadlines, we are in danger of becoming so preoccupied with the very short run that we fail to see economic events in perspective. For that very reason, I have wanted to take advantage of your invitation, so that we might ponder together the historical developments which have brought our economy to its present condition. This is a large and highly important subject. full justice to it on the presem.t occasion.  I cannot hope to do  Nevertheless, I shall  make a start this evening. As you are well aware, these past few years have been trying times for the American people.  Not only have we lived  through the agony of Vietnam and·Watergate, but some of us   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  126 have even begun to wonder whether our dream of full employment, a stable price level, and a rising standard of living for all our people is beyond fulfillment. Early last year, economic expansion began to falter in our country, as it did in other countries around the world.  At  the same time, the pace of the inflation that had been building for more than a decade accelerated sharply further.  As the  year advanced, it became increasingly clear that our economy was moving into a recession. During the past two quarters, the real gross national product has declined by 5 per cent, and the level of industrial production is now 12 or 13 per cent below last September. The unemployment rate has risen swiftly, and so also has the idle capacity in our major industries.  The decline in business  activity since last fall has been the steepest of the post-war period, and yet the advance of the price level -- while considerably slower than last year -- is continuing at a disconcerting pace. No business-cycle movement can be comprehended solely in terms of the events that occur within that cycle or the one preceding it.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The economic currents of today are h-vily  127 influenced by longer-range deve,lopments -- such as changes in economic and financial institutions, the course of public policy, and the attitudes and work habits of people.  By examining the  historical background of recent economic troubles, we should be able to arrive at a better understanding of where we now are. The current recession is best viewed, and I believe it will be so regarded by historians, as the culminating phase of a long economic cycle. There have been numerous long cycles in the past -that is, units of experience combining two or more ordinary business cycles.  One such long cycle ran its course from 1908  to 192.1, another from 192.1 to 1933.  And if we go back to the  nineteenth century, we encounter long cycles from 1879 to 1894 and from 1894 to 1908. ways from one another.  These long cycles differ in innumerable But they also have some features in  common -- in particular, each culminates in an economic decline of more than average intensity. The beginning of the long cycl~ that now appears to be approaching its natural end may be dated as early as 1958, but it is perhaps best to date its start in 1961.  The upward move-  ment of economic activity which began in that year was checked briefly in 1967 and interrupted more significantly in 1970.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  128 Although these interruptions were watched with concern and some anxiety by practicing economists and other interested citizens, they will be passed over lightly by economic historians concerned with large events. The reason is not hard to see.  Putting aside monthly  and quarterly data, and looking only at annual figures, we find that total employment rose every year from 1961 through 1973. So also did disposable personal income and personal consumption expenditures -- both viewed on a per capita basis, and in real terms.  This sustained upward trend of the economy came to  an end in 1974. The successive phases of the long upswing from 1961 to 1974 provide a useful perspective on our current problems. Some years ago, in my work at the National Bureau of Economic Research, I observed a pattern in past long upswings -- an initial stage that may be called the "industrial phase" followed by what is best described as the "speculative phase." The imbalances that develop in this latter phase lead inevitably to the final downturn.  The events of the past 15 years conform rather  closely to this pattern.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  129 The period from 1961 through 1964 may be regarded as the industrial phase of the long upswing.  Productivity grew  rapidly -- increasing in the private nonfarm sector at an annual rate of 3. 6 per cent between the final quarters of 1960 and 1964, or well above the average rate of the preceding decade.  Unit  labor costs were then remarkably stable, and so too was the general price level.  Real wages and profits rose strongly.  During this period of sustained economic expansion, unemployment fell from about 7 per cent of the labor force to 5 per cent, while the rate of use of industrial capacity rose substantially. The second -- or speculative -- phase of the long upswing began around 1965 and continued through much of 1974. This ten-year period was marked by a succession of major, interrelated, and partly overlapping speculative waves that in varying degrees gripped other leading industrial countries as well as the United States. The first speculative movement involved corporate mergers and acquisitions.  In the euphoria of what some com-  mentators have called the "go-go" years, rapid growth of earnings per share of common stock became the overriding goal of many business managers.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Other yardsticks of corporate performance  130 such as the rate of return on new investments -- were neglected, and so too were the serious risks of increased leveraging of common stock. The aggregate volume of large corporate acquisitions, which for some years had been running at about $2 billion per year, jumped to $3 billion in 1965, to $8 billion in 1967, to $12-1/2 billion in 1968, and then tapered off.  This was the  great era of conglomerates, when a variety of unrelated businesses were brought together under a single corporate management.  Entrepreneurs who displayed special skill in such  maneuvers were hailed as financial geniuses -- until their newly built empires began to crumble.  Being preoccupied  with corporate acquisitions and their conglomerate image, many businessmen lost sight of the traditional business objective of seeking larger profits through better technology, aggressive marketing, and improved management.  The productivity of  their businesses suffered, and so too did the nation's productivity. The spectacular merger movement of the late 1960's was reinforced, and to a degree made possible, by the speculative movement that developed in the market for common stocks. The volume of trading on the New York Stock Exchange doubled   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  131 between 1966 and 1971, and for a time trading volume on the American Exchange rose even faster.  The prices of many  stocks shot up with little regard to actual or potential earnings. During the two years 1967 and 1968, the average price of a share of common stock listed on the New York Exchange rose 40 per cent, while earnings per share of the listed companies rose less than 2 per cent.  On the American Exchange, the  average price per share rose during the same years more than 140 per cent on an earnings base that again was virtually unchanged. Much of this speculative ardor came from a section of the mutual fund industry.  For the new breed of "performance  funds," long-term investment in the shares of established companies with proven earnings became an outmoded concept.  In their quest for quick capital gains, these institutions displayed a penchant for risky investments and aggressive trading.  In  1965, a typical mutual fund turned over about one-fifth of its common stock portfolio; by 1969, that fraction had risen to nearly one-half.  As Wall Street then had it, the "smart money"  went into issues of.technologically-oriented firms or into corporate conglomerates -- no matter how well or poorly they met the test of profitability.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  132 Speculation in equities was cooled for a time by the stock market decline of 1969-1970, but then it resumed again and took on new forms.  Money managers began to channel a  preponderant part of their funds into the stocks of large and well-known firms -- apparently wU:h the thought that earnings of those companies were impervious to the vicissitudes of economic life.  A huge disparity was thereby created between  the price-earnings ratios of the "favored fifty" and those of other corporations. Share prices of these "favored" companies were, of course, especially hard hit in the subsequent shakeout of the stock market. Speculation in common stocks was not confined to the United States.  From the late 1960's until about 1973, nearly  every major stqck exchange in the world experienced a large run-up in share prices, only to be followed by a drastic decline. Indeed, speculation reached a more feverish pace in some countries than in the United States.  On the Tokyo stock exchange,  for example, both share prices and the trading volume actually doubled in the twelve months between January 197Z and January 1973, and then suffered a sharp reversal.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  133 The third speculative wave that nourished the long upswing of our national economy occurred in the real estate market. Homebuilding fluctuated around a horizontal trend during the 1960 1 s.  The vacancy rate in rental housing was at a high level  from 1960 to 1965, then fell steadily until the end of the decade, and thus helped pave the way for a new housing boom.  Between  January of 1970 and January of 1973, the volume of new housing starts doubled.  Since then, homebuilding has plunged, and in  some sections of the nation it has virtually come to a halt. Failures of construction firms and unemployment among construction workers have reached depression levels.  These un-  happy developments stem in large measure from the excesses of the housing boom that got under way in 1970. Inflationary expectations clearly played a substantial role in bolstering the demand for houses.  But the boom was  fostered also by an array of governmental policies designed to stimulate activity in the housing sector.  These governmental  measures, however well-intentioned, gave little heed to basic supply conditions in the industry or to the underlying demand for housing.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  134 In response to easy credit and Federal subsidies,  merchant builders moved ahead energetically, put up onefamily homes well ahead of demand, and thus permitted the inventory of unsold homes to double between 1970 and 1973. Speculative activity was even more intense in the multi-family sector -- that is, in apartments built for renting, and particularly in condominiums and cooperatives, which accounted for a fourth of the completions of multi-family structures by the first half of 1974. The boom in housing was financed by a huge expansion of mortgage credit and construction loans.  Real estate invest-  ment trusts played an exceptionally large role in supplying highrisk construction loans for condominiums, recreational developments, and other speculative activities.  The growth of real  estate trusts was extraordinary by any yardstick.  Their assets,  amounting to less than $700 million in 1968, soared to upwards of $20 billion by 1973.  Unsound practices accompanied this  rapid growth and, as a result, many real estate trusts now face difficult financial problems. The speculative boom in real estate was not confined to residential structures.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  It extended to speculation in land,  135 to widespread building of shopping centers, and to construction of office buildings.  By 1972, the vacancy rate in office buildings  reached 13 per cent, but this type of construction still kept climbing. The real estate boom in the United States during the early 1970's had its parallel in other countries.  Speculation  in land and properties became rampant in the United Kingdom. In 1972 alone, new house prices rose 47 per cent on the average. The amount of credit absorbed in real estate ventures rose so rapidly that the Bank of England felt forced to place special controls on bank lending for such purposes.  And in Germany,  the boom in residential construction during 1971- 73 left an inventory of about a quarter million unsold units -- more than a third of a peak year's output -- that now overhang the market.  It is in the nature of speculative movements to spread from one country or market to another.  Just as the speculative  wave in real estate was beginning to taper off in 1973, a new wave of speculation got under way -- this time in inventories. That was the fourth and final speculative episode of the long economic upswing from 1961 to 1974.  It involved massive  stocking up of raw materials, machinery, parts, and other supplies in the United States and in other industrial countries.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  136 The inventory speculation of 1973 and 1974 was the outgrowth of a boom in business activity that had raised its head by 1972 in virtually every industrial country of the world.  The  synchronism of economic expansion in these countries was partly coincidental, but the expansion that i,temmed from ordinary business-cycle developments was reinforced by the adoption of stimulative economic policies almost everywhere. As a result, production increased rapidly around the world, and led to a burgeoning demand for raw materials, machine tools, component parts, and capital equipment -- goods for which our country is a major source of supply.  The preuure  of rising world demand was reinforced in our markets by the devaluation of the dollar, which greatly improved our competitive position in international trade. By the beginning of i973, as business firms attempted to meet intense demands from both domestic and foreign customers, serious bottlenecks and shortages had begun to develop in numerous industries - - especially those producing steel, non-ferrous metals, paper,· chemicals, and other raw materials.  In this environment  of scarcities, the rise in prices of industrial commodities quickened both here and abroad.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The dramatic advance of food prices in  137 1973, and later in energy prices, greatly compounded the worldwide inflationary problem.  In our country, these price pressures  were suppressed for a time by price and wage controls, but the general price level exploded when controls were phased out in late 1973 and early 1974. One of the unfortunate consequences of inflation is that it masks underlying economic realities.  As early as the spring  of 1973, a perceptible weakening could be detected in the trend of consumer buying in this country.  The business community,  however, paid little attention to this ominous development. The escalating pace of inflation fostered expectations of still higher prices and persistent shortages in the years ahead, so that intensive stockpiling of commodities continued.  Inventories  increased out of all proportion to actual or prospective sales. In· fact, the ratio of inventories to sales, expressed in physical terms, had risen by the summer of 1974 to the highest figure for any business-cycle expansion since 1957 - - another year when a severe recession got under way. In summary, the period from 1965 to 1974 was marked by a succession of interrelated, partly overlapping, speculative waves -- first, in buying up of existing businesses; then, in the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  138 stock market; next, in markets for real estate; and finally, in markets for industrial materials and other commodities. A prolonged speculative boom of this kind can seldom be traced to a single causal factor.  In this instance, however,  a dominant source of the problem appears to have.been the lack of discipline in governmental finances. The industrial phase of the long upswing drew to a close in late 1964 or early 1965.  By then, the level of real output  was very close to the limits imposed by our nation's physical capacity to produce.  By then, the level of wholesale prices was  already moving out of its· groove of stability.  Nevertheless,  our Govermnent did nothing to moderate the pace of expansion of aggregate monetary demand.  On the contrary, it actually  embarked on a much more expansive fiscal policy.  The tax  reductions of 1964 were followed in 1965 by fresh tax reductions and by a huge wave of spending both for new social programs and for the war in Vietnam.  These misadventures of fiscal policy  doomed the economy to serious trouble, but we were slow to recognize this.  Indeed, aubstantial tax reductions occurred  again in 1969 and 1971, and they too were followed by massive increases of expenditures.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  139 Deficits therefore mounted, and they persisted year in and year .out.  Over the last ten complete fiscal years -- that  is, from 1965 through 1974 -- the Federal debt held by the public, including obligations of Federal credit agencies, rose by more than 50 per cent.  The large and persistent deficits  added little to our nation's capacity to produce, but they added substantially to aggregate monetary demand for goods and services.  They were thus directly responsible for much of  the accelerating inflation of the past decade. Monetary and credit policies were not without some fault.  As every student of economics knows, inflation cannot  continue indefinitely without an accommodating inr.rease in supplies of money and credit.  It is very difficult, however,  for a central bank to maintain good control of money and credit when heavy governmental borrowing drives up interest rates, and when the public is unwilling to face squarely the long-run dangers inherent in excessively stimulative economic policies. To make matters worse, laxity in our national economic policies spilled over into private markets.  The "new economics,"  of which less is now heard than before, held out the possibility, if not the actual promise, of perpetual prosperity.   https://fraser.stlouisfed.org 0 • 77 Federal Reserve Bank of86-817 St. Louis  • 10  Ma1;1y businessmen  140 and financiers came to view the business cycle as dead, and to expect the Federal Government to bail out almost any enterprise that ran into financial trouble.  All too frequently, therefore,  the canons of financial prudence that had been developed through hard experience were set aside. Many of our business corporations courted trouble by permitting sharp reductions in their equity cushions or their liquidity.  In the manufacturing sector, the ratio of debt to  equity -- which had been stable in the previous decade -- began rising in 1964 and nearly doubled by the end of 1974.  Moreover,  a large part of the indebtedness piled up by business firms was in the form of short-term obligations, and these in turn grew much more rapidly than holdings of current assets. Similar trends developed in some segments of commercial banking.  Large money-market banks came to rely more heavily  on volatile short-term funds to finance their business customers, and at times they increased their loan commitments to businesses beyond prudent limits.  A few bank managers, too, began to  concern themselves excessively with maximizing short-run profits, so that the prices quoted for their common stock would move higher. Capital ratios of many banks deteriorated; questionable loans were   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  141 extended at home and abroad; insufficient attention was given here and there to the risks of dealing in foreign exchange markets; and too much bank credit went into the financing of speculative real estate ventures, A variety of loose practices also crept into State and local government finance,  Faced with rapidly expanding demands  for services and limited sources of revenue, some governmental units resorted to extensive short-term borrowing and employed dubious accounting devices to conceal their budget deficits. Statutory debt limits were circumvented through the creation of special public authorities to finance the construction of housing, schools, and health facilities.  Some of these authorities issued  so-called "moral obligation" bonds, which investors in many instances regarded as the equivalent of "full faith and credit" obligations.  The novel financial devices seemed innocuous at  the time, but they have recently become a source of serious concern to investors in municipal securities. A nation cannot realistically expect prosperous economic conditions to continue very long when the Federal Government fails to heed the warning signs of accelerating inflati.on, when many of its business leaders spend their finest hours arranging   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  142 financial maneuvers, and when aggressive trade unions push up wage rates far beyond productivity gains.  After 1965, the  strength of the American economy was gradually sapped by these ominous trends.  Productivity in the private nonfarm  sector, which had grown at an annual rate of 3. 6 per cent from 1961 through 1964, slowed to a Z. Z per cent rate of advance from 1964 to 1969, then to 1. 5 per cent from 1969 to 1974. Expansion in the physical volume of national output likewise declined during successive quinquennia.  The rate of inflation,  meanwhile, kept accelerating, With the pace of inflation quickening, seeds of the current recession were thus sown across the economy.  Rising prices  eroded the purchasing power of workers' incomes and savings. Corporate profits diminished -- a fact that businessmen were slow to recognize because of faulty accounting techniques.  New  dwellings were built on a scale that greatly exceeded the underlying demand.  Inventories of commodities piled up, often at a fantastic  pace, as businessmen reacted to gathering fears of shortages. Credit demands, both public and private, soared and interest rates rose to unprecedented heights.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  143 These basic maladjustments are now being worked out of the economic system by recession -- a process that entails enormous human and financial costs.  Our country has gone a  considerable distance in developing policies to alleviate economic hardships, and these policies have been strengthened recently.  Nevertheless, the recession has wrought great  damage to the lives and fortunes of many of our people. This recession has cut deeply into ,tlconomic activities.  It must not, however, be viewed as being merely a pathological phenomenon.  Since we permitted inflation to get out of control,  the recession is now performing a painful -- but also an unavoidable - - function. First, it is correcting the imbalances that developed between the production and sales of many items, also between orders and inventories, between capital investment and consumer spending, and between the trend of costs and prices. Second, business managers are responding to the recession by moving energetically to improve efficiency -- by concenti:ating production in more modern and efficient installations, by eliminating wasteful expenditures, by stimulating employees to work more diligently, and by working harder themselves.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  144 Third, the recession is improving the condition of financial markets.  Interest rates have moved to lower levels as a result  of declining credit demands and of the Federal Reserve's efforts to bolster the growth of money and credit.  Commercial banks  have taken advantage of the reduced demand for loans to repay their borrowings from Federal Reserve Banks, to reduce reliance on volatile sources of funds, and to rebuild liquid assets.  The rapidly rising inflow of deposits to thrift  institutions has likewise permitted a reduction of indebtedness and addition to their liquid assets. Fourth, the recession is wringing inflation out of the economic system.  Wholesale prices of late have moved down,  and the rise of consumer prices has also slowed.  Although  general price stability is not yet in sight, a welcome element of price competition has at long last been restored to our markets. These and related business developments are paving the way for recovery in economic activity. confidence when the recovery will begin.  No one can foresee with The history of our  country indicates clearly, however, that the culminating downward phase of a long cycle need not be of protracted duration.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  145 Signs are multiplying, in fact, that an upturn in economic activity may not be far away.  For example, employment rose  in April after six successive months of decline. the workweek also stabilized last month.  The length of  The rate of layoffs in  manufacturing is now turning down, and some firms have been recalling workers who formerly lost their jobs.  Sales of  goods at retail -- apart from autos -- have risen further. Business and consumer confidence has been improving.  And  prospects for an early upturn in economic activity have been strengthened by passage of the Tax Reduction Act of 1975. Our nation stands at present at a crossroads in its history.  With the long and costly cycle in business activity  apparently approaching its end, the critical task now is to build a solid foundation for our nation's economic future.  We will  accomplish that only if we understand and benefit from the lessons of recent experience. Since World War II, a consensus has been building in this country that the primary task of economic policy is to maintain full employment and promote maximum economic growth.  We  have pursued these goals by being ever ready to stimulate the economy through increased Federal spending, lower taxes, or   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  146 monetary ease,  Neglect of inflation, and of longer-run economic  and financial problems, has thus crept insidiously into public policy making,  Our Government has become accustomed to  respond with alacrity to any hint of weakness in economic activity, but to react sluggishly, and sometimes not at all, to signs of excess demand and developing inflationary pressures. The thinking of many of our prominent economists has encouraged this bias in our economic policies,  During the  1950's and 1960 1 s, they frequently argued that "creeping inflation" was a small price to pay for full employment.  Some even sug-  gested that a little inflation was a good thing - - that it energized the economic system and thus promoted rapid economic growth. This is a dangerous doctrine.  While inflation may begin  slowly in an economy operating at high pressure, it inevitably gathers momentum.  A state of euphoria then tends to develop,  economic decision-making becomes distorted, managerial and financial practices deteriorate, speculation becomes rampant, industrial and financial imbalances pile up, and the strength of the national economy is slowly but surely sapped,  That is the  harsh truth that the history of business cycles teaches,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  147 To emphasio::e this truth, I should now like to offer this distinguished group of journalists a bit of professional advice, Since few of you are reluctant to pass along hints as to how I should do my job, I have decided to suggest to you what the really big economic news story of 1975 is likely to be. The story has to do with the drama now unfolding on Capitol Hill in the implementation of the Budget Control Act adopted last year.  If I am right in thinking that our present  economic difficulties are largely traceable to the chronic bias of the Federal budget toward deficits, there can be no doubt about the importance of what is now being attempted.  No major  democracy that I know of has had a more deficient legislative budget process than the United States -- with revenue decisions separated from spending decisions and the latter handled in piecemeal fashion.  Budgets in this country have just happened.  They certainly have not been planned. We are now attempting to change that by adopting integrated Congressional cre'~isions on revenues and expenditures. to you journalists is to follow this new effort closely.  My advice It has a  significance for our nation that may carry far into the future. But nothing can be taken for granted here,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  We have tried budgetary  148 reform once before under the Legislative Reorganization Act of 1946, and it failed.  It failed partly because of the challenge  to cherished Committee prerogatives, partly also because Congress as a whole balked at accepting so much self-discipline; I would urge you to study the history of that earlier effort and to watch the present undertaking for tell-tale signs of similar faltering_. The potential gain for our nation from budget reform is enormous even in this first year of "dry run. " If, in fact, the work of the new budget committees produces in the Congress a deeper understanding of the impossibility of safely undertaking all the ventures being urged by individual legislators, a constructive beginning toward a healthier economic environment will have been made.  On the other hand, if the new budget  procedures are scuttled, or if they are used with little regard to curbing the bias toward large-sized Federal deficits, there ultimately may be little anyone can do to prevent galloping inflation and social upheaval. I am inclined to be optimistic about the outcome.  More  and more of our people are becoming concerned about the longerrange consequences of Federal financial policies.  Perspective  on our nation's economic problems is gradually being gained by   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  149 our citizens and their Congressional representatives. healthy impatience with inflation is growing.  A  You journalists  are becoming more actively involved in the educational process. I therefore remain hopeful that we shall practice greater foresight in dealing with our nation's economic problems than we have in the recent past, and that we will thus build a better future for ourselves and our children in the process.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  *****  150 The CHAIRMAN. I agree with that. I think if you had no failures at all, obviously the system is not working. There should be some failures now and then. When you have thousands of institutions, thousands and thousands of banks, obviously some will make mistakes and fail. But it seems to me that overall we have a situation in which there has been deterioration, based on undercapitalization, based on the percentage of loans that are questionable in relation to capital. All of these details seem to indicate that the banks are not as sound as they have been or as they should be by any means.· Dr. BuRNS. Well, you can focus on one set of facts or another. I have tried to present a balanced picture in my report today. As for your observation that the supervisory process can be improved, of course it can be. That is why we work so hard at it. The CHAIRMAN. Dr. Burns, I want to thank you very very mu~h for, as I say, a most thoughtful and balanced statement. We appreciate 1t very much. And I am sure it will be studied by all of the members of the committee. I think we will be able to work very well together on legislation. I hope you will come around and support our proposal to consolidate the bank regulatory agencies. But I won't hold my breath until then. Dr. BURNS. I don't want the last word, Senator, but I am going to oppose your proposal, as you know. The CHAIRMAN. Very good. Thank you very much. Our next witness is Mr. Robert F. Keller, Deputy Comptroller General. Mr. Keller, we are happy to have you. I apologize for the late hour. You have a substantial statement here. And you indicate at the conclusion of your statement that it could have been much longer if you had given us the full treatment. You have made some very thorough and thoughtful studies. If you can abbreviate this in any way, the entire statement will be printed in full in the record.  STATEMENT OF ROBERT F. KELLER, DEPUTY COMPTROLLER GENERAL, ACCOMPANIED BY ELLSWORTH H. MORSE, JR., ASSISTANT COMPTROLLER; FRED LAYTON; AND DONALD PULLEN, BANKING TASK FORCE Mr. KELLER. Mr. Chairman, the statement is lengthy. It summarizes a very detailed report which I am sure you have a copy of~ and it represents a great deal of effort by our people. If I may, Mr. Chairman, I would like to introduce Mr. Morse, Assistant Comptroller General, Mr. Fred Layton, director of the Banking Task Force, and Mr. Donald Pullen, his deputy. I will try, Mr. Chairman, to mention the highlights in the interest of time. First, I want to say we are very glad to he here and we are delighted with the committee's interest in looking into our report. We spent a good deal of time on it, and did it in a fairly short period of time. We started our study in April and completed it about the first of the year.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  151 As a result of the arrangements we had to work out with the Federal Reserve, the Comptroller of the Currency, and the FDIC, we did not independently evaluate the soundness of any of the banks included in our samples. We depended on the examiners' expertise in identifying bank problems, and on evidence in the agencies' files showing the followup actions they had taken. We reviewed examination reports and correspondence files for a general sample of 600 banks, 294 problem banks, and 30 failed banks. We focused our stud,r primarily on determining whether bank examinations are of sufficient scope to identify banks which are likely to run into serious management for financial difficulties, and whether supervisory agencies can and do follow through on their findings of problems in banks to see that corrective actions are taken by the bank managers. This morning I would like to present five key areas covered in our report. The first is an analysis of the 30 banks that failed in the period 1971 to 1976. We reviewed the examination reports and correspondence relating to 30 of the 42 banks that failed between January 1971 and June 1976. We found that 14 of those failures were caused by improper or selfserving loans to bank employees or directors. Eight others were caused by fraud or other defalcations. And the remaining eight by regional loan mismanagement. Bank examination records showed that the examiners had readily identified the poor practices that eventually led to the bank failures well before the banks closed. In fact, I think in most cases the problem was first identified about 2 years before the bank was closed. The agencies' major difficulty was in getting the bank managers and directors to correct these problems. The supervisory agencies :usually relied on informal methods to influence bank managers to solve problems. These methods, such as meeting with bank officials, requiring progress reports from banks, and scheduling more frequent examinations, obviously were not effective in the cases of banks that failed. The agencies then could have turned to their formal legal powers, such as issuing cease and desist orders. Of the 30 cases we studied, formal action was taken in only 8 of them, and then only after the bank's problems had become quite serious. We believe that the supervisory agencies did not make effective use of their formal powers in dealing with banks that failed. Notwithstanding that fact, we think that certain additional powers would help the agencies in cases like these. I will discuss those in just one moment. In reviewing the agencies' bank examination practices for the 1971 to 1975 period, we found that the examination procedures followed by the three agencies were very much alike. The major emphasis of the agencies' examination effort was on evaluating quality of assets, adequacy of capital, and quality of management. Also examinations placed great emphasis on analyzing the bank's condition at the time of the examination. While this approach has been reasonably effective in identifying problems in banks, it often does not address the underlying causes of the problems, such as poor loan policies, or weak internal controls. Examination reports also showed the agencies only rarely reported violations of consumer protection laws and regulations. The agencies  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  152 acknowledged they have not aggressively monitored consumer protection law compliance and they have now begun to revise their approaches. The agencies' reports of examination, however, did not effectively communicate the examiner's observations to the banks. We say this ,.1ecause many of the problems and criticisms were stated in the confidential section of the reports which were not disclosed to the banks. And second, the examiners generally did not recommend how the banks could correct their problems. The reports of examination in our opinion should tell the banks, in a concise straightforward fashion, the results of the examination and include recommendations for corrective action. I will not deal with agencies' actions to encourage banks to resolve problems. At the outset, Mr. Chairman, examiners find problems in virtually all banks. However, some banks have more serious problems and require more supervisory attention than others. During the 5-year period ending December 31, 1975, a total of 1,532 commercial banks were on the agencies' problem bank lists. Of those banks 55 percent were returned to the nonproblem status by December 31, 1975. Although most of the banks returned to the nonproblem status in 2 years or less, 24 percent remained problem banks over 2 years. We found that some banks were considered to be problems for longer than 5 years. We believe that the success of the supervisory process depends heavily on how results of the bank examinations are communicated to the boards of directors of the banks. In addition to failure to communicate information in the confidential section of the examination reports, which I just mentioned, the agencies generally did not meet with the bank's board of directors. In a general sample of 600 banks, we found that examiners met with boards of directors in less than 10 percent of the cases we studied. Even when banks had major problems, the examiners met with the boards of directors in only about half of the cases. We believe that the agencies should discuss the results of their examinations with the boards of directors or at least with the directors' audit or examining committees after each examination. Our analysis of the enforcement actions taken by the supervisory agencies for the banks included in our sample showed that informal actions were used most of the time and formal actions were seldom used. The agencies expressed several reasons for not using their formal enforcement powers to a greater degree. Briefly, their reasons were thatLegal actions could generate publicity which could adversely affect the bank; Existing legal powers are not appropriate for all circumstances; Certain legal powers are too cumbersome to use; and There is a fear of appearing too harsh or of suppressing management's prerogatives. We believe, Mr. Chairman, that the supervisory agencies should have used their formal enforcement powers more frequently when dealing with problem banks, and that they should establish guidelines   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  153 for the types and magnitudes of problems where formal actions could betaken. We recognize of course that use of formal enforcement powers has to be very carefully considered. However, in our opinion there was an under-use in these cases. The agencies, as you know, Mr. Chairman, have requested additional authority to remove a bank official whose acts stem from either personal dishonesty or gross negligence and to assess civil penalties ag_ainst banks and individuals for specific violations. Our study of failed and problem banks showed that these powers could have been helpful in dealing with the officials of those banks. We would therefore support legislation giving the agencies this authority. During 1976, the agencies were taking a tougher line with the banks, and began to use their legal enforcement power more frequently. There has been some publicity in recent months about the agencies' lists of problem banks. During the period covered by our review, that is, 1971 to 1975, the number of problem banks grew from 352 to 607. More important, the number of large problem banks, that is, over $100 million in deposits, increased sevenfold from 13 to 90. As of October 1, 1976, the number of problem banks was 572, of which 83 were large banks. As we discussed in chapter 8 of our report, Mr. Chairman, each agency uses its own criteria for identifying problem banks. Using different criteria, results in different problem lists. For example, at December 31, 1975, the FDIC included 20 national banks which were not included by the Comptroller of the Currency. One result is that some banks may be receiving more attention than they need, and others less. We believe, Mr. Chairman, that the agencies should develop a uniform criteria for identifying problem banks. During 1976, all three agencies revised their examination approaches to give greater priority to examining the weakest banks, and less emphasis in examming the relatively trouble-free banks. The Comptroller of the Currency has developed detailed examination procedures which place greater emphasis on early identification of weaknesses in bank policies, practices, procedures, controls and audits. In our view, an important facet of OCC's new examination procedure is that they will center more on identifying the underlying causes of problems, rather than on the results of operations. Neither we nor OCC, have been able to fully evaluate the practical problems that may b~ ~nc<?un~ered in implementing the new procedures, such as the resource itnphcat10ns and the usefulness of the procedures in all types of banks. Undoubtedly many practical problems will be encountered and further refinement of the process will be necessary. But we do feel that this new approach can be a big step forward and that the three agencies should jointly test and evaluate the approach. Each agency has been developing and improving computerized bank monitoring systems. All of these systems are designed to provide the agenci~s with quickly accessible up-to-date analysis of the banks they supervise. All three agencies are revising their examination procedures for determining compliance with consumer protection laws, and have begun more intensive training programs for their examiners. During   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  154 the time period we studied, the banking agencies had not aggressively enforced consumer compliance and protection regulations. In part this was because many of these laws are relatively new and quite complex. OCC, since December 1975, has required meeting with the boards of directors of each national bank, at least once each calendar year. The Federal Reserve System has required that the examination reports be considered by the bank board with the directors signing a statement that they have considered the report, and since 1975 the Federal Reserve Board has required that there be a meeting with the board~ of pr:oblem banks. FDIC's policy is to require a meeting when there 1s a serious problem. Mr. Chairman, as part of our study we sent a questionnaire to more than 1,600 commercial bankers, of which 90 percent responded. A copy of the questionnaire and a summary of the responses are included in the appendix of our report. There are many questions in the questionnaire and it is quite complex. To summarize, the bankers responses indicated that they endorsed governmental involvement in the banking business. Almost 90 percent felt that the elimination of bank regulation entirely would be, to some degree, "detrimental." We also asked for their opinion on three possible alternatives to the present system of bank regulation. Of the three, the most favored alternative consists of one Federal agency with continued State supervision. The two alternatives which did not include State involvement were opposed by large majorities. The CHAIRMAN. You say the most popular solution was one Federal agency~ Mr. KELLER. About 50 percent, wasn't it, Mr. Layton~ Mr. LAYTON, Forty-two percent. Mr. KELLER. Forty-two percent. It was the predominant choice. The CHAIRMAN. Very interesting. They favor my proposal over Chairman Burns' then. · Mr. KELLER. Well, we didn't really put the question to them that way. The CHAIRMAN. I am sure you didn't. But that is the way I like to interpret it. Mr. KELLER. I think one important point that reaches into the area is the point we were just discussing. That is the question of how well the three bank regulatory agencies work together. I know that has been of real concern to your committee, and to others. We found that some coordination occurs between the agencies through formal and informal means. In response to a letter from President Johnson, an Interagency Coordinating Committee was established in 1965, to study conflicting rules, regulations, and policies. It includes representatives of each of the three agencies, as well as a representative of the Federal Home Loan Bank Board. During the past 2 years, the committee has met 17 times. The coordinating- committee provides a forum for exchanging information among the agencies. However, it does not provide a mechanism for the three agencies to combine their forces in undertaking significant new initiatives to improve the bank supervisory process or to solve problems common to all three agencies.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  155 Coordination, I understand, also occurs through meetings and discussions with senior management officials at the three agencies. Of course, in addition, the Comptroller of the Currency is by law a member of FDIC's board of directors and thus has direct involvement with that agency. · We really couldn't ascertain the full extent of coordination and cooperation among the three agencies because such actions are mostly undocumented, including the activities of this coordinating committee. In our report we identify a number of areas where the agencies could benefit by sharing experiences, innovations in bank supervision, and undertaking activities jointly, or on a reciprocal basis. We believe, Mr. Chairman, that a better mechanism is needed to insure the effective interagency coordination, and that the Congress should enact legislation establishing such a mechanism, giving consideration to identifying those areas where it feels effective mteragency coordination is essential. Mr. Chairman, I have tried to be as brief as possible. I ask that my full statement be put into the record. The CHAIRMAN. Without objection. [The complete statement and appendix of Mr. Keller follows:]   https://fraser.stlouisfed.org 86-817 0 • 77 • 11 Federal Reserve Bank of St. Louis  156 UNITED STATES GENERAL ACCOUNTING OFFICE WASHINGTON, D.C. FOR RELEASE ON DELI~ERY EXPECTED AT 10:00 A.M. EST THURSDAY, MARCH 10, 1977  STATEMENT OF ROBERT F. KELLER DEPUTY COMPTROLLER GENERAL OF THE UNITED STATES BEFORE THE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS UNITED STATES SENATE  Mr. Chairman: We are pleased to be here today to discuss our report on Federal supervision of State and national banks by the Comptroller of the Currency, the Federal Reserve System, and the Federal Deposit Insurance Corporation. The supervisory agencies are in a better position than the General Accounting Office to comment on the overall health of the banking industry because of their access to more current and complete information through   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  157 --periodio bank examinations --surveillanoe of financial and statistioal trends using analysis of reports reoeived from banks, a:nd --researoh studies in speoial areas affeot1ng the banking industry. However; we believe many of the observations made during our study are relevant to your hearings. Our study was made in response to the interest expressed by several Congressional committees, inoluding this Committee. Our objeotiv_e was to study the effeotiveness of the three agencies in oarrying out their bank supervisory responsibi-  lities. As you are aware, the General Acoounting Office does not have statutory authority to audit the Federal Reserve or the Comptroller of the Currenoy.  Although we are  authorized to audit the FDIC, our right of aooess to their bank examination records has long been a matter of dispute between FDIC and GAO. Beoause we laoked the statutory authority, we entered into written agreements with the three agencies in April and May of 1976 to obtain aocess to bank examination reports and oorrespondenoe files whioh were essential to making this study. A principal oondition of the agreements was that we would not disolosa any information about specifio banks, bank   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  158 officers, or customers.  We also agreed that we would  not examine any banks ourselves but would accept the facts found by the three agencies' examiners.  We made no attempt  to independently evaluate the soundness of any of the banks included in our samples.  We depended on the examiners' exper-  tise in identifying bank problems ind on evidence in the agencies' files showing the followup actions they had taken.  We reviewed examination reports and correspondence  files for a general sample of 600 banks, 294 problem banks, and 30 failed banks. Before discussing the results of our study, it might be helpful to recall the events which led up to requests that we review the performance of the three agencies. During the months preceding the requests, several large banks had failed, and there had been much publicity about the so-called lists of "problem banks."  It was  also reported that some of the Nation's largest banks were on these lists.  These events caused concern in  the Congress about the banking industry and how well it is regulated by the Federal supervisory agencies. With this background, we focused our study primarily on determining: --Whether bank examinations are of sufficient scope to identify banks which are likely to run into serious management or financial difficulties, and   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  159 --Whether supervisory agencies can and do follow through on their findings of problems in banks to see that corrective actions are taken by bank managers. The three supervisory agencies were given an opportunity to review a draft of our report and their written comments are included as appendices to the report. In my statement today, I would like to present to you our key observations resulting from: l.  A detailed analysis of 30 banks that failed in the period 1971-1976.  2.  Our review of the basic approach and methodology of bank examinations.  3.  Our analysis of the actions taken by the three agencies to encourage bank managers and directors to correct problems identified in examinations.  4.  A questionnaire mailed to about 1,600 bankers asking their views about the objectives and worth of Federal bank supervision.  Although not specifically addressed in our report, there is a fundamental issue underlying bank regulation which the regulatory agencies must constantly deal wlth.  The issue is  how much regulation of banking is necessary to assure a sound banking industry.  If regulations were to be carried  to the extreme, the agencies could become so zealous in their dealings with the banks that they, in effect, would take over the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  160 management of the banks.  Thus, the regulating agencies must  constantly try to strike a balance between assuring soundness of the banking industry and promoting healthy competition among the banks without becoming involved in day-to-day management decisions. ANALYSIS OF FAILED BANKS In our study, we analyzed several of the recent failures to see what lessons might be drawn from them. In 1976 there were 16 bank failures, the largest number in any one year since 1942.  Yet, this number represents only  about one-tenth of one percent of all banks.  Deposits !n  those 16 banks totaled almost $900 million, but the vast majority of these deposits were protected either through deposit insurance or by another bank assuming the deposits. In spite of the large failures in recent years, the Deposit Insurance Fund has continued to grow. In our study, we reviewed the examination reports and correspondence relating to 30 of the 42 banks that failed between January 1971 and June 1976.  We found that 14 of  those failures were caused by improper or self-serving loans to bank employees or directors.  Eight others were  caused by frauds or other defalcations, and the remaining eight by general loan mismanagement.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  161 Although economic conditions in the early 1970's did contribute to the failures, the basic underlying causes were the management practices of the banks.  Further details of  our analysis of failed banks are included in chapter 9 of our report including specific case studies. One factor common to most of the failures was that th·e bank·s' boards of directors failed to fulfiil their responsibilities for overseeing bank operations. Bank examination records showed that examiners had readily identified the poor practices that eventually led to the bank failures well before the banks closed.  The  agencies' major difficulty was in getting the banks to correct those problems. The supervisory agencies usually relied on informal methods to influence bank managers to solve problems. These methods--such as meeting with bank officials, requiring progress reports from the banks, and scheduling more frequent bank examinations--obviously were not effective in the cases of failed banks.  Their managers and directors did  not respond to these techniques. The agencies then could have turned to their formal legal powers, such as removing bank officials, issuing cease and desist orders, and others which I shall discuss later.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  162 Of the 30 cases we studied, formal action was taken in only 8 of them--and then only after the banks' problems had become quite serious. We believe that the supervisory agencies did not make effective use of their formal powers in dealing with the banks that failed.  Notwithstanding this fact, we think  certain additional powers would help the agencies in cases like these, and I shall elaborate on that later. THE BANK EXAMINATION PROCESS We reviewed the agencies' bank examination practices for the 1971-75 period.  We found that  --Examination procedures followed by the agencies were much alike.  They looked at the same things  and did the same kinds of analyses and evaluations. The major emphasis of the agencies' examination efforts was on evaluating quality of assets, adequacy of capital, and quality of management. --Also examinations have placed great emphasis on analyzing the bank's condition at the time of the examination. While this approaoh has been reasonably effective in identifying problems in banks, it often did not address the underlying causes of the problems, such as poor loan policies or weak internal controls.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  163 --FDIC and the Federal Reserve have attempted to examine the banks they supervise at least once a year.  The  Comptroller of the Currency is required by law to examine national banks at least three times in each 2-year period.  In our view, the number of  times a bank is examined should not be based upon a rigid frequency requirement. Rather, the agencies, using the results of previous examinations and information from reports submitted by banks, should schedule examinations based on an evaluation of a bank's soundness, and the quality of its policies, procedures, practices, controls, audit, and management. --Examination reports also showed that the agencies only rarely reported violations of consumer protection laws and regulations.  They acknowledged that they  have not aggressively monitored consumer protection law compliance, and they have begun revising their approaches.  There were many new laws enacted in this  area in the past few years and it has taken the agencies some time to gear up their enforcement program and develop special training programs for their examiners. The banks examined by FDIC and the Federal Reserve are also examined by State examiners.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Sometimes FDIC and  164 the Federal Reserve conducted their examinations at the same time as the State banking agencies. Both agencies are conducting limited experimental programs to determine if they can rely more on the work of State examiners instead of examining banks indepenqently in those States. We believe that the agencies should expand these programs to as many States as possible.  ·or  course, the quality  of State examinations must be taken into consideration in such a program. The agencies' reports of examination were not effectively communicating the examination results to the banks, because: --Many problems and criticisms were stated in the confidential sections of the reports but not disclosed to the banks. --The examiners generally did not recommend how the banks could correct the problems. The reports of examination should tell the banks, in a concise and straightforward fashion, the results of the examination and include recommendations for corrective action. Many of the banks !n our samples were controlled by bank holding companies.  While we did not review the Federal  Reserve's overall regulation of bank holding companies, we did check on the problems in our sample banks which were related to holding companies.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  We found that 22 of the  165 344 banks in our samples which were affiliated with holding companies had problems resulting from that affiliation. In most of these cases, the holding companies' actions  were not uncovered until problems had been identified in the banks. As you are aware, we were limited by the study agreement to reviewing only the supervisory aspects of holding companies which contributed to problems of affiliated banks in our samples.  AGENCY ACTIONS TO ENCOURAGE BANKS TO RESOLVE PROBLEMS I would naw like to summarize our views on the agencies' efforts to encourage banks to correct problems. Examiners find problems in virtually all banks; however,  some banks have more serious problems and require more supervisory attention than others. From our review of examination reports, we.summarized the nature and frequency of problems disclosed in them.  Chapter 5 of our report includes tabulations  of the problems identified by examiners for various size banks and between agencies. The agencies cannot correct the banks' problems themselves but they do have several tools to get banks to correct their problems. Earlier I alluded to the methods used by the supervisory  agencies to influenoe banks to solve problems. both informal and formal actions.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  These include  166 The agencies prefer to use informal methods as much as possible to persuade bank managers to take corrective action. These include: --discussing the problems with bank managers; --requiring the banks to submit progress reports on corrective actions taken, --visiting the banks to see if progress is being made, and --meeting with the banks' boards of directors to make sure they are aware of the problems. We believe the success of the supervis!on process depends heavily on how results of bank examinations are communicated to the boards of directors of the banks.  We  found that the agencies generally did not meet with the boards.  In a general sample of 600 banks, we found that  examiners met with boards of directors in less than 10 percent of the oases we studied.  Even when banks had  major problems, examiners met with the boards of directors in only about half the cases. We believe that the agencies should discuss the res~lts of their examinations with the boards of directors or with· the directors' audit or examining committees. When a bank's managers do not take corrective action in response to the agencies' informal methods, the agencies have several formal actions available to them.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  167 --The Comptroller of the Currency can revoke a bank's charter. --The Federal Reserve can expel a member bank. --FDIC can terminate a bank's deposit insurance. --All three agencies can enter into written agreements with banks, requiring that certain corrective actions actions be taken. --All three agencies can issue cease and desist orders. --All three can initiate efforts to remove or suspend bank officials, but the Comptroller of the Currency must rely on the Federal Reserve to conduct hearings and present evidence. Our analysis of enforcement actions taken by the supervisory agencies for the banks included in our samples showed that informal actions were used most of the time and that formal actions were seldom used.  Even though the same types  of problems existed from one examination to another, the agencies often did not change the type of enforcement actions used or intensify the use of an enforcement action to get the problems corrected.  For example, from 1971 through 1975  the agencies made limited use of written agreements and cease and desist orders--probably their most effective tools.  FDIC  used written agreements 3 times, the Federal Reserve 8 times,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  168 and the Comptroller of the Currenoy 48 times.  Cease and  desist orders were used by FDIC 38 times, by the Federal Reserve 5 times, and by the Comptroller 13 times. The agenoies expressed several reasons for not using their formal enforcement powers more.  Briefly, their rea-  sons were that: --Legal aotions could generate publioity that could adversely affect the bank. --Existing legal powers are not appropriate for all circumstanoes. --Certain legal powers are too cumbersome to use. --There is a fear of appearing too harsh, or of suppressing management's prerogatives. During 1976, the agencies were taking a tougher line with the banks and began using their legal enforoement powers more frequently. The agencies have requested additional statutory authority to remove a bank official whose acts stem from either personal dishonesty or gross negligence and to assess civil penalties against banks and/or individual officers for specific violations.  Our study of failed and problem  banks showed that these powers could have been helpful in dealing with the officials of those banks.  We would,  therefore, support legislation giving the agencies this authority.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  169 There has been some publicity in recent months about the agencies' lists of problem banks.  During the period  covered by our review, 1971-75, the number of problem banks  grew from 352 to 607.  More important, the number of large  problem banks (over $100 million) increased 7-fold, from 13 to 90.  As of' October l, 19-76, the number of problem  banks was 572, of which 83 were large banks. Each agency uses its own criteria to identify problem banks.  Using different criteria results in different problem  bank lists. For example, at December 31, 1975, the Federal Reserve included 204, and the FDIC included 20 national banks as problem banks which were not included by the Comptroller. One result is that some banks may be receiving more attention than they need and others less. Therefore, we believe the agencies should develop uniform criteria for identifying problem banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  170 In our study we analyzed the agencies' lists of problem banks 1n detail to see how long banks remained in problem status--as defined by the primary supervisory agency-and how the agencies dealt with those banks. During the 5-year period ending December 31, 1975, a total of l,532 commercial banks were on the agencies' problem bank lists.  Fifty-five percent of those banks  were returned to nonproblem status by December 31, 1975. Although most of the banks returned to nonproblem status 1n 2 years or less, 24 percent remained problem banks over 2 years.  We found that some banks were considered to be  problems for longer than 5 years. We believe that the supervisory agencies should have used their formal enforcement powers more frequently when dealing with these banks, and that they should establish guidelines for the types and magnitudes of problems where formal actions could be taken. As a starting point, the guidelines should identify those problems for which formal action had been taken in the past, and the types of actions most appropriate for each kind of problem.  They should also establish reasonable  timeframes for initiating such action because of t~e seriousness of the problem, because the problem was getting worse, or because the bank had not corrected the problem   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  171 over a period of time.  We recognize that every problem  situation should be evaluated on a case by case basis and that formal enforcement action will not always be appropriate.  Therefore, the guidelines should not be  established as hard and fast rules.  However, ·when the  agencies decide not to follow their guidelines, they should be required to document their reasons for not doing so.  RECENT IMPROVEMENTS BY THE AGENCIES TO IMPROVE SUPERVISION I would like to comment at this time on the improvements made by the agencies during 1976 in several areas of bank supervision.  The most significant improvements  which I would like to discuss are those related to the bank examination process.  All three agencies revised  their examination approaches to give greater priority to examining the weakest banks and less emphasis to examining the relatively trouble-free banks. The Federal Reserve revised its examination policies in March 1976, to enable their examiners to concentrate more on banks with problems.  In January of this year  the Federal Deposit Insurance Corporation adopted a new examination policy to provide more fiexibility to schedule and scope examinations based on bank soundness and the quality of policies and controls.   https://fraser.stlouisfed.org Federal Reserve Bank of 86•817 St. Louis 0 • 77  • 12  172 The Comptroller of the Currency has developed detailed examination procedures which place greater emphasis on early identification of weaknesses 1n bank policies, praclices, procedures, controls, and audit.  If tfie  Comptroller can effectively influence the banks to correct these weaknesses promptly, many of the types of problems now being disclosed by the traditional examination approach may be prevented or, if they occur, corrected before they develop to the point of seriously threatening the soundness of the bank. The new procedures were incorporated into a new manual and were field tested at 10 banks by mld-1976, OCC started using the new approach in the Fall of 1976 and expects to complete the transition by mid-1977, In our view, an important facet of ace's new examination procedures is that they will center more on identifying the underlying causes of problems rather than on the results of operations.  The traditional examination has  focused primarily on identifying poor results of operations such as bad loans, oonoentrations of credit, exoeseive insider loans, risky investments, inadequate capital, inadequate liquidity, and violations of laws.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  173 Under the traditional examination approach examiners were instructed to examine and evaluate bank policies, controls, and audit, but were provided little or no detailed guidance on how deeply they should examine these areas or how they should document their work and support their conclusions.  As a result, many examiners had developed  their own informal examination procedures, which differed from examiner to examiner and from bank to bank. The new procedures are intended to provide greater assurance that indepth analysis of policies, practices, procedures, controls, and audit would be made during each examination.  Additionally, it provides documentation of  examination procedures followed, tests performed, information obtained, and conclusions reached.  This documentation  can assist the examiner-in-charge in judging the overall condition of the bank and in planning subsequent examinations. Neither we nor the agency have been able to fully evaluate the practical problems that may be encountered in implementing the new procedures, such as the resource implications and the usefulness of the procedures to all types of banks. Undoubtedly, many practical problems will be encountered and further refinement of the process will be necessary. But we feel that this new approach can be a big step forward and the three agencies should jointly test and evaluate the approach.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  174 Each agency has been developing and improving computerized bank monitoring systems.  All these systems are  designed to provide the agencies with quickly accessable up-to-date information and analyses of the banks they supervise.  The agencies use these systems to identify  banks which show unusual activity or deviate from their peer group.  In theory, bank monitoring systems can help  the agencies focus on potential bank problems early and concentrate their efforts where needed most. The agencies' experience with bank monitoring systems 1s limited.  It is too early to judge their operational  cost effectiveness or appraise their significance as a supervisory tool. All three agencies are revising their examination procedures for determining compliance with consumer protection laws and have begun more intensive training programs for their examiners. During the time period we studied, the banking agencies had not aggressively enforced consumer compliance laws and regulations.  In part this was because many of these  are relatively new and complex.  Nevertheless, FDIC examiners  cited 29 percent of the banks in our general sample for truth-in-lending violations.  FRS examiners similarly  cited 17 percent of our sampled banks, and OCC 14 percent.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  175 THE AGENCIES NEED TO IMPROVE COORDINATION How well the three bank regulatory agencies work together has been one area of ooncern to your Committee and we have several observations in this area. The legislation establishing the three agencies oreated several overlaps in authority.  However, the Federal  agencies do not examine the same banks.  The Federal  Reserve could, but does not, examine banks examined by the Comptroller, and FDIC could, but does not, examine banks that are examined by the other two agencies.  We recognize that each agency has been granted certain authority by the Congress and that each enjoys considerable independence of action.  Nevertheless, from an overall Fed-  eral viewpoint it is important that the agencies work closely together to promote efficient operation and insure that banks in similar circumstances be treated uniformly regardless of which agency 1• their primary supervisor. We found that some coordination occurs between the agencies through formal and informal means.  An 1nteragency  coordinating committee was established at President Johnson's request in 1965 to resolve conflicting rules, regulations, and policies.  It includes representatives of each of these  three agencies, as well as a representative of the Federal   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  176 Home Loan Bank Board.  During the past two years the  committee has met 17 times. The coordinating committee provides a forum for exchanging information about possible conflicting rules, regulations, or policies which might exist between the agencies.  However,  it does not provide a mechanism for the three agencies to combine their forces in undertaking significant new initiatives to improve the bank supervisory process or in resolving problems common to the three agencies. Coordlnation also occurs through meetings and discussions with senior management at the three agencies.  In addition,  the Comptroller of the Currency is by law a member of the FDIC Board of Directors and thus has direct involvement with that agency.  However, we could not ascertain the full  extent of coordination and cooperation among the three agencies because such efforts are mostly undocumented.  For example,  no mlnutes are taken at the coordinating committee meetings and few records are malntained of telephone conversations and informal discusssions among the staffs of the three agencies. In our report we identified several areas where the agencies could benefit by sharing experiences about lnnovations in bank supervision and undertaking activities jointly or on a reciprocal basis. For example, in the fall of 1975, OCC began developing its new examination   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  177 procedures which were field tested in mid-1976. The three agencies did not work together in develo~ing and testing the new procedures. It was not until November 1976 that OCC met with the other agencies to present in any detail its new approach. When one agency plans major changes in its activities which may be applicable to the other agencies, early consultation and exchange of views would benefit all agencies concerned.  We believe that the three agencies should  jointly participate in developing and testing the new approach. We believe that a better mechanism is needed to insure effective 1nteragency coordination.  We believe that the Congress  should enact legislation establishing such a mechanism and give consideration to identifying those areas where it feels effective interagency coordination· is essential.  BANKERS'  VIEW  OF BANK  SUPERVISION  We sent a questionnaire to more than 1,600 commercial bankers, of which about 90 percent responded.  A copy of the  questionnaire and a summary of the responses are included as an appendix of our report.  The bankers' responses indicated  that they endorse Government involvement in the banking industry.  Almost 90 percent felt that "elimination of bank  regulation entirely" would be, to some degree, "detrimental."   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  178 Other aspects of Government intervention received similar endorsements. For example --70 percent felt eliminating Federal chartering would be detrimental, --72 percent felt eliminating State chartering would be detrimental, and --88 percent felt eliminating bank examinations would be detrimental. We also asked bankers whether they supported or opposed the current regulatory system of three Federal agencies together with State supervision. A majority (58 percent) indicated that they supported the present system.  We also asked for their opinion on three possible alternatives to the present system.  Of the three,  the most favored alternative consists of sua-Federal agency with continued State supervision.  The two alternatives  which did not include State involvement were opposed by large majorities. As a group the responding bankers had a generally favorable opinion of Federal bank examiners.  For example, we  asked bankers to rate the competence of the senior Federal examiners in 10 areas covered by the examination.  In all  10 areas the examiners' competence was rated very favorably. For instance, in the area of determining the quality of loans   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  179 --28 percent said competence was •more than adequate";  --66 percent said it was "ad·equate•; --5 percent said i t was "borderline"; and --1 percent said i t was "inadequate• or •very inadequate. n  The pattern of responses was similar for the other nine areas.  I have only discussed the principal message in our report this morning:  The report also comments on other aspects of  bank supervision, such as chartering new national banks and maintaining examiner competence and independence.  I have  attached to my statement all the recommendations in our report, the agencies' comments to them, and our evaluations of those comments. This concludes my statement, Mr. Chairman.  If you have  questions about our study I will be happy to try to answer them.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  180 APPENDIX 1  CHARTERING NATIONAL BANKS (Seep. 2-21) *  Recommendations GAO recommends that the Comptroller of the Currency (l) develop more definitive criteria for evaluating charter applications and (2) thoroughly document the decisionmaking process, including an identification by reviewers of each factor as favorable or unfavorable. OCC response While OCC indicated that widely differing banking environments make it almost impossible to develop definitive criteria·which can be ~niversally applied, the agency said --a market study has been undertaken to identify, statistically, those factors that can be identified with the growth or lack of growth of new banks, and --if positive, the s~udy results will be incorporated into the chartering decision-making process. With regard to the second part of the recommendation, OCC stated that it ts now documenting the deoisionmaking process and that efforts will be made to identify each factor as favorable or unfavorable. GAO comc:ent The actions OCC has taken will substantially impleld8nt our recor.-i:.1er.dations.  *Page numbers are referring to those in GAO report which is reprinted in this volume beginning at page-.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  181 SCHEDULING BANK EXAMINATIONS (Seep. 4-7) Recommendation GAO recommends that the Board of Directors, FDIC, the Board of Governors, FRS, and the Comptroller of the Currency establish scheduling policies and procedures which would avoid setting examination patterns. FDIC response FDIC believes its revised examination policy, expressed in General Memorandum #1, "largely satisfies this recommendation.• FRS response FRS "believes that, in many oases, there is serious doubt as to the benefits to be gained and hence the desirability of surprise examinations.• The agency stated that, where surprise is important, it is FRS practice to schedule examinations so they cannot be predicted. OCC response OCC indicated that while •occ has viewed surprise as an important element of an examination• [historically], its new examination approach precludes the need for surprise examinations except where internal controls have been weak and fraud is possible. GAO comment We do not interpret FDIC's General Memorandum.#1 as addressing examination scheduling except as it relates to examination frequency.  We do not question the value of surprise examinations. Indeed, the arguments presented against it by FRS and OCC seem logical. We only wish to point out that heretofore the agencies have considered the surprise element as important, yet we found many oases where they have not been adhering to their own policies. In our report we noted that 204 of 744 banks in our samples were examined in the same month of 2 or 3 consecutive years. We believe the agencies should clarify their respective positions on the surprise element and, if considered important, enforce their scheduling policies.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  182 EXAMINATlON FREQUENCY (Seep. 4-9) Recommendation GAO recommends that the Board of Directors, FDIC, and the Board of Governors, FRS, adopt flexible policies for examination frequency which would allow them to concentrate their efforts on banks with known serious problems. FDIC response FDIC stated that •although it was FDIC's long-standing policy to examine each bank once a year, it is inaccurate and misleading to suggest that timeframe was the only guideline used by the FDIC in scheduling examinations.• The agency noted ·that it •conducted 213 follow-up examinations and a number of on-stte visitations at banks presenting either financial or supervisory problems.• The agency believes that its General Memorandum #1, implemented January l, 1977, expresses FDIC's policy that the scheduling of examinations is based on criteria other than t1meframe priorities alone. FRS respQ..!lll FRS stated that it "already has established policies that are flexible enough to allow [it] to concentrate [its] efforts on banks with known serious problems.• FRS said the policy requires examination of problem banks at least once every 6 months. The agency believes its recently approved Asset Quality and Management Performance Examinations, for banks thought to be free of major problems, will provide flexibility of examination frequency consistent with our recommendation. GAO comment We believe FDIC's General Memorandum #1 goes only partway in responding to our recommendation. Our interpretation of GM#l is that problem banks must be examined at least once every 12 months, and non-problem banks at least once every 18-24 months; with more frequent examinations·at the discretion of the Regional Director. In our opinion, the extension or timerrame requirements misses the essence of our recommendation. A bank's condition and the quality or its policies, procedures, and internal controls should be the basis of how frequently it is examined.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  183 Some ba~ks with poor policies and controls might require examinations every 6 months, while others with good policies and controls could be examined every 2 years. The decision on examination frequency should be made on a bank by bank basis rather than as a general rule. We understand that the quality of a bank's policies, etc., could deteriorate over time and that examinations must be conducted at some point in time to reevaluate the bank's operations. We interpret FRS's asset-management examination concept as providing limited scope examination procedures, designed to improve the allocation of examiner resources by curtailing the amount of work when examining relatively sound banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  184 EXAMINATION F!ifill.!!.fillCY--NATIONAL BANKS (Seep. 4-9) Reoommeridation GAO reoommends that the Congriss amend the National Bank Aot to allow the Comptroller of the Currenoy to examine national banks at his/her disoretion. We would be glad to assist the oommittees in drafting appropriate legislation.  ace  response  ace supported our reoommendat1on and pointed out that the amendment would enhanoe its effeotiveness in supervising banks under its new approaoh. GAO oomment No oomment.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  185 USE OF STATE EXAMINATIONS (Seep. 4-13) Recommendatio9 GAO recommends that the Board or Directors, FDIC, and the Board or Governors, FRS, extend their purrent efforts to use State examinations and, if they do, GAO also recommends that they --develop minimum standards for acceptable State examiner training and examination procedures and --use only reports of State examinations meeting those standards. FDIC response FDIC implied a willingness •to cooperate to the fullest extent possible with the various states• in placing reliance on the efforts of State supervisors. The agency stated that "guidelines s~t forth in General Memorandum #1 provide a workable framework for increased cooperation with the states." FRS reponse While commenting upon its •current extensive efforts to eliminate unnecessary duplication by utilizing State examiners and State examination reports" the FRS pointed out that its experimental program with Indiana should result in the development or standards for State examinations. GAO comment We understand that many States are not interested in, or prepared to, increase their examination efforts.  We believe, however, that for the many other States interested in expanding their examination responsibilities, long-term and mutually satisfactory arrangements will germinate only when the agencies promulgate comprehensive and realistic performance standards. In this regard, we think the agencies should work with the States in developing acceptable standards in addition to conducting various experimen.tal programs.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  186 EXAMINATION SCOPE (Seep. 4-17) Recommendation GAO recommends that the Board of Directors, FDIC, and the Board of Governors, FRS, establish procedures to base the scope of each examination on the examiners' evaluation of the quality of the bank's controls, policies, procedures, and audit. • FDIC response FDIC believes that •the findings and conclusions expressed by GAO are not accurate.• It stated that •the primary factor influencing the scope of the examination is not size, but the known history of strengths and weaknesses of the particular institution.• The agency contended its examiners do pre-plan the scope of examinatio~s and review a bank"s internal controls, policies, and procedures prior to commencing examinations. In addition, FDIC believes its recently adopted General Memorandum #1 provides considerable leeway in this respect. FRS response FRS believes the recommendation encompasses what it is already doing. It stated that policies, procedures, and controls are reviewed in connection with all bank examinations and that, in large banks, a preexamination review is used to determine the amount of scrutiny given to each area. GAO comment In our review of bank examination reports we did not find any discernable difference in examination scope among banks in our samples. For example, for a test group, we found the percentage of loans reviewed did not vary between banks with sound internal controls and those with weak internal controls. Nor did we find evidence in our samples that an evaluation of controls, policies, procedures, and audit took place prior to, and was the basis for, determining examination scope. In addition, we were told by Reserve bank officials that examination scope is not normally determined by an evaluation of controls, etc., beforehand. The basic report format is used for all examinations.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  187 We interpret FDIC's GH#l as permitti · a modified examinat1on scope under certain conditions. Se n of the eight conditions are fairly objective determina ins (e.g., asset size, years of operation, management rat1 adjusted capital and reserves ratio, etc.). The other co~ cion requires "a record of acceptable internal routine and ,ontrols and an effective internal audit program or an a~ ol outside audit considered adequate in scope and performa se by a qualified public accountant, corresponder. o ank, or other qualified firm." We do not read GH#l as prescribing gxamination approach substantially different from what is pre ;ly conducted. When a bank meets the eight conditions, c ,·;ain examination procedures may be eliminated or curtatlec jowever, there are no guidelines directing which procedc ,s should be curtailed as a result of what strengtjs. Nor was th ce any mention of extending certain examination procedures when certain weaknesses are found.  We believe a test and evaluation of controls, etc., should take place first, and the results of such evaluation should be used to set the scope of the particular examination. In this regard the nature and extent of each procedure should be expanded or curtailed based upon certain weaknesses or strengths found during the evaluation phase. As a comprehensive examination policy, GH#l is well constructed. We believe FDIC has taken significant steps to improving its examination effectiveness and efficiency. We would, however, prefer to see a clearer link between the evaluation of controls, etc., and the scope of examination procedures; guidelines for the evaluation of controls, etc.; and a secondary role for the other conditions in determining examination frequency and scope.  86-817 0 - 77 - 13   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  188 EXAMINATION WORKPAPERS  (Seep.  4-19)  Recommendation GAO recommends that the Board of Directors, FDIC, and tbe Board of Governors, FRS, develop standards for the preparation, maintenance, and use of examination workpapers. FDIC respons! FDIC believes its nexamination workpapers will permit a determination that appropriate examination procedures have been followed, provide support for the preparation of the Report of Examination, and are utilized at the next examination.n The agency said that its workpaper standards are included in the nourse of study at its various training schools. FRS response FRS believes that examination workpapers are generally adequate to meet its needs. The agency also notes that the manner in which workpapers are prepared and maintained is covered in connection with the training of its examiners. GAO comment In our review of workpapers supporting examination reports of sampled banks, we found --little uniformity of workpaper form or content among examiners, --incomplete workpapers, or no workpaper evidencing examination steps performed, --poorly organized workpapers (unbound, without indexing), and --workpapers unsigned by the preparer, not dated, and lacking evidence of review. We did not find a topic concerning workpaper standards, prepara~ion, or maintainance in training course syllabuses. The purp~se of workpapers is too important to leave to training alone. Written standards are needed to assure quality throughout the agencies. Also, we believe that many of the schedules and other data contained in the body sections of examination reports are, in effect, workpapers and should be considered as such (see also our recommendation and comments regarding bank exa~i~atin~ report~).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  189 CLASSIFYING COUNTRY  RISKS  (Seep. 4-33)  Recommendation GAO recommends that the Board of Governors, FRS, and the Comptroller of the Currency, using all available information, develop and use a single approach to classify loans subject to country risk. FRS and occ response The FRS raised a question about country risk classification in theory, but it did agree that uniform treatment is desirable. OCC also agrees, although it points out that country risk evaluation is not an exact science. GAO comment We have no additional comments.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  190 , EXAMINING FOREIGN OPERATIONS  Csee  P. 4-35)  Reoommendation GAO recommends that the Board of Governors, FRS, and the Comptroller of the Currency implement procedures to examine (where permitted by the country involved) major foreign branches and subsidiaries, including subsidiaries of Edge Act corporations, periodically and whenever adequate informatio~ about their activities is not available at the home office.  occ  and FRS response  On the desirability of onsite inspections, both OCC and FRS agree with us, although both point out, as we did, that some countries do not permit such inspections. In 1976, OCC was able t~ conduct inspections in 37 countries. FRS in the fall of 1976 conducted onsite inspections in banks previously inspected at their home of-fices. GAO comment We are pleased at the recent agency actions, and they are in keeping with the recommendation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  191 CONDUCTING FOREIGN EXAMINATIONS MORE EFFICIENTU (Seep. 4-35) Recommen1ation GAO recommends that the Board of Governors, FRS, and the Comptroller of the Currency utilize each others examiners to cut expenses when conducting examinations in foreign countries. tRS response FRS did not comment on this recommendation. OCC response OCC agreed with this recommendation, but it pointed out possible jurisdictional difficulties. GAO comment We would hope such difficulties could be overcome, and we would support necessary legislation to remove barriers to sharing resources and promoting more efficient and effective examinations of foreign branch operations.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  192 EDP EXAMINATION REPORTS (Seep. 4-39) Recommendation GAO recommends that the Board of Directors, FDIC, and the Board of Governors, FRS, develop reports of examination for EDP operations which present the problems found, corrective action needed, and any necessary explanatory data in a clear and concise manner. FDIC response FDIC stated that the •summary comments page of the FDIC EDP questionnaire provides clear and concise description of the results of a data center evaluation." In its judgment, a new evaluation report is not ne~essary at this time. However, the agency views its questionnaire as a constantly evolving tool. FRS response FRS "believes its present EDP examination report adequately presents the major problems found and corrective action needed." The agency, however, indicates it has ~ndertaken a review of its EDP examination procedures and, as a result, will prepare a revised examination report. GAO comment In our opinion, the agencies' EDP examination report contained more information than required to tell bank managers of corrective action needed. The banks received all questionnaires answered during examinations, whether a deficiency was disclosed or not. We believe the EDP examination report, like the commercial examination report, should contain deficiencies noted by examiners, recommended corrective actions, and only· necessary supporting data.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  193 SUPERVISING BANK HOLDING COMPANIES (Seep. 4-51) Recommendation GAO recommends that the Board of Governors, FRS, implement a system of supervision which is based on onsite inspections of holding companies and their major nonbanking subsidiaries. We also recommend that the Board strengthen its oversight of holding company supervision by establi4h1ng --a systemwide manual of inspection procedures, --a standard inspection report, and --periodic onsite evaluations of Reserve bank supervisory activities. FRS response FRS saw no difficulty with the thrust of our recommendation, and it noted several recent improvements including --requesting and obtaining cease and desist authority over holding companies, --developing a systemwide manual for inspections, and --working on a computer-based monitoring system. FRS said it may consider a standardized inspection report. FRS expressed concern over our sample method, stating GAO selected a sample in which problem banks were more likely to occur than in the industry as a whole. GAO comment  We are pleased at the FRS's recent efforts. Concerning our sample or holding companies, it was the FRS that determined which holding companies we could review. The FRS restricted us to looking at companies owning banks in our samples. Of the banks in those samples, 344 were affiliated with holding companies and 72 had problems related to the affiliations, according to the examiners. We can·make no other comments on the industry as a whole because of the FRS restrictions.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  194 MEETING WITH BANKS" BOARDS OF DIREC~  3 (Seep. 6-5)  Recommendation tors, FDIC, and GAO recommends that the Board of Di: examiners to meet the Board of Governors, FRS, require the with thEi bank" s board of directors or au,: .; or examining committee after each examination. FDIC response FDIC cited its current policy of me· directors in problem banks and determini adequately considered examination report tf.f;j policy is practiced in its field o ( p;tJted to its practice of requiring the officers to certify on a receipt that tho the reports.  :ng with boards of if the boards FDIC also said ., es. FDIC ~nk"s executive joards did consider  FDIC added that it expects to 1ncre~se the frequency of its meetings with boards of directors. FRS response FRS also requires bank directors to sign a statement that certifies they have read and considered the examination reports. Examiners are supposed to review minutes of board meetings to ensure this is done. Also, FRS has expanded Lis policy on meetings with directors of banks, and now Reserve banks" staffs are required to meet with directors of problem banks. GAO comment Notwithstanding the agencies' policies, we found no evidence of meetings with directors in many of the problem banks in our samples. In ·our study of failed banks, we found specific statements in examination reports indicating directors were unavailable and examiners did not meet with them. On the other hand, when we did find evidence of meetings with directors, it was often on an ad hQ.Jl_ basis with some directors of problem banks, not on a standard basis with the entire board or even an audit committee of the ~card. In its own study of failed banks, FDIC pointed out that a frequent factor in ba~~s that failed was lack of involvement by the boards of directors in the banks' affairs. Therefore, assuming the directors d~1 read the examination reports they may not have realized the seriousness of the problems. We believe the directors must be made aware of affairs at their banks. The only way to ensure this is through personal meetings between the agencies and the directors on a regular b~sts.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  195 BANK EXAMINATION REPORTS (Seep.  -13)  Recommendation GAO recommends that the Board of Di~ Board of Governors, FRS, develop and use tion which provide the banks with the re tion and any necessary supporting 1nforrr.  Jtors, FDIC, and the :~orts of examina'.ts of the examina.on.  FDIC response FDIC believes its examination repor• "ormat and related guidelines, "provides a olear, oonoise p ture of problem areas to bank mangements.~ However, the agenoy said it has begun ·a study of the role and use of the oonfidential seotion of its examination report which will probably result in its change or elimination. FRS reponse FRS believes its "bank examination report presently provides the banks with the results of an examination and necessary supporting information." FRS noted, however, that "the System is continually exploring methods of improving communications." · GAO comment In our report we criticized the agencies· bank examination reports because --recommended corrective actions often were not included, --the body sections contained tables, questionnaires, lists, and other data copied from banks' records, or presented without interpratition, and · --the confidential section which contains the examiners' more explicit co □ Jents and opinions of the banks' condition, manageT.ent, ownership, earnings, growth potential, and p•~•ress In resolving problems, was not given to the hanks.  We do not believe the bank examination reports presently used by FDIC and FRS effectively communicate the results of examinations and the action~ required to resolve problems.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  196 OCC'S NEW EXAMINATION APPROACH (Seep. 7-25) Recommendation GAO recommends that the Comptroller of the Currency invite FDIC and FRS to jointly evaluate its new examination approach. We further recommend that, in the event of a favorable assessment of the new process, the Board of Directors, FDIC, and the Board of Governors, FRS, revise their examination processes to incorporate the concepts of occ·s approach. FDIC response FDIC believes that the new OCC examination approach has not been sufficiently tested to determine its applicability to FDIC, especially its applicability to examining small banks, Further, FDIC believes that its own improvements to the examination process, which became effective January 1, 1977, are more logical, beneficial, and prudent. FRS response In FRS~s on-going review of their examination procedures, they intend to use whatever benefits may be derived from occ·s new examination approach. occ response OCC welcomed a joint FDIC/FRS/OCC review and evaluation of their new procedures. GAO comments In our report we pointed out that "At the time or our study, the process had only recently been developed and field tested at 10 banks. Neither we nor the agency could fully evaluate the practical problems that may be encountered in implementing the new procedures, such as the resources needed and the applicability of the process to all types of banks.***" During our study we examined OCC's new procedures, we consldered the concepts 1nvolve·d, and we reviewed the examination reports or the 10 test banks. Based on this review we concluded that the new approach seemed logical and offerej substantive benefits over the traditional approach. Because of the potential benefits that could be derived from the new approach, we recommended that t~e three a;encies jointly evaluate it ■ u~ imple~ent it only if t~e-sJcb an evaluation concluded in a ·ravorable assessment of t.he new proceas.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  197 OCC--like FDIC--supervlses many small ba~ka. About half of the banks that OCC supervises have assets of less than $25 million. OCC has recognized that the detailed procedures it has developed are not totally applicable to small banks. The agency believes, however, that the basic concepts of their new approach are applicable to small banks and, at the time of our report, OCC had examiners at three small banks working to design modified procedures. With respect ~o FDIC's new examin~tlon policy, we do not believe that it ls the most logical, beneficial, and prudent approach to bank examinations. While imple~entation of the policy did not become effective until after we had completed our study and had furnished a draft of our report to the agency for comment, and thus we were unable to review its actual implementation, it appeared to have many of the characteristics of the traditional examination approach which.we criticized in chapter 4 of our report. The procedures are somewhat similar to the "bobtailed" or abbreviated examinations that OCC had been making since early 1975 and the •compacted examinations" that FRS began making in March 1976. Our basic concern with these approaches is that they do not provide adequate assurance of an in-depth, systematic, structured approach to documenting and evaluating a bank's policies, procedures, practices, control, and audit as a basis for determining the detailed testing needed during the examination.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  198 CLASSIFYING  NATIONAL  CRE!llll (Seep. 7-25)  Recommendation GAO recommends that the Board of Directors, FDIC, the Board of Governors, FRS, and the Comptroller of the Currency jointly staff a group to analyze shared national credits at State and national lead banks under Federal supervision and that the three agencies use the uniform classification of these loans when they examine the participating banks.  FDIC  reaponse  FDIC said it is now a participant in the Shared National Credits Program. In December 1976 FDIC headquarters advised its regional offices generally to accept OCC's classification. FRS response FRS stated it agreed with the recommendation and entered into a preliminary agreement with OCC in Ju~e 1976 for sharing examiners' classifications of national credits.  occ  response  occ's commentary on the history of the program and the other agencies' involvement differed slightly from their versions, but OCC agrees that the idea of sharing classifications is a sound one. It indicated that FRS is exploring uniform procedures with OCC.  GAO  comments  There seems to be a lack or uniformity in the agencies' understandings or their agreements, but we are pleased there is a move toward adopting a uniform classification. There is not yet in existence the joint staff we recommend.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  199 MONITORING SYSTEMS AND CONSUMER CRE:  " (See p. 7-25)  Recommendation GAO recommends that the Board of 01 Board of Governors, FRS, and the Comptro work together to refine their monitoring approaches to examining for compliance~ laws.  0tors, FDIC, the ~r of the Currency ~stems and their ·., consumer cred 1 t  FDIC response FDIC is in favor of sharing experi~ es, but it believes competition in the area of consumer affc. ,·..; could be "healthy" and lead to a better system of enforcement. FRS response FRS notes that it 13 now training its examiners in the consumer affairs require~ents and has recently developed an appropriate examination manual. OCC response OCC further explained its new program which is operational and believes 1t has cooperated with the other bank regulators and with some other Federal agencies. GAO comment We are pleased that the agencies are now improving their supervision in the area of consumer affairs. We do not see how competition in the area of determining bank compliance with consumer laws is necessarily "healthy.• The cooperation recommend should not preclude innovation, but we believe all banks should be treated consistently in this important area.  we  While the agencies did not comment on our recommendation concerning monitoring s,..;tems, we feel this ls a great opportunity for joint cooperation in this area.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  200 USE OF FORMAL ACTIONS (Seep  -18)  Recommendation GAO recommends that the Board of Di Board of Gove~nors, FRS, and the Comptrol establish more aggressive policies for u Written guidelines should be developed t and magnitude of problems that formal ac: prtately correct.  ,tors, FDIC, the er of the Currency 1g formal actions. tdentify the types 0ns could appro-  FDIC response FDIC admitted that for several year ~here was a reluctance to use the cease and desist power ➔ to a general misundertstanding of it. More cease and d~ st orders are now being issued as a result of a program to ➔ ducate FDIC personnel in their purpose and use. FDIC points out that cease and desist orders nonetheless are not· a panacea and do not apply to all bank problems. FDIC does not feel written guidelines for using formal powers would be advisable. It believes --statutory criteria are adequate, --circumstances surrounding bank problems vary, and --banks could contest actions based on criteria not included in the guidelines. FRS response FRS did not believe we gave adequate weight to the hindrances to using present formal actions, but notes we support the agencies' request for additional powers. FRS further states that it ls impossible to compare the three agencies' enforcement actions since they have different judgments on the severity of bank problems. FRS questions our statistics on banks returning to nonproblem status. It says they do not include institutions withdrawing from member~~~~ and merging. Merged banks, FRS argues, were probably in good condition or the mergers would not have b~en allowed, and the withdrawals could have been under supervisory pre~sure.  CCC maintains that informal methods are sufficient for the vast majority or banks, e3pec!ally meetlng with banks'   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  201 boards of directors. OCC also points to increase in its use of cease and desist agreements, and to its greater use of th• compared to the other two agencies. OCC of its new systems which will help it re to bank problems.  ,e significant ~rs and written tools when ~ates some features 1nd appropriately  GAO comm~ Overall, we encourage the recent 1~ Jase in the use of formal enforcement powers. While it is :e that the current formal enforcement powers cannol ,lve all problems, our point is that they should have been 'd sooner and more often than they were. That point has no: jeen disputed by the agencies. And, as we stated in the )Ort, additional powers which we support for the agencle~ .ould give them more flexible tools. We do account for FRS banks withdrawing from the system and merging. On page 8-13 of the report we show that 7 banks withdrew and 6 mer~ed. However, our concern here is with the dynamics of the problem bank lists. If we assume that the merged and withdrawn banks had solved their problems, then the FRS would have returned 72 percent to nonproblem status. However, some banks every year withdraw from FRS on a completely voluntary basis, and we reviewed at least one failed bank that had converted charters, a move which the new supervisors, in retrospect, admitted may have been a mistake. OCC's new system does identify banks which need attention, but 1t does not identify what type of action is needed. Though the agencies say that written guidelines for using formal powers are inappropriate, FDIC admits that on.e reason their staff did not use the powers was unfam!llarlty with them. FDIC says the recent increase in their use can be attributed to an education program given to their personnel. Obviously such a progra~ would have to include some criteria for using the powers. It ls not our inter.c for the agencies to develop hard and fast rules which se?erely limit the circumstances in which formal actions could be ~1ken. Our point ls that written illustrative criteria WQald help field personnel decide when formal powers are aprropriate, and this fact seems to be borne out by FDIC 3 education program. To say that circumstances vary does not overcome the argument for illustrative guidelines,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  0  202 IDENTIFYING PROBLEM BANKS (Seep. 8-49) Recommendation GAO recommends that the Board of Directors, FDIC, the Board of Governors, FRS, and the Comptroller of the Currency develop uniform criteria for identifying problem banks. FDIC response FDIC emphasized the different uses by each agency for classification of banks. It believes its own detailed review of banks to ascertain potential risk to the insurance fund is sufficient without imposing •across-theboard" guidelines. Besides, FDIC feels, there is no great disagreement among the agencies as to which banks should be accorded close supervision. FRS response FRS stated that the agencies' rating systems are used for different purposes, but agreed there is room for common ground, perhaps through a Federal Bank Examination Council. OCC res,~nse OCC believes there is no confusion in communicating with the other agencies on particular bank situations. They contend the term •problem bank" is just agency jargon for many different circumstances. OCC said it has computerized variables for identifying potential problems as much as possible. OCC expressed a willingness to consult and cooperate with FRS and FDIC. GAO comment Although the term "problem bank" ie agency jargon, and the classification is subjective, it is hard to believe, as we report on page 8-48, that FDIC felt 20 national banks were financial risks to the insurance fund and OCC, the primary supervisor, did not classify them as problem banks. This indicates an apparent need for better coordination.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  203  p. 10-6)  COMBINING EXAMINER SCHOOLS ( Recommendation GAO recommends that where feasible' Currency, the Board of Directors, FDIC, nors, FRS, combine their examiner school curriculums. (Seep. 10-6.)  Comptroller of the , the Board of Gover1nd standardize their ~  FDIC response While FDIC indicated interest in ou:· cecommendation, the agency believes its tra1n1cg facility 16 ~e best available and wishes to have FRS and OCC join in eJtablishing a cooperative facility. FRS response FRS supports our recommend~tion. OCC response While OCC indicated that a common training effort and combined examiner school would be highly desirable, the agency expressed concern that it would be difficult to coordinate a curriculum unless FDIC and FRS changed their examination approaches in line with the changes being made at OCC. GAO Comment We believe the FDIC training facility at Rosslyn, Virginia exemplifies FDIC's commitment to examiner training, and justifies the agency's pride. We also agree that it would be difficult to combine commercial exanlner training if FDIC and FRS do not revise their examination approaches similar to OCC. However, as a minimum, we still recommend combining training efforts in other e~amination areas (e.g., EDP, trust, international and compliance with consumer laws and regulations), and essential knowledge areas (e.g., data proceJsing, law, and accounting).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  204 EXAMINER TRAINING (Seep. 10-11) Recommendation GAO recommends that the Comptroller of the Currency, the Board of Directors, FDIC, and the Board or Governors, FRS, increase their training in EDP, law, and accounting, as desired by their examiners. FDIC response FDIC indicated it will attend to the training needs expressed by its examiners. FRS response FRS scheduled a new EDP training course and indicated it will study the need for other additional examiner training.  OCC  response  OCC acknowledged the need for additional specialized examiner training, and stated it has offered, or will offer, training in several areas, including EDP, l~w, and accounting. GAO comment We are pleased with the actions taken by the agencies thus far.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  205 FRS TRAINING IMPROVEMENTS (Se  ~- 10-11)  Recommendations GAO recommends that the Board of Go establish a full-time training office tc training program and (2) carry out the r school curriculums which it has recognic time.  rnors, FRS,.(l) ,erate its examiner :sion of examiner as needed for some  FRS response While FRS believes its present tra! '.ng arrangement satisfies its needs, the agency will conJider establishing a full-time training office if a joint training facility cannot be worked out with FDIC and OCC. With regard to our second recommendation, FRS notes that the needed curriculum revisions have been accomplished. GAO comment  We concur. However, even with a joint training facility FRS will need to monitor their examiners· training needs. A full-time training office might be useful for this purpose.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  206 EXAMINER EVALUATION PROCESS (Seep. 10-15)  Recommendation GAO recommends that the Board or Governors, FRS, also establish aformal evaluation process to measure the competence or persons seeking advancement to examiner status. FRS response FRS states that it would not want to rely exclusivly on •standardized tests• as a form of evaluation. However, the agency indicated it intends to investigate their feasibility. GAO comment Our recommendation does not intend that the formal evaluation process be comprised of standardized tests, nor do we intend that the process be the only basis for advancement. The existing performance and potential evalu~t1ons would continue but be supplemented by the formal evaluation process when considering candidates for examiner status. We believe the formal evaluation processes used by FDIC and OCC offer one w~y of measuring the competence uf persons seeking examiner status. They are not standardized, but are structured, since they last 3 to 4 days; and they are not the sole determinant of advancement, but do carry significant weight.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  207 AGENCY COOPERATION (Seep. ll-8) Recommendation GAO recommends that either (l) the Board of Directors, FDIC, the Board of Governors, FRS, and the Comptroller of the Currency jointly establish a more effective mechanism to combine their forces tn undertaking significant-initiatives to improve the bank supervisory process or in attacking and resolving common problems, or (2) the Congress enact legislation to establish a mechanism for more effective coordination. We would be glad to assist the committees in drafting appropriate legislation. FDIC response FDIC stated that it would give serious consideration to establishing a vehicle for the three agencies to resolve common problems and make joint efforts in new initiatives. FRS response FRS believes a Federai Bank Examination Council such as the one sugiested by Senator Stevensnn when he introducAd S. 3494 during the last session of the Congress could-correct most_of the problems set out in our report with respect to coordination and cooperation. OCC response OCC has suggested to FDIC and FRS that a permanent start set up to strengthen coordination of the examination procedures.  be  GAO comments We believe that the best solution to establishing a ·mechanism to insure effective interagency coordination is for the Congress to enact appropriat~ legislation •nd to identify those areas where it feels effective interagency coordination is essential. In the absence of legislation, the proposal made by OCC to establish a permanent interagency coordinating staff would be a positive step in improving interagency coordination.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  208, The CHAIRMAN. I want to congratulate you on your statement and your study. I think one measure of its force and value and effecti~~ness was the reaction of Dr. Burns, who seemed to resent the criticism, and th1tt is normal. He is a marvelous man, he has a very healthy ego, and I think anybody with a healthy ego doesn't like to be criticized. Mr. KELLER. He was a bit concerned and seemed to take some issue with the report this morning, yet when he had the report for comment, he had no serious reservations, some differences but no major disagreements. Mr. LAYTON. That is right. The CHAIRMAN. I think he asked for permission to indicate in detail his disagreements for the record, and I would be very interested in seeing what they are, his differences with you. Mr. KELLER. If it would help the committee any, we do have a summary of our recommendations and the comments of the three agencies and our evaluation of their comments. The CHAIRMAN. Now part of my difference with Dr. Burns, as you may have detected in the questioning and his responses, was I felt we can greatly improve our regulatory operations and they are in need of a great deal of improvement, we could reduce the number of bank failures and improve the soundness of the banking system if the regulators did a better job. On pages 9 to 16 of your report you say: "Most bank failures were caused by bad management practices which were readily identified by the supervisory agency's examiners. Although economic conditions worsened the banks problems, the primary cause of the failures was the management decisions that left the banks inordinately vulnerable." You are saying it was not the recession, but it was the weakness of bank management. Mr. KELLER. I would like to qualify that a bit. The recession, the economic conditions, aggravated it. The CHAIRMAN. You say: Although economic conditions worsened the banks' problems, the primary cause--  Mr. KELLER. That was our conclusion from the examination reports. The CHAIRMAN. You say: The difficulty was in influencing the banks to solve the problems. In the 30 bank failures studied, 17 had self-serving loan practices, 17 had overconcentrated on credit to a single industry, and in 27 out of the 30 cases, loan records were inadequate. Even among the eight banks which failed because of fraud, the examiners noted problems with internal controls in seven long before they were forced to close.  Now, as you know, we have had the largest failures in the history of the Nation in the past 5 years. In your judgment, could most of these failures and their adverse public consequences have been averted by tougher regulatory policies? Mr. KELLER. It is hard to make a judgment on that, Mr. Chairman. I think that probably some of them could have been averted. You are dealing with something that didn't happen, and it is pretty hard to say that if the agencies had been tougher none of the banks would have failed. Maybe some of them would not have. The CHAIRMAN. You said eight banks failed because of fraud and in seven of those cases it was known long before that they had to close.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  200 So that if the action had been taken, it would seem to me that in some of those seven cases they would have been able to avoid failure. Mr. KELLER. I don't disagree with you. It is a question of whether all or part of the failures could have been avoided. The CHAIRMAN. You made a good point, I thought, in presenting your case of the importance of examiners meeting with the boards of directors. Mr. KELLER. We think that is quite important. I guess it is our training as auditors. We always try to have a conference with people and let them know what the problems are. I would urge it, as I understand examiners find some problems in nearly every bank. I think meeting with the boards is a good discipline and a good procedure to follow. The CHAIRMAN. As you point out in the statement, you found that most, the overwhelming majority of the bankers you talked to indicated they thought the examinations were useful. And if they were useful, the defects and shortcomings should be called to the attention of the people who are responsible for the bank. On page 20 of your summary, you say that the agencies rarely met with boards of directors of banks, and very often did not meet with those banks that had major problems. It seems to me although bankers deem bank examination important, the agencies have been too slow in bringing matters to the attention of the people who can do something about it, the boards of directors. Mr. KELLER. Mr. Chairman, I would like to draw a distinction here. I don't have any doubt that the supervisory agency had a lot of contacts with the bank management. However, I think if a bank is in trouble the agency should meet with the board of directors. The CHAIRMAN. Sure. As I say, nobody likes to be criticized. You tell a bank manager he is not doing a good job, he is likely to resent it. The people who can do something about it are the boards of directors who are his boss, they are the ones who hire and fire him and determine whether his policies are sound. So isn't your report strong evidence that bank boards of directors have not been required to do their duty by the agencies, and I wonder how we can make bank boards more responsible for the management of the banks. Mr. KELLER. Well, I don't claim to be an expert on this, and I am sure it varies very much in different banks. I think we have a real question, probably a public question, of more responsibility on the part of boards of directors, not only of banks, but public corporations. The CHAIRMAN. One way of doing it is by asking them to meet with Mr. KELLER. That is right. The CHAmMAN. Now the survey responses to your questionnaire on agency organization were most revealing; 75 percent of the respondents supported or were neutral toward the present system; 56 percent would support or have neutral views on combining the three agencies at the Federal level: 57 percent of the State nonmember banks would support a single Federal agency, which leaves intact the State regulatory system, as you just pointed out; 63 percent of the national banks were opposed to this reorganization. The national banks are the ones that have the most permissive regulators, and where in my view they have had the most serious problems, and we have been able to document that based on the evidence. So the smaller banks tended to support a single regulator, and the banks that weren't regulated by the most permissive regulator.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  210  The bankers generally aren't as opposed to reorganization as the lobbyists make out. National banks would oppose abolishing the Comptroller, but he has been the most permissive regulator and big banks have been allowed to operate with lower competitive ratios. Don't you agree this shows banking support for a single agency at the Federal level 9 Mr. KELLER. Mr. Chairman, the way we come out on this is that we think there should be better coordination. We don't think it is absolutely esse~tial that there be a banking commission to carry this out, but we are not opposed to it. I think it is a matter of judgment as to how far you want to go in. this area. I am not saying the banking commission would be wrong. The CHAIRMAN. Well, over 90 percent of the banks responding rated bank examiners' knowledge of banking as adequate or better. In your report you show that examiners usually identify the problems that banks have. On page 8 of your summary you say: We noted a tendency by each agency to delay legal action until the banks problems had become so severe as to be difficult at best to correct. We believe the supervisory agencies did not use the cease and desist authority as effectiveless as they might have.  What is responsible for this management failure or reluctance on the part of the agencies to take action i Why shouldn't they have used the cease and desist and saved some of the banks~ Mr. KELLER. We th'ink they should have used it more, and I gave you the reasons the agencies gave us for not using formal actions. They say legal actions could generate publicity which could adversely affect the banks, legal powers are not appropriate for all circumstances, certain le~al powers are too cumbersome to use, and there is a fear of appearmg too harsh or of suppressing management prerogatives. I think all of those things have to be taken into consideration. However, I think there should be more use of formal actions. The CHAmMAN. It seems to me the cease-and-desist order is not a matter of tossing the manager in the slammer and keeping him there. Mr. KELLER. But they seem to be very nervous about using it. The CHAIRMAN. That is right, and I am concerned about that. Mr. KELLER. In 1976 they used it more. The CHAIRMAN. If they are confident the practice that is being followed is wrong, and is hurtful for the bank, they ought to act and act more freely. Mr. KELLER. I certainly agree with you. If you don't get tough once in a while, nothing will happen. The CHAIRMAN. Isn't one of the reasons that if they get the reputation of a tough examiner, there is a tendency for the bank to opt out from under their control, and if they are regulated by FDIC, for instance, to become a national bank, and get into the Comptroller's orbit, where they might not have that action taken with such force 9 Mr. KELLER. I suppose it might be. The CHAIRMAN. Mr. Keller, I want to thank you very much for a.n excellent report. We very much apprecia.te it; . The committee will stand in recess until tomorrow morning at 10 o'clock. [Thereupon, at 12 :15 p.m., the hearing was recessed, to reconvene at 10 a.m., the following day.]   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  FlRST MEETING ON THE CONDITION OF THE BANKING SYSTEM FRIDAY, MARCH 11, 1977  U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Wa,shington, D.O. The committee met at 9 :35 a.m., in room 5302, Dirksen Senate Office Building, Senator William Proxmire, chairman of the committee, presiding. Present: Senators Proxmire and Lugar. The CHAIRMAN. The committee will come to order. As you gentlemen know, we are holding hearings beginning yesterday on the condition on the banking system in this country. We had testimony yesterday from the General Accounting Office and from the Federal Reserve Board and it seems that there is considerable evidence that the condition of our banking system has been concerning members of this committee and-other Members of the Congress as well as the public generally so we are glad to have, this morning, the Chairman of the Federal Deposit Insurance Corporation, Mr. Barnett, the Acting Comptroller of the Currency, Mr. Bloom, to testify before us, and then they will be followed by a panel of Professors Minsky, Shull, and Sinkey. Gentlemen, I want to thank you very, very much for accommodating the committee by agreeing to appear early and also by providing your excellent statements well in advance so we had an opportunity to go over them. Our first witness is Mr. Barnett. Mr. Barnett, if you would proceed, and if you would like to abbreviate your statement we will have the entire statement printed in full in the record. It's a substantial statement. We have, as you know, other witnesses, so we would appreciate it if you could abbreviate it.  STATEMENT OF ROBERT E. BARNETT, CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION, ACCOMPANIED BY lOHN EARLY, DIRECTOR, DIVISION OF BANK SUPERVISION Mr. BARNETT. I'd be pleased to, Mr. Chairman. I would like to introduce to the committee Mr. John Early, who is the Director of Bank Supervision, whom I've asked to participate. I will abbreviate my statement, Mr. Chairman. I am pleased that the committee is holding this type of review of the condition of the banking system, and I hope that this will be a regular part of the congressional oversight of the banking industry and   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  (211)  212 the banking supervisory agencies. Regular routine disclosure and discussion of information concerning the banking industry is in the public interest. Let me first state my belief that the banking industry is in reasonably sound condition, certainly in much better condition than it was during the past year or two. The statistical trends in the industry over the past year seem to reflect movements toward stability, increased capital ratios, better liquidity, declining loan losses, although they remained high in 1976, and higher earnings. Nonstatistical items, such as management experience, also have improved. The industry is in an a-ppropriate position to recover from the remaining ill effects of the problems of the early 1970's. That this should be so is interesting since the banking industry placed itself in a much riskier operating environment over the past 10 to 15 years. As I describe more completely in my written testimony, banks themselves expanded into new and riskier ventures, bank holding companies expanded rapidly and introduced new activities to bank managers, liability management was practiced beyond traditional restrictions, loan-deposit ratios increased dramatically, rapid deposit growth lowered capital ratios, a number of banks never before in the business entered international banking, P /E multiples became paramount, banks' customers became more heavily leveraged, and all of this was placed in the hands of a number of bankers whose recollection of severe business cycle movements was only secondhand. Once both the banking· system and the economy arrived in this riskier position, the world was beset by an extraordinary combination of crises. First, the world energy crisis precipitated by the OPEC cartel.:_the embargo and the huge increase in the price of oil. This produced a massive shift in the balance of payments of the United States and other countries requiring the financing of resulting deficits and reinvestment of the OPEC surpluses. One result was the serious threat to the status of multibillion-dollar oil tanker loans. Another was to generate questions about the economic outlook of less-developed c.ountries who were, in fact, the hardest hit by the increase in oil prices. These developments, along with such developments as wide swings in commodity prices, not only helped produce inflation at a record rate, but led to a recession deeper than any downturn since the 1930's. The inflation and recession combined with what appears to be a peaking of another of the periodic cycles of real estate speculation in the United States to produce massive deterioration of the real estate market, generating huge loan losses. A separate crisis in municipal credit was triggered by. New York City's near default. In the midst of all this, we had the failure of what had been the 20th largest bank in the United States and many news stories about the regulatory agencies' list of problem banks. As a result of all of this, we saw 16 bank failures in 1976-the largest number in nearly 25 years-following closely the 13 the previous year. The number of banks on our problem list, which includes national banks and State member banks, as well as nonmember banks, increased from 156 on January 1, 1974, to 349 on January 1, 1976, a very rapid increase. We usually expect the number of our problem banks to level off and decline after some time lag during the recovery period for the economy. The time lag was much greater in the case of the 1973-74 recession, probably because of the depths of the recession, and during  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1976, the number of banks on the problem list actually increased, rising to 373 by early summer of 1976 and fluctuating around that number since that time, reach a high of 385 in November. As of January 1, 1977, we had 379 banks on the problem list, and as of March 8, 1977, we had 384. It is significant that the number of banks in our serious problem categories has declined substantially from a high of 128 in the spring of last year to 115 at the present time, and that the number of banks that were not on our problem list was always about 14,500 throughout this period. Similarly, although 16 insured banks failed, nearly 98 percent of all deposits were immediately available because of successful purchase and assumption transactions, and over 99 percent were available in all cases within a few days. As has been pointed out frequently in the past year by myself and 'by others, because of these successful purchase and assumption transactions, bank failures generally are no longer the disastrous events in a community that they once were. With all that bad news as background, we can look at more recent developments with some optimism; 1976 was a good year for the banking system in terms of earnings and improvement in financial conditions. Bank liquidity positions improved dramatically with substantial increases in holdings of Government securities-holdings were up $17 million, :following a $30 billion increase in 1975. While banks might have preferred that loan demand were stronger, we must recognize that lack of demand has led to an improvement of the liquidity position of the banking system. The liquidity position was also improved by the continued displacement of volatile money market sources of funds with stable saving-s-type deposits. Large CD's dropped by $19 billion and consumer savings-type deposits incrPased $58 billion. The reduction in interest costs allowed an increase in earnings despite the relatively slack loan demand. The capital position of the banking industry also improved during 1976, as the growth rate of capital, through retention of earnings, was higher than the modest growth rate of loans. Total capital accounts were up 10 percent-revised from the 8.5 percent in my written testimony-but 10 percent on a similar accounting basis and loans were up 7 percent, revised from the 5 percent in my statement. Bankers necessarily have learned something :from their experiences of the last few years. Activities that were new to many of them in the 1960's are more familiar now that they have lived with them through bad times as well as good. Bankers' attitudes toward risk and appropriate loan policy have benefited from this experience. The real estate developer with a great idea will sit down with a loan officer more experienced and more skeptical than a few years ago. Bank loan problems still exist. Since a major element of problem loans for banks over the last :fe.w years has been real estate loans, loans that take a lon,g- time to work out, the volume of underperforming loans and classified loans is still high. Complete figures are not available, but the ratio of classified loans to capital appears to be up slightly in 1976, and that seems to 'be holdin,g- true with preliminary figures. But net loan losses in 1976, while high, should not exceed the record levels of 1975. Complete figures are not yet available, but the trend seems to be down. All in all, it does seem fair to say that the bankin~1stem has turned the corner and its condition is improving.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  214  A key factor in its continuing recovery will be the cost of carrying problem assets until their disposition and whether the op:portunity cost of missed investments will exceed or fall short of ultimate recovery values. Thus, although some banks are not yet clear of the serious financial problems that surfaced during the 1973-74 recession, the industry ·as a whole continues to experience steady improvement in both balance sheet liquidity and capital strength in early 1977. Implicit in what I have said up to this point is that the Corporation believes that appropriate standards for judging the health of the banking industry include the following: Earnings, capital, loan losses, liquidity, management, number and size of banks on the problem list, classified assets, and the failed banks. In addition, the Corporation refers to other standards that are more difficult to apply. For example, without question, public confidence in the banking system is important to the health of the banking industry. To measure confidence is somewhat difficult, but we do see signs that public confidence in the system is present. There is no evidence that money is bypassing the banking system; deposits are growing rapidly. The CHAIBMAN. Mr. Barnett, would you go back again just for a minute and go over the criteria that you indicated which should tell us the condition of our banking system? Mr. BARNETT. It's on page 11 of my statement. The CHAIRMAN. Thank you. Mr. BARNETT. I'm now moving to page 12 where I'm discussing three other criteria I believe we should look at. There were no major runs on banks during the past year even though there were a large number of bank failures, and considerable publicity about banks in trouble, and intensive scrutiny by Congress and State legislators of banking structure, powers, and functions. All of this suggests that public confidence is high. In addition, we believe that relatively free entry and intraindustry competition are appropriate standards for measuring the health of the banking industry. Again, this is difficult to measure statistically, but we do have some numbers that suggest that desirable markets are subject to competition from different institutions. For example, the Corporation approved 116 applications for Federal deposit insurance in 1976 for State-chartered nonmember banks. Likewise, 609 applications for new branches and 254 applications for limited branch facilities were approved, and 116 notifications of unmanned remote service facilities. Finally, it is important to the health of the banking industry that a viable dual banking system operate. We think 1976 saw the continued aggressive participation in the banking industry by State legislators and supervisors, as well as Congress and the Federal supervisors. The dual banking system seems to have been viable during 1976, and that should contribute to the health of the industry. In my written statement I continue on to discuss some specific items FDIC has been dealing with, our monitoring systems and some specific criteria we use for capital adequacy and liquidity and management confidence, and then discuss in some detail the GAO study. Because of time pressures this morning, Mr. Chairman, I would stop at this point and respond to questions if that's desirable to you. [Complete statement follows:]  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  215  FDII  IL.+--N_E_W_S_RE_L_E_A_S_E__J  f[DEU.lDEPOSII INSURANCECORl'OIATION  PR-19-77 (3-11-77)  RELEASE UPON DELIVERY  Statement on  Condition of the Banking System and  Report of the General Accounting Office  Presented to  Committee on Banking, Housing and Urban Affairs United States Senate  by  Robert E. Barnett, Chairman Federal Deposit Insurance Corporation  March 11, 1977  FEDERAL DEPOSIT INSURANCE CO RPO RATION, 550 Seventeenth St. N.W., Washington, D.C. 20429   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  202-389-4221  216 I am pleased that the Committee is holding this type of review of the condition of the banking system, and I hope that this will be a regular part of the Congressional oversight of the banking industry and the banking supervisory agencies.  Regular routine disclosure  and discussion of information concerning the banking industry is in the public interest.  General health of the banking industry; standards appropriate for judging its health.  Let me first state my belief that the banking industry is in reasonably sound condition, certainly in much better condition than it was during the past year or two.  'Ihe statistical trends in the  industry over the past year seem to reflect movements toward stability, increased capital ratios, better liquidity, decli11ing loan losses (although they remained high in 1976) and higher earnings. Nonstatistical items, such as management experience, also have improved.  'Ihe industry is in an appropriate position to recover  from the remaining ill effects of the problems of the early 1970s. 'Ibis is a significant achievement if the developments of the past number of years are listed: Over the last 1 S years, banks have chosen to operate in a riskier manner; At the same time, the U.S. and world economies have become riskier places in which to do business; Over the last S years or so, there have been some very unfavorable economic developments which had serious effects   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  217 because of the riskier structure of the economic system; As a result of these unfortunate events, the greater risk in the economic environment and the greater risk inherent in their own financial structure and operations, the banking system underwent a severe shock; The banking system was hit hard by the confluence of these forces in the 1973-74 period, and this resulted in severe problems·for a number of banks, including some large banks; Despite all of this, the banking industry and the financial system were basically sound and stable, and this enabled the industry to weather the storm.  Let me go back  and consider these points in order. Over the last 10-15 years the banking system has become a riskier one as banks, particularly the larger banks, have operated in a more aggressive manner.  Since the early 1960s, many banks,  and particularly the large banks, abandoned their traditional conservatism and began to strive for more rapid growth of assets, deposits and net income.  Large banks be.gan pressing at the legal  boundaries of allowable activities for banks.  Beginning in the  mid-1960s, national banks were allowed to expand their activities into fields which, to many observers, involved more than the traditional degree of risk for commercial banks.  Whether such activities  are inherently riskier, or riskier only in their newness to bank managers is a problem I must leave to others to resolve. it to say that at least in the short run, they are riskier.  Suffice These  included such activities as direct-lease financing, underwriting of   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  218 revenue bonds, and expanded foreign operations.  I am not sug-  gesting that banks should not be in these activities,  One could  make the argument, I believe, that such increased riskiness is healthy, desirable for the nation's economy, and competitively responsible.  Nevertheless, these activities are examples of the  general trend toward increased aggressiveness and increased willingness to bear risk on the part of the banking system in general, and large banks in particular. The bank holding company movement is another such development.  It allowed banks to get into areas somewhat different from  their traditional activities; again, not necessarily inappropriate, but activities at least generally perceived to involve a greater degree of risk. Beginning at about the same time, larger banks began to advocate and practice the concept of liability management.  This  involved a change from the traditional balance sheet requirement of adequate liquidity of assets to a willingness to go into the money market and buy liquidity if needed, regardless of prevailing rates. Most of the traditional financial measures of bank aggressiveness and riskiness show these trends.  In 1960, for example,  banks with deposits of between $5-10 million had an average loandeposit ratio of 46 percent, whereas banks with deposits over $500 million had a loan-deposit ratio of 56 percent.  Both· size categories  of banks showed significant increases in this ratio over the last 15   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  219  years, but the increase has been more dramatic for the large banks. Their loan-deposit ratio at the end of 1974 was 79 percent as compared with 63 percent for the smaller banks.  This came about as  a result of a very large increase in the volume of business loans (including commercial real estate loans) in the early 1970s,  In  addition to the loan-deposit ratio, the capital-asset ratio showed the same trends,  The capital-to-asset ratio of both size categories  of banks was nearly the same in 1965, and averaged for all banks, about 8 percent.  Since that time the small banks have maintained  their capital ratio at about 8 1 /Z percent, while the large banks' ratio has declined to under 7 percent, causing the average of all banks to drop to about 7 percent.  While one can argue the merits  of these or other ratios as measures of risk, for whatever they are worth, they do exhibit a change in traditional ratios of risk measurement, with a much greater change on the part of the larger banks than the smaller ones, One of the areas in which large banks have moved with great vigor in recent years has been the international area,  Approximately  140 American banks, or one percent by number of American banks, have foreign branches, compared with only Z7 in 1968,  These banks,  while small in number, account for nearly half of total U, S. bank deposits, and the assets of their foreign operations amount to about 30 percent of their total assets,  Part of this operation involved a  much greater role for American banks in lending to foreign businesses  86•817 0 • 77 • 15   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  220 and governments,  Operation outside the country in which a corpora-  tion is originally established is not necessarily riskier than domestic operations,  But for most A.nlerican banks engaging in this activity  during the 1960s and 1970s, it was at least a new venture, and new ventures are almost necessarily riskier than those in which one has built up a solid base of experience,  Not surprisingly; a number of  A.nlerican banks have incurred losses in their foreign operations. Again, none of these losses have been sufficient by themselves to result in a bank failure, although the international operations of Franklin National Bank greatly added to its other problems, Related to the move into new types of activities, and new geographical areas for banking activity, has been a change in orientation of A.nlerican banks.  Performance began to be a more important  consideration, as did growth,  Banks became more concerned about  their immediate profit picture and the price of their stock.  In several  cases, banks took on activities, loans or commitments that seemed to have the promise of immediate profitability or favorable stock market reaction, Part of this was associated, at least in the United States, with a new breed of banker -- younger and more aggressive,  Not only did  youth itself tend to make for more aggressiveness, but we began to see rising to positions of responsibility bankers who had not had direct personal banking experience during the depression of the 1930s. One can take that argument only so far, however, since some of the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  221 industry leaders during this period were individuals who were personally familiar with the depression, It is generally acknowledged that the state of the world economy has become riskier in recent years.  '!here are sP.veral forces at work  here: 'Ihe long-run world inflationary trend is one aspect of it.  Another  is the replacement of the system of relatively fixed exchange rates that has prevailed for most of the post- World War  n period by a  more-or-less freely fluctuating exchange rates,  system of  A world of fluctuating  exchange rates is a riskier one in which to do business.  In fact, the  means by which business firms have minimized their exchange risks have been their utilization of banks to take on the exchange risks.  On  the domestic scene, over the last ZO years corporations have restructured their balance sheets on a rather massive scale, substituting debt for equity and increasing their leverage, Not only did the financial structure of the firms that banks lend to become riskier, but at the same time corporate profits were weak, so that the corporations have found themselves more dependent on external financing for both their long-term and short-term financing needs. Once both the banking system and the economy arrived in this riskier position, the world was beset by an extraordinary combination of crises.  First the world energy crisis precipitated by t.lie OPEC  Cartel - - the embargo and the huge increase in the price of oil.  This  produced a massive shift in the balance of payments of the U.S. and   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  222 other countries requiring the financing of resulting deficits and reinvestlnent of the OPEC surpluses,  One result was the serious threat  to the status of multi-billion dollar oil tanker loans,  Another was to  generate questions about the economic outlook of less developed countries who were, in fact, the hardest hit by the increase in oil prices, These developments, along with such developments as wide swings in commodity prices, not only helped produce inflation at a record rate, but led to a recession deeper than any downturn since the 1930s, The inflation and recession combined with what appears to be a peaking of another of the periodic cycles of real estate speculation in the U, S, to produce massive deterioration of the real estate \  market, generating huge loan losses,  A separate crisis in municipal  credit was triggered by New York City's near default,  In the midst  of all this, we had the failure of what had been the twentieth largest bank in the United States and many news stories about the regulatory agencies' list of problem banks, One observer of the banking scene put it this way: "some time after 1965, the halcyon age apparently ended, Rising inflation was the harbinger, but certainly not the sole cause or symptom, of heightened economic instability, This was a period of collapse of the Bretton- Woods Agreement and disappearing anchovies, of social unrest in America and widespread drought abroad. An American president was shamed into resignation and traditional allies grew restive as former adversaries were embraced under the guise of detente, In addition, petroleum producers established a potentially disastrous precedent for other primary materials producers in effectively cartelizing the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  223 industry. In short, the period after 1965, and particularly after 1970, was one in which numerous seemingly unrelated shocks buffeted the economic system. Quite expectedly, the system lurched to and fro, while stabilization policymakers sought to administer offsetting shocks. "* As a result of all of this, we saw 16 bank failures in 1976, the largest number in nearly 25 years, following closely the 13 the previous year.  The number of banks on our problem list, which  includes national banks and state member banks, as well as nonmember banks, increased from 156 on January 1, 1974, to 349 on January 1, 1976.  We usually expect the number of our problem  banks to level off and decline after some time lag during the recovery period for the economy.  The time lag was much greater in the case  of the 1973-74 recession, and during 1976, the number of banks on the problem list actually increased, rising to 373 by early summer of 1976 and fluctuating around that number since that time.  As of  January 1, 1977, we had 379 banks on the problem list, and as of March 8, 1977, we had 384.  It is significant, however, that the  number of banks in our serious problem categories has declined substantially from a high of 128 in the spring of 1976 to ll5 at the present time, and that the number of banks that were not on our problem list was always about 14, 500 throughout this period. Similarly, although 16 insured banks failed, nearly 98 percent  * Stuart Greenbaum,  Professor of Finance, Northwestern University, "Economic Instability and Commercial Banking. ,·, Compendiwn of Major Issues in Bank Regulation, Senate Banking Committee, May 1975.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  224 of all deposits were immediately available because of successful purchase and assumption transactions, and over 98 percent were available in all cases within three days.  As has been pointed out frequently in  the past year, because of these successful purchase and assumption transactions, bank failures generally are no longer the disastrous events in a community that they once were.  (See the FDIC 1976 Annual  Report, a copy of which is attached hereto.) With all that bad news as background, we can look at more recent developments with some optimism.  Nineteen seventy- six  was a good year for the banking system in terms of earnings and improvement in financial conditions.  Bank liquidity positions  improved dramatically with substantial increases in holdings of government securities (holdings were up $17 billion, following a $30 billion increase in 1975).  While banks might have preferred  that loan demand were stronger, we must recognize that lack of demand has led to an improvement of the liquidity position of the banking system.  The liquidity position was also improved by the  continued displacement of volatile money market sources of funds with stable savings type deposits.  (Large CDs dropped by $19  billion and consumer savings-type deposits increased $58 billion.) The reduction in interest costs allowed an increase in earnings despite the relatively slack loan demand. The capital position of the banking industry also improved during 1976, as the growth rate of capital, through retention of earnings, was higher than the modest growth   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  225 rate of loans.  (Total capital accounts were up 8. 5 percent and loans  were up 5 percent. ) Bankers necessarily have learned something from their experiences of the last few years.  Activities that were new to many of  them in the 1960s are more familiar now that they have lived with them through bad times as well as good.  Bankers' attitudes toward  risk and appropriate loan policy have benefitted from this experience. The real estate developer with a great idea will sit down with a loan officer more experienced and more skeptical than a few years ago. Bank loan problems still exist.  Since a major element of  problem loans for banks over the last few years has been real  estate loans, loans that take a long time to work out, the volume of underperforming loans and classified loans is still high.  (Com-  plete figures are not available, but the ratio of classified loans to capital appears to be up slightly in 1976.) But net loan losses in 1976, while high, were less than the record levels of 1975.  (Com-  plete figures are not yet available, but the trend clearly is down.) All in all, it does seem fair to say that the banking system has turned the corner and its condition is improving.  A key factor in  its continuing recovery will be the cost of carrying problem assets until their disposition and whether the opportunity cost of missed investments will exceed or fall short of ultimate recovery values. Thus, although some banks are not yet clear of the serious financial problems that surfaced during the 1973-74 recession, the industry as   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  226 a whole continues to experience steady improvement in both balance sheet liquidity and capital strength in early 1977.  We might note  that no bank has closed because of financial difficulties so far in 1977.  By this date last year, we had seen four bank failures. It is perhaps unfortunate that the initial disclosure of the  numbers of banks on our problem list came at a time ·when the numbers were larger than they had been previously.  Nevertheless,  the periodic dissemination of such information is useful and appropriate public information.  Confidential information concerning the  condition of an individual bank that arises from the examination process should remain confidential,  But aggregate information that  relates to the health of the banking system as a whole is appropriately a part of the public record,  It remains our intention to make such  'periodic disclosure of aggregate information from our problem list in regular forums such as periodic Congressional hearings on the condition of the banking industry. Implicit in what I have said up to this point is that the Corporation believes that appropriate standards for judging the health of the banking industry include the following: earnings capital loan losses liquidity management number and size of banks on the problem list classified assets failed banks   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  227 In addition, the Corporation refers to other standards that are  more difficult to apply.  For example, without question public confidence  in the banking system is important to the health of the banking industry, To measure confidence is somewhat difficult, but we do see signs that public confidence in the system is present,  There is no evidence that  money is bypassing the banking system; deposits are growing rapidly. There were no major runs on banks during the past year even though there were a large number of bank failures, considerable publicity about banks in trouble, and intensive scrutiny by Congress and state legislators of banking structure, powers, and functions,  All of this  suggests that public confidence is high, In addition, we believe that relatively free entry and intra-  industry competition are appropriate standards for measuring the health of the banking industry,  Again, this is difficult to measure  statistically, but we do have some numbers that suggest that desirable markets are subject to competition from different institutions.  For  example, the Corporation approved 116 applications for Federal deposit insurance in 1976 for state-chartered nonmember banks. Likewise, 609 applications for new branches and 254 applications for limited branch facilities were approved, and 116 notifications of unmanned remote service facilities. Finally, it is important to the health of the banking industry that a viable dual banking system operate,  We think 1976 saw the  continued aggressive participation in the banking industry by state   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  228 legislators and supervisors, a.s well as Congress and the Federal supervisors.  The dual banking system seems to have been viable  during 197 6, and that should contribute to the health of the industry. There may be other standards which the Corporation applies which would be appropriate, but these seem to be the ones that are the most obvious.  The FDIC monitoring systems.  In my earlier statements on the improved condition of the banking  industry, I mentioned the evidence of improvement in ratios of capital to assets for commercial and mutual savings banks, larger ratios of U.S. Government securities to total assets, increased earnings between 1975 and 1976, etc.  Such measures were mentioned to highlight the recovery  of banks generally from the pressures of the 1973-75 recession. It is important to note that the FDIC has begun to use similar measures to determine the condition of the individual banks we supervise. In the development of our monitoring systems over the past few years,  we have observed that in many instances, developing problems in individual banks were foreshadowed by a demonstration of a lack of ability on their part to keep up with their peers.  In comparing banks with known  serious problems with banks which we felt were in sound condition, our researchers noted that sometimes there were distinct differences in the size of certain ratios derived from the balance sheet and income statement.  Differences, more·over, did not always develop overnight but   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  229 sometimes over a period of years.  Now this is not a revolutionary  concept; our supervisory force has been utilizing balance sheet and income data for years to assist in the evaluation of banks.  What is  new is that, with the help of the computer, the Corporation has put the "early warning" analysis on a more formal basis. Take for example, the various ratios of capital to assets we supplied the Committee.  These are average ratios for insured non-  member commercial banks.  One series consists of average ratios  for all such banks, another consists of average ratios for those particular banks which FDIC thinks warrant the designation "problem banks."  ~  June 1976 Problem  Equity capital to total deposits  8.7  6.3  Equity capital to total assets  7.8  5.7  Total capital to total assets  8.2  6.7  Total capital to risk assets  11.1  8.2  Total capital to total liabilities  8.9  7.2  Debt capital to total capital  5.2  14.2  For June 1976, every single average ratio of equity and total capital in problem banks is lower than the average for all insured commercial banks.  The ratio of debt capital to total capital is  significantly larger for problem banks than that for all banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  230 These ratios then become part of the criteria the FDIC uses in its monitoring system.  We now flag for further analysis any bank  that has a much lower capital r&tio than that of other banks, Sbnilar research has been done on other ratios and, as a result, we flag any bank with a much higher ratio of loans to deposits than that of most other banks, a much higher ratio of operating expenses to operating earnings, an unusually large increase in amount of time deposits, etc,  Once the outliers or mavericks have been flagged, the  deviant ratios are reviewed over the past three years to see if a condition in some particular part of their operation has been developing.  If there is a condition that our examiner force does not already know about, an examination is quickly scheduled,  We have found no substi-  tute for an on-site examination to determine the actual condition of the bank. It has not been easy to gain the acceptance of these early warning systems by the examination force,  The system itself has  been generally usable for the past two or three years, but it is only during 1976 that a general acceptance of it has been achieved in the Corporation.  Specific standards about which comment has been requested.  The Committee has specifically requested comment about the Corporation's standards for determining capital adequacy, liquidity requirements, and management competence,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Attached for reference  231 are appropriate Corporation bulletins or memoranda which articulate our standards for those three areas.  While it is difficult to summarize  these statements, let me make a brief comment on each: Capital Adequacy -- Attached are the sections from the Manual of Examination Policies dealing with capital and applications for deposit insurance, and a copy of a 11-6-73 speech by former Chairman Frank Wille on "Capital Adequacy", a speech which has received wide distribution and continues to be an important document on the subject. It remains the position of the FDIC that capital adequacy must be measured for each bank individually since banks are sufficiently dissimilar as to the quality and nature of their assets, the relative competency of their managements, and the relative stability of the economic environment in which they operate.  The only practicable  generalization is that the capital of any given bank should be sufficient to support the volume, type, and nature of the business presently conducted, provide for the possibilities of loss inherent therein, and permit the bank to continue to meet the reasonable credit requirements of the area served.  The monitoring system I have referred to above  places capital in a framework with other measures and permits a more objective evaluation than has been possible before.  Specific numerical  standards for a capital ratio are avoided because, while they are a benchmark of industry practice and custom, they are a mere starting point in determining whether or not adequate capital protection is present.  The components of the capital accounts are another factor   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  232 to be considered.  In the case of a new bank applying for deposit  insurance, the FDIC has adopted a guideline which calls for that initial amount of capital which is estimated will be necessay to result in at least a 10 percent ratio of capital to assets three years after organization. Liquidity - - Attached is a copy of a 7-22- 76 memorandum to all regional directors (copies were furnished to examiners) which deals with new examination report pages on liquidity analysis.  Also attached  is a copy of the section from the Manual of Examination Policies dealing with liabilities and the draft of a proposed section on liquidity which is under staff consideration. The liquidity needs of a bank are a result of that individual bank's mix of assets and liabilities and therefore requires an analysis of asset quality and structure, trend and distribution of liabilities, earnings trend and capital adequacy. conditions also have an impact.  Local and national economic  Management's ability to make asset  selections consistent with anticipated and potential liquidity demands, while at the same time conducting affairs in a sound, profitable manner, is a major consideration in the evaluation of a bank's future prospects. Until recently the Corporation's examiners had evaluated the adequacy of a bank's liquidity provisions in a rather subjective manner, but in mid-1976 a quantitative analysis became a part of each examination and it is believed that benchmark ratios which can signal the need for further investigation will soon be determined,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  However, we believe that no one  233 ratio can ever be considered a norm for all banks.  'Ihe increased use  of liability management concepts has led to a closer look at the credit side of i:he balance sheet, while at the same time not losing sight of the asset side.  Any analysis of liquidity must necessarily be concerned  with the structure, character and trend of deposits, seasonal fluctuations in deposits and loans; amount of primary and secondary reserves; quality and maturity of the loan portfolio; quality and maturity spacing of the securities portfolio; and the volume of secured liabilities. Consideration must be given the bank's borrowing record and its ability to borrow additional sums, to the adequacy of its capital, and to its earnings record, which impacts significantly on its ability to market additional capital.  Each of these-areas is normally reviewed  during an examination and, combined, they reflect a bank's liquidity position and provide subjective evidence of bank management's attitude, practices, and policies for liquidity management. Management Competence - - Attached are sections from the Manual of Examination Policies dealing with management and that part of the supervisory section where management is rated. The quality of management is perhaps the single most important element in the successful operation of a bank.  'Ihe board of directors  is the source of all authority and responsibility and therefore a significant degree of our attention is focused on the ability and participation of the directors.  The formulation of policies and procedures to assure  adherence to such policies is a paramount function of the directors.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  234 Their characteristics should include knowledge of the duties and responsibilities of their office, a genuine interest in performing those duties and responsibilities to the best of their ability, the capability of recognizing and avoiding potential conflicts of interest, sound business judgment and experience, familiarity with the community the bank serves and economic conditions generally, and an independence in approach to problem solving and decision making. is fundamental.  Personal integrity  Many of the duties and restrictions on a bank director  are specifically set by law. It makes sense to repeat at this point the cliche that directors direct and managers manage.  To have a viable, productive bank that  serves the community well the board of directors must employ and retain active, day-to-day officers of competence and integrity.  The  competence of executive management is reflected in its general and technical ability, its experience and capacity and general attitude and character; by the general condition and performance of the bank; by the bank's attendance to the reasonable and legitimate credit needs of the community; and by its ability to meet reasonable competition.  Changes in examination, supervision and regulation during the year; comparison with old standards.  There have been many changes in examination, supervision and regulation during 1976.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Permit me to limit this section to a  235 discussion of those which seem to be the most significant for purposes of exaII1ination and supervision: 1, Examination priorities, frequency, and scope, Z,  Liquidity analysis,  3,  Relationship with bank Boards of Directors,  4.  Enforcement actions.  For continuity, please refer to the previous section relating to Corporation definitions of standards relating to capital adequacy and liquidity. Examination priorities, frequency and scope -- With respect to item 1, we have put into effect a policy delineated in General Memorandum #1, in which top priority is accorded the examination of banks with known supervisory or financial problems, that Memorandum,  Attached is a copy of  These banks will receive a full-scale examination  at least once every lZ months, For banks with no known supervisory·or financial problems and which have assets of less than"$100 million, a modified examination is permitted for alternate exaIIlinations provided the banks meet criteria indicating satisfactory management, adequate capital, acceptable fidelity coverage, suitable earnings, and adequate internal routine and controls, Banks which appear as exceptions on the FDIC's monitoring program and which are not already known to have supervisory or financial problems would, of course, not be candidates for a modified examination,  The  modified exaII1ination emphasizes management policy and performance;  86-817 0 • 77 - 16   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  236 the evaluation of asset quality, distribution and liquidity; capital adequacy; and compliance with laws and regulations. Banks with assets of $100 million or more that do not present supervisory or financial problems will continue to receive a full-scale examination during each 18-month period.  But the examination is  designed to make full use of the bank's own reporting capabilities and generally is tailored now to the size and the complexity of the bank more than was the case before. Focusing the examiner's attention on particular banks and modifying the scope and techniques are the culmination of a gradual change from former standards geared toward examining all banks at similar intervals and in a similar manner. I earlier mentioned our increased use of monitoring or "early warning" systems.  To emphasize our commitment to this approach,  we added to our regional offices in 1976 the manpower which permits our regional directors to assign specific personnel to monitor the output of that system. Liquidity analysis - - In the past, while examiners were charged with comparisons of the maturities and interest rates of various asset and liability categories, the FDIC had no firmly established procedures or criteria for the measurement of liquidity.  However, the liquidity  problems of 1973-1975 prompted development and implementation in July 1976 of a 3-part procedure which we believe will be of significant   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  237 value in the advance detection of liquidity problems and the marshalling of corrective efforts. The first schedule of the liquidity analysis is essentially a ratio of net liquid assets to net current liabilities and is computed at each regular examination.  As a guide to examiners and pending  further experience, a 20 percent "benchmark" ratio was established. When the ratio falls below the benchmark, further analysis using a cash flow projection schedule is required.  When a negative cash flow  is projected using this second schedule, or if the examiner considers the total available funds to be insufficient, further evaluation and review with bank management is necessary, and a series of questions is provided in the corrective measures (third) schedule as a guide for the examiner in seeking corrective actions by bank management for indicated liquidity problems.  Although FDIC does not prescribe  any number or ratio as a standard, the new procedures for liquidity analysis are more formal.  Copies of all schedules are attached.  Relationship with bank boards of directors - - The FDIC is stepping up the frequency of meetings of examiners with boards of directors, and is pursuing other courses aimed at making directors more aware of their responsibilities with respect to the operations of the bank.  For example, the FDIC has adopted a regulation under which  the board of directors of each bank is required to review and vote on every insider transaction involving assets having a fair market value greater than a specified amount, that amount varying with the size   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  238 of the bank.  Although examiners have continually devoted attention  to insider transactions, this new regulation tends to standardize the procedures to be followed. Formal enforcement actions - - Over the last few years, the Corporation has moved to more frequent initiation of formal actions, generally cease-and-desist orders issued pursuant to'Section S(b) of the FDI Act,  There were 41 cease-and-desist proceedings initiated  in 1976, compared with 8 in 1975 and only 7 as recently as 1971, This change of policy reflects a shift from reliance on persuasion to reliance both on persuasion and on formalized efforts toward correc.tion where necessary.  Comments on the GAO report,  Attached for the Committee's analysis is a detailed critique prepared by the FDIC staff in response to specific items covered by the GAO report.  My comments will be more general than that  critique, To begin with, I would like to point out that in comparing the supervisory procedures of the three Federal bank regulatory agencies, it must be borne in mind that the day-to-day relationship which the FDIC has with state banking supervisors is extremely important in our supervisory effort,  Unlike the Comptroller of the Currency,  but like the Federal Reserve Board, we supervise banks who are operating under 54 state and territory laws, as well as the Federal   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  239 Deposit Insurance Act,  Those banks are chartered by 54 different  state and territorial supervisory authorities and the manner of supervising those banks at the Federal level differs as a result from state to state,  It is also important to realize that the FDIC is the sole  Federal regulator for the entire mutual savings bank industry, a $100 billion industry.  While we appreciate that the GAO report is  directed only to cormnercial banks, it is essential to take into account the FDIC'• activities with respect to the mutual savings bank industry in order to understand its supervisory effort, As to flexibility in examination techniques, we wholeheartedly  concur with the GAO in the need for such flexibility,  As a result of  a continuing study going back a number of years, we amended in early November of 1976 the basic memorandum which governs our examination policy,  This amended General Memorandum No. l,  which I mentioned earlier in this test:l.mony, is quite consistent with the thrust of the GAO report and we believe that a full discussion of it should have been included in that report,  We like to think that  the philosophy outlined in this memorandum, which we have tested during the past few years by experimenting in different FDIC regions, is the best philosophy for the FDIC to pursue in the examination of  nomnember banks.  Since it is so central to our operations, and  since it is a relatively new statement of a flexible examination policy, we would have liked to have had the benefit of the GAO'• in-depth comments about it.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  240 We also agree, as the report recommends, that more administrative enforcement proceedings should be undertaken in the supervisory process by the Federal regulators,  We have attempted to pursue that  policy, particularly since late spring and early summer of 1976, and have requested from the Congress additional supervisory powers,  In this connection, the GAO report notes the large number of violations of law found during a typical examination,  We were pleased,  however, to note that the GAO pointed out that some of the laws and regulations are complex and that some of the violations were of a technical nature that would in no way affect the soundness of a bank,  It  is the experience of our Division of Bank Supervision that the major portion of violations of laws set forth in reports of examination does not affect the soundness and safety of a bank.  All violations of laws  or regulations are a matter of concern, of course, but it is the particular responsibility of the bank regulator to consider each violation in terms of whether it was intentional or willful, the consequences flowing from it, the likelihood of continued violation, and other similar matters, and then to take the appropriate corrective action, 'Ihe report implicitly suggests that FDIC examiners should be criticizing loan policies before bad loans are made,  We certainly  agree that a closer review of loan policies is important, and criticism of such policies in advance of their implementation should be made where the written policies will o;bviously lead to an unsafe or unsound condition for the bank or to violations of law,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Most written loan  241 policies will be written in such a way, however, that a reasonable examiner will find it difficult to find something significant in them to criticize,  We believe that the written policies themselves are  not the problem - - it is rather the implementation of these policies, The GAO also recommends that the Federal bank regulatory agencies develop greater uniformity and cooperation with respect to:  a,  Standards of examination procedures,  b,  Uniform classification of shared National credits,  c,  Uniformity in approach to monitoring and examining for compliance with consumer credit laws.  d,  Uniform criteria for identifying problem banks,  e,  Uniform examiner training.  In some of these areas we have already achieved uniformity with the other Federal agencies or are in the process of working out details with a goal of achieving uniformity. We are now participating in the program initiated by the Office of the Comptroller of the Currency for the review of shared national credits.  Although the number of such credits found in banks which  we supervise is relatively small, we have directed our examiners to apply the classifications arrived at by the interagency examining team for all banks we examine which share such credits.  This con-  stitutes a significant step in interagency cooperation in the examination process.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  We are developing plans to enlarge on this concept  242 by providing for joint interagency review of shared national credits in which a state nonmember bank is the lead bank. With respect to examiner training, we have reached tentative agreement with both the Comptroller's Office and the Federal Reserve to explore the feasiblity of a joint training center for examiners.  The  FDIC has outgrown its training center because of an increase in the number of examiners and an increase in the curriculum required for each examiner.  It seems a propitious time to discuss a joint facility,  and to that end I sent letters to both Chairman Burns and Comptroller Bloom inviting them to join us in the development of a joint facility. Both responded favorably to the idea and our staffs are now at work on the idea.  In a more advanced stage are plans for an interagency consolidation of consumer protection schools.  Although not finally  approved, plans are being formulated to hold the first session this June at the present FDIC Training Center in Rosslyn, Virginia. Examiners and other personnel involved in bank supervision from the FDIC, the Office of the Comptroller of the Currency, and the Federal Reserve System would participate and instructors would 1!1'ewise be drawn from the three participating agencies.  Included  in the curriculum would be Truth in Lending, anti-discrimination laws and the Real Estate Settlement Procedures Act.  In addition,  training will be provided in the areas of consumer complaint procedures and consumer education.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  This effort, although not  243 representing a complete consolidation of existing consumer regulation training, is an experimental step which may lead to eventual consolidation.  In order to promote coordination and to provide a vehicle for the interchange of ideas and policies, the Jnteragency Coordinating Committee has established a top level staff subcommittee made up of the senior examination staff officials of the FDIC, the Comptroller's Office, the Federal Reserve, and the Federal Home Loan Bank Board to coordinate matters relating to bank examination and supervision. The function of this Committee, which will meet on a continuing, periodic basis, is to provide a clearinghouse for ideas, policies and procedures in the area of examination and supervision. Uniformity may not always be practical, or serve the best interests of the public.  Some divergence among the agencies in  their approaches to problems may result in innovations which may later be adopted by the other agencies.  This is especially true  in newly emerging areas of regulatory concern such as consumer  legislation, EFTS and bank securities regulation.  This divergence  is beneficial and is assisted by a commitment from all the agencies to review their own procedures and to adopt alternative approaches which other agencies have found to be successful in solving problems effectively and efficiently.  Tue Jnteragency Coordinating Subcom-  mittee, referred to previously, evidences our commitment to this principle.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  244 'Ihe need to develop common criteria for determining problem banks, for exaznple, is not obvious and may not be appropriate,  Our  experience is that the accurate designation of a problem bank does not lend itself to the application of simple mechanical formulas that can be universally applied,  While we do apply certain screening  devices as initial tests, we believe the actual designation of a bank as a problem should only be imposed on a case-by-case basis after a comprehensive, in-depth analysis of the entire bank.  We also  believe it is appropriate for the FDIC, as insurer, to view what constitutes a problem situation from a somewhat different perspective than the other two Federal regulatory agencies, namely from the standpoint of undue risk to the insurance fund, 'Ihe differences in perspective and responsibility make uniform criteria for designation of problem status impractical; the division of supervisory authority over various classes of banks makes uniform criteria unnecessary,  'Ihe fact that the Corporation places a national  or state member bank on its problem list generally results in no different supervisory attention accorded that bank by its respective supervisor - - in almost all cases that bank is already a matter of supervisory concern to the appropriate agency.  It does not, except  in the most unusual and severe cases, result in FDIC exazniners exaznining the bank or impo-sing any conflicting supervisory directions on the bank,  While some have suggested that the Corporation should  use its statutory authority to examine national and state member banks,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  245 the legislative history of the FDI Act makes it quite clear that such authority was granted the Corporation only if it were to be used exceedingly sparingly.  The fact that the FDIC might have some  what different banks on its problem list than the Comptroller or the Federal Reserve does not, then, confuse the bankers or the public and lead then1 to believe that their bank may be a problem to one Federal agency but not to another. Undoubtedly, there is merit to the proposition that problen1s common to the three agencies should be resolved through closer coordination and cooperation.  There is, as I have pointed out, a  substantial flow of information between and coordination among the agencies at the present time.  Ii, however, there is any merit to the  concept of separate Federal supervisory agencies, and to a dual banking system with state and Federal supervision of banks, among those benefits would seem to be the opportqnity to try different approaches and to have a diversity of examination and supervisory procedures, thereby enhancing the possibility of useful innovation and improvement in bank examination and supervision.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  246  I.  Introduction  ffle primary purpose of bank examination and supervision is the protection of creditors, particularly depositors. Some qualifications are necessary, but in general, the degree of protection afforded depositors is closely related to tha strength of a bank's capital position. Por this reason many important phases of bank examination procedure· have as their pJll'pOBe the determination and analysis of a bank's capital. (a)  Assets are appraised and liabilities proved by Examiners with a view to determining adjusted capital as distinguished fran book capital,  (b)  ffle amount and character of fixed and substandard assets and concentrations are ascertained, since such assets IIIBY result in losses and a weakened capital position at a later date1  (c)  Managanent policies and the qualifications and record of the managanent are determined, since ill-advised policies and poor management will ordinarily be follawed by losses and the disaipation of capital,  l!i)  ~cords of earnings are studied a, determine the legality and adviaability of the bank's dividend policy and its ability to absorb losses currently, both of which are considerations related to the analysis of a bank's capital position, and  (e)  Trust departments are examined, since serioua contingent liabilities IIIBY lead to surcharges and depletion of capital.  These and other steps in examination procedure help to evaluate the adequacy of a bank's capital and thereby determine what, if any, supervisory action is needed to initiate plans for strengthening the institllticn. II.  Bank capital Standards  The Co:r:poration•s interest in bank capital and in :Improved bank supervision arises fran an identity of its interests with t:hoole of insured dapoaitors. As the insuring agency, the Corporation has a direct financial stake in pr.,,...,ting bank failures. Indeed, Congress has recognized this special interest of the Co<i>oration in the bank capital problan by requiring consideration of the ~ of capital in connection with a,pplicati011& for inauranca and in other -t,:ar■•  As a consequence, the CO<l)oration has traditionally been ooncerned with the general level of capital ratios, because of the close relationship b a - . i these ratios and the Co<l)o-,ation'• risk. Hawever, this emphaaill on capital ratios, which simply measure the ability of the banking. system as a whole (or the average bank) to withstand unexpected losses or shrinkage in asset values, should not be taken out of context and misconstrued as a minimum standard applicable to indi,vidual banks. On the contrary, banks are sufficiently dissimilar as to the quality and character of their assets, the relative CCIIIP"tency of their aana~ts, and the relative stability of the econanic envir....,.t in whioh they aparata that it is never practicable to generalize on the aubJect of capital adequacy. If any generalization may be made, it is that the capital of ,-ny given bank should be sufficient to support the volume, type, and character of the business presently conducted, provide for the possibilities of loss inherent therein, and permit the bank to continue to meet the reasonable credit requirements of the area served. In attempting. to evaluate capital adequacy, there are factors that must be weighed and judged, (a)  ■ everal  important  Management - The ability, attentiveness, integrity and· record of management, together with the soundneaa of its policies am of 111Bjor importance. Sound managanent, prudent policies, and effective aparating procedures are probably the key elanents in the overall ri■k equation of business enterprise, and it is, after all, protection against risk that capital plays its singular role in any business enterprise.  Section D   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 1 -  Capitat  (Revised 8-28-73)  247 (b)  ~  (c)  ~  (d)  Deposit Trends - If the trend of deposits is up,ard and appears likely to continua, and if retained earnings have not kept pace with the grc,,,th in the size and the scope of the bank's operations, there can be little question that management should recognize its responsibility and make all reasonable effort to a ~ n t capital through whatever means poaaible. The potential volatility of deposit structure, on the other hand, aclda another cliaansion of a different character to the analysis of a bank's capital structure.  (a)  Piduciuy BUaina■ a - The volume and nature of the buaineaa transacted in a fiduciary capacity are of ■ ignificanca in determining capital needs. Contingencie ■ in this area, as wall as the poasibility of 11urcharges, must be carefully appraised.  (f)  Local Characteristics - The general type of clientele, stability and diversification of local industries or agriculture, and the ccmpetitive situation are important considerations.  III.  - The general character, quality, liquidity and diversification of assets, with particular reference to asaeta adversely claaaified, are necessarily vital factors in determining the adequacy of capital.  - The earnings capacity of a bank is of marked significance in aaseaaing the. ability of a bank to maintain an adequate capital position. The dividend policy of the institution is also of importance, as is the willingness of management to recognize and absorb losses currently. Supervisors generally feel that earnings should first be applied to the elimination of losses and depreciation and the establishment of necessary reserves and that dividends should be disbursed in reasonable amounts only after full consideration has been given to those needs and other factors impinging on capital needs.  Capital Ratios  The question frequently arises regarding the :iJnportance of ratios in determining capital adequacy. As previously noted, capital ratios (or risk asset ratio■) are merely s:lJnple, objective measures of the shrinkage in asset values a bank's capital structure can absorb at a given point in time, and, as such, are but a first approximation of a bank's ability to withstand adversity. A low capital ratio by itself, however, is no more canclusive of a bank's weakness than a high ratio is of its invulnerability. It would be hard to find much correlation between book capital ratios and the incidence of bank failure -- that eventuality against which capital protects, but does not prevent. Banks with high capital ratios have failed because of the low quality and/or WJWise distribution of their assets, while others with low ratios have survived because of a hyper-liquid condition.  Ratios may also have limited use as rough benchmarks, representative of industry practice and custom, and in that limited sense, may be useful as a starting point in evaluating an individual bank's capital position. i:n the average bank, with average management, the capital-asset ratio or the risk-asset ratio, when they go beyond reasonable bounds, may be of importance in deciding that additional capital is necessary, even though existing asset problems ara relatively minor. The relative degree of quality in a bank's loans, bonds, and other risk assets, is a valid argument in relation to capital needs up to a 'certain point, but the validity of this argument decreases rapidly and disappears when the sheer volume·of such assets completely overshadows the capital structure. on the other hiUld, certain banks have reasonable capital ratios but management and asset weaknesses necessitate requesting additional capital. In other words, ratios alone are not conclusive, and they always must be integrated with all other pertinent factors. However, once this integration has been effected they do have a bearing, their relative importance increasing in direct relation to the degree of seriousness attached to management and asset problems, or conversely, decreasing in direct relation to the degree of managaent competency and asset soundness the bank under consideration.  in  Ssoti.on D   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 2 -  CapitaZ (Revised 2-23-13)  248 IV.  :Increasing capital. in Operating Banks  Whenever capital in any given bank, regardless of the capital ratio, is detennined to be inadequate and satisfactory improvement is not being !Mde, it is the responsibility of the Regional Director in cooperation with the State Authority to arrange for the adoption of a program the fulfillment of which 'WOUld bring about an improved relationship of capital to risk. The basis for the belief that capital is inadequate may be any one or more of a number of circumstances having to do with management policies, past record, character of assets, trend of deposits, type of clientele,·type of territory, dividend policies, fiduciary activities, future needs, etc. :In most cases it is believed that it l.ill be found advisable for a program to includs both the conservation of earnings and the elimination of excessive risks. The sale of new capital stock is to be encouraged wherever the need therefor is determined. The Corporation's authority to enforce capital standards in operating banks is limited. Its legal authority is confined to discretionary action in connection with preferred capital retirements, capital adjustments, branch bank applications, changes in location, and recourse to the provisions of Section B(a) and B(b). The latter are relatively ineffective in this regard as it would be difficult to prosecute a sustaining cue on unsafe or unsound practices where the only major canplaint would be continued operation with an insufficient margin of capital protection. Practically, therefore, we haw recourse to only two lines of approach: (al  To induce the bank management, by logic and perauaaion, to increase capital by sale of new local capital i■Bues, and  (bl  To encourage, by the same methods, the conservation of net profita by additions to capital or surplus.  The Regional Director should keep the Field Examiner fully infonned about any program for the upbuilding of the capital account so that when an examination is conducted of any bank the Examiner will know in advance the attitude of the State Authority and the Regional Director and how far along the program has advanced. Only in rare instances should the Examiner feel restrained fran freely discussing with bank management the adequacy of capital. However, ha should not make specific recamnendations on capital adequacy solely on his own initiative, for coordination between the Examiner and the Regional Director is of essential importance on all matters pertaining to capital. When, after detailed analysis, the Examiner has concludsd that a bank's capital is inadequate, ha should so state in the Supervisory Section of the report, unless he has previously consulted with the Regional Director and been otherwise instructed. Any discussion or comnents on the subject, whether in the Supervisory Section or the ~en Section, should be supported by reference to the particular circumstances which give rise to the need. canp&rison to average ratios, while a guide in the Examiner's analysis, should not be the sole factor relied upon. The Examiner will find his strongest argument in the examination report itself, the summation of which, properly presented, should substantiate any recanmendation for increased capital. In deciding upon banks where capital programs should be initiated, every effort should be made to select only those cases actually requiring additional capital. New capital requests made of sound, well managed banks with very favorable earning retention records, even though not too well capitalized, only serve to hinder capital efforts with regard to definitely undercapitalized banks, because the latter gain the moral support of the fOZl!ler in refwling to raise new capital. Therefore, because of the canplexity of the 1?roblem and the many factors involved, which are subject to varying interpretations by different individuals, it is essential that Examiners work closely with the Regional Director on all banks !:>elieved to be undercapitalized. In those banks where the solution of an inadequate capital problem may require the sale of new stock, it is suggested that the rollowing infonnation be incorporated in the Supervisory section of the axaminal:ion report: (a)  canpleta list of present shareholders, indicating amounts of stock held and their financia,l worth insofar as available. Small holdings A  Seati.on D   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 6 -  Cafritat (RtWt■ed  2-26-78)  249 ay, however, be aggregated if a canplete listing is impractical, (b)  A list of praninent custaners and depositors of the bank who are not shareholders but who might possibly be interested in acquiring stock;  (c)  A lls t of other individuals or possible sources of B'Ul'Port in the ca11111mity who, because of known wealth or for other reasons, might desire to subscribe to new stock, and  (d)  All other data bearing upon the problem of raising new capital as well as the Examiner's opinions regarding the moat likely prospects. Insofar as possible this information should be obtained without bringing to the bank's attention the reason for which it is being gathered.  flle purpose in including this information is to inform the Regional Director currently relative to the practical possibilities of new stock sales by indicating all sources from which funds might be obtained. n.e information will also be helpful as background data for preliminary discussions with State Authorities in connection with developing corrective programs. In general, the greater the apparent need for capital, the more exhaustive should be the study of the possibility of selling new capital. Where a bank's capital is impaired, the same general type of information ia essential. Special emphasis should be given, however, to the financial responsibility of larger shareholders so that the replenishment of capital deficiency, if requested, may be estimated.  V.  Capital CClnponents  For purposes of examination, the general term "bank capital" refers to the total of (1) CC111110n stock, (2) preferred stock, (3) capital notes and debentures, (4) surplus, (5) undivided profits, (6) rsserve for securities, (7) reserve for bad debts , and ( 8) other capital reserves • n.e different segregations of capital accounts have significance bscause of their distinctive availability or accountability for different purposes. So called "basic capital" (camon and preferred stock and subordinated capital notes and debentures) is the most inviolable and least subject to discretionary disposition. Control of surplus ia shared by management and bank supervisors, while undivided profits are generally subject only to management's discretion. Following this gradation of availability, losses impinge first on undivided profits, then surplus, and finally basic capital. Since impairment of basic capital -- and sanetimes of surplus -- typically invokes legal sanctions for its correction, establishment of a minimum level of basic capital is a safeguard against allowing banks to continue on a disaster course. Accordingly, the corporation encourages movement of undivided profits into surplus and basic capital, where such disposition is not prevented by relevant statutes and regulations. fllis procedure discourages dissipation of these accounts through unwarranted dividends. VI.  Senior Capital Issues  Recent years have witnessed significant changes in the canp011ition of basic capital and in attitudes toward preferred stock and debt capital. flle old antipathy toward the use of these instruments to bolster capital, a product of the depression years of the l930's, has bsen displaced by a willingness among bank supervisors to accept, in certain circumstances, preferred stock ~ capital debentures into the permanent structure of capital accounts. Although senior capital provides an alternate source of bank <:apital, and, hence, added protection to depositors and creditors, it does not possess all the attributes of bank capital. fllis is particularly true of debt capital, which is fundamentally a debt obligation and must ultimately be retired in accordance with its teJ:1118. Moreover, interest is a fixed charge against future incane that must be met, whether earnings are available or not, and the payments necessary for debt servicing represent reductions of funds available for additions to undivided profits or payment of dividends. In many respects, therefore, the issuance of long term debentures represents capitalization of future incane. Finally, debt capital generally may not be used to absorb losses and, hence, fails to serve two of the primary func-  Seotion D   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 4 -  Capitat (a.vised 2-23-?J)  250 ti01111 of banlt capital, continuity of operations and public confidence. '1'o a le■■ er degree, the deficiencies noted above alao extend to preferred stock issues, which are often acccmpanied by elaborate indenture ~ t a Mterially restricting their functions as banlt capital. Acccrdingly, although nc formal policy in this area has been enunciated, except in the context of Delegated Authority to Ragional Directors, the Corporation has been reluctant to approve applications for the is■uance of subordinated capital notes or debentures, where the aggregate total of debt and/or senior cap,ital (including the d ~ capital i■aue under conaideration) exceeds one-third of total capital funda.Y thing■,  IBBuea of senior capital present special probl-, and, eong other - i n e r s should determine, is■ued  (a)  That outstanding securities have been tory requirements,  (b)  That all conditions imposed by the State Authority in connection with iBBuance or retiranents of the instruments are being _t,  (c)  That all required prior approvals have been obtained for any reti-,ita and, where applicable, the date the Corporation gave consent to retir-nt1  (d)  '!.'he rate of interest, maturity schedule, convertible proviai01111 (if any) and the canputation formula for conversion,  (e)  '!.'he current status of interest and dividends and/or principal payments on outstanding issues;  (f)  ONnerahip of the preferred stock, notes or debentures,  (g)  aa■ trictions that may be impolled under State 1 - with respect to treatment of preferred capital, notes or debentures in ccmputing loan and inve■ taent limitations, and their relevance,  (h)  other special provisions, if any, regarding acceleration of maturities, dividend restrictions, maintenance of lliniaum equity capital levela, voting rights, etc.  A.  in accordance with statu-  Preferred Stock  Use of net profits in a certain order of priority is contractual and llllndatory where J>Hferred capital existe. Intereat or dividend paymente on prererred stock may not be withheld if - t profits for the period, a■ defined in the underlying agreements, are sufficient to pay them. Moreover, in am,y instance■ payment of intereat or dividends may be made at the discretion of the banlt' ■ directors even in the abeence of net profits, provided total capital is not reduced below a specified amount. It is :Important, therefore, to know: (1) whether payment of interest or dividends canes fr<111 net profits which should have gone to eliminate losses, (2) whether such payment reduced the unimpaired capital structure below the s,a specified in the instrument, and (3) whether the applicable provisi01111 of State law have been met. A cash dividend on c0111111on stock should not be declared or paid if dividend arrearage& exist on preferred iSBuea. Similarly, payment of interest or dividends on junior preferred is made only after payments on senior preferred, and provided such payments do not reduce total capital below the minilllum aaount specified in the underlying instruments. In the cue of cumulative preferred stock a bank is ~ in if it faila to pay all dividends or accrued interest on any dividend or payment date specified in the preferred capital instrument. Arrearage■ treated as deductions in the adjusted capital and reserves ccmputation,  y  arrears intereat are not except  The sum of capi1tal accounts and reserves on loans and securities.  Section D   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - s-  Capttat (Rnieed 4-28-?3)  251 when net profits have been sufficient and fr• frcm atatutory prohibition, en unlikely aituation. !'rem tha standpoint of depoaitors and tha Corporation, it is ~ l l y preferable far a bank to acC1m1Ulate arnarages rather than pay dividend., ar intere■ t frcm net profits arising frca failure to el:lminate lasses.  B.  Debt Capital  All new capital note and debenture agr-.it■ mu■ t contain a statement to the effect that the prior consent of tha l'DIC is required before any portion of the debt can be retired. 'l'ha usual stataent, which should be included in each note and debenture, as well as the agreement governing the issue, is as foll01181 thi■ a g ~ t (or this trust indenture, ar this note, or debenture, etc.) is subject to provisions of Section 18(il (1) of the Pedaral DapoBit In■ urenca Act, 12 u.s.c. 1828 (i) (lh which ■ tate■ that no imured State ~ r bank shall, without th■ prior consent of the Pedaral Deposit Insurance COxporation, retire any part of it■ 011pital note■ ar debenture■•  Notwithstanding any other provisions,  The purpaae of including the statement is to assure that all parties involved, including future holders of th■ notes, are aware of the requirements of Section 18 (i) (1) of the :n>I Act.  Where periodic mandatory payment■ are required, the agreement and the MY include the additional stateant that these particular mandatory pay..,.ts have already bean consented to by the l'DIC, if such advance consent has, in fact, been given. note■  'l'he issuance of 011pital notes or debentures by in■urad n ~ r banJcs is also governed by the provisions of section 329.10 of the Corporation's Rules and Jla~lations (tt>ligation■ othar than depoait■), which, with certain exception■ ,Y requires that any such obligation:  (i) Bears on its face, in bold-face type, tha foll.owing, 'I.his obligation is not a depo■ it and i■ not insured by the Pedaral Deposit Insurance corporation, (ii) Has en original maturity of 7 years or mare and i■ in im amount of en least $5001  (iii)  State■  expressly that it is subordinated to the claims of dapollis■ uing bank,  itar■  and is ineligible as collateral far a loan by the  (iv)  Is unsecured, and  (v) Has been approved by the Federal Deposit Insurance Corporation as an addition to the bank's capital structure. 'l'he restrictions on the maturity set forth above may be waived if the corporation has determined that •exigent cirC1DStancas• require the iBBuance of such obligation without regard to the provisions of Part 329. "Exigent cir.,,.,.tances• has  been narrowly construed to apply to situations in which there is a critical need for capital, without which the bank's continued operation and safety of depaaitors' funds would be in jeopardy. VII.  Retiranent or Reduction of capital  Prior consent of the Corporation is required for all retiranents ar reductions of "basic capital" of banks under its supervision, pursuant to section lB(i) of the Federal Deposit Insurance Act. 'l'he corporation's Legal Diviaion has ruled that the provisions of this section also apply to capital retirement■ or  y  Refer to subparagraph& (1), (2), and (4) of Section 329.10  Saoti.on D   https://fraser.stlouisfed.org 86-817 0 • 77 • 17 Federal Reserve Bank of St. Louis  - 6 -  Capital (Revised 2-2S-?3)  252 reductions of the following character: (a)  .Retirements or reductions which are part of ancther proposal for which a concurrent application has been filed for Corporation approval1  (b)  Conversion of capital notes or debentures to an equivalent amount of ccmmon stock or preferred stock,  (cl  Replacement of an entire issue of ccmmon stock with another issue wherein there is no diminution either of total par value or total dollar value, and  (d)  Repurchas,a and retention by a bank of its own capital as part of a stock q,tlon plan.  Adequacy of ~ning capital is ·the chief factor considered in acting upon an application for capital retirement or reduction. Nevertheless, except in rare and unusual cases, reti~nt of senior capital will generally be approved in an amount up to SO.. of a bank's retained earnings (after taxes and dividends) for the preceding year. Substantial pending -turities of capital notes and debentures should be discussed with ~ement and commented on in the Open or Supervisory Section of the examination report, so that timely provisions for raplacaaent may be made, if necesaary.  VIII.  C&pital of Prc,posed New Banks Seeking Insurance  Prq,osed new banks applying for deposit insurance repre■ ent a special situation and are expected to have relatively more capital during their f~tive ye11r11 than the miniaum applicable to q,erating banJca. A new bank poses extra ri■k because of the uncertainties involved. Our growing aconcmy and more aggressive competition for funds have increased the size of banks and the consequent need for capital. Too, initial outlays for facilitisa da■ igned to meet future needs are necea■arily larger and, along with high initial costs in building up an adequate vol,_ of business, require additional capital to becane establi■hed on a Bound  ba■ i■  As  • a general rule, a prq,oaed new bank should have an initial capital-  ization of sufficient IIIIIOUllt to provide a prospective capital cushion (total unimpaired capital and reserves) at the and of the first three year■ of its q,erations at least equal to l°' of estimated total assets at the and of the third year. Bxceptions may be made for good reasons, but rarely will an application for l'edaral depoait insurance of a proposed _,, bank be reCCIIIIUlndad for approval by the D:1.vi■ ion when the ratio of total capital fund■ to estimated total as■eta at the and of the third year is lea■ than the prevailing ratio of insured ca..rcial banks in the State within which the _,, bank is located. Irre■pactive of the above considerations, it i■ a,q,actad that any new ■aeking Federal deposit insurance have a minilmm initial total capitalization of $250,000, and only under exceptional circuma"'taiices will ■uch applications with a leaser capitalization be approved, one such exception would be where the camaunity to be served is isolated geographically frcm other camaunitiaa and the only Man■ of providing banking services would be through a _,, bank in the caamunity.  bank  Section D   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - ? -  CapltaZ (Rsvlsed 2-/J~-?8)  253 APPLICATIONS FOR DEPOSIT IHSIJRAIICE  I.  Introduction  The granting of deposit insuTance confers a valuable etatu■ on an applicant bank; it ■ denial, on the other hand, with raspect to State nonmember banks, may have aeriouely adverse competitive consequences, and, in the case of a new bank, may effectively preclude entrance into the banking businesa. Obviously the role of the Board of Di-cectO't'a of the Corporation, in acting upon such applications, involves important responsibilities and the exercise of ■ ound di■cretion in the public intere ■ t. In this regard, the Federal Deposit Insurance Act states:  Section lO(a): "The Board of Director ■ shall adainiater the affairs of the Corporation fairly and impartially and without diacrillination ••• 11 (12 u.s.c. Sec. l820(a)). Section 22: "., .the purpoH (of the Act) 1a to provide all banlul with the aau opportunity to obtain and enjoy the benafita of thia Act •• ," (12 u.s.c. Sac. 1830). The aeveral section• of the Federal Depo1it Inaurance Act (the "Act") which apecifically deal with adm.iaaion to depoait 1Daurance coverage are •• followe:  Section S: "Subject to the provision■ of thi■ Act ••• any State nonmember bank, upon application to and examination by the Corporatioo and approval by tho Board of Director ■, uy become an i111ured bank. Before approvin1 tha application of any ouch State nonmember bank, tha Board of Director ■ ahall give conaideration to the factor ■ enumerated in· Section 6 and ahall determine, upon the N. ■ i■ of a thorough axamination of ■uch bank, that it ■ aa■et ■ in ace■■ of ite· capital requirement ■ are adequate to enable it to meet all of it ■ liabilities to depo ■ itora and other creditor ■ aa 1hown by tha booka of the bank." (12 u.s.c. Sec. 1815). "The factora ••• to be conaidered by the Board of Director ■.•• ahall be the followiq: The financial hi■ tory and condition of the bank, the adequacy of its capital atructure, it ■ future earnin& ■ pTo ■pecta, the general character of ite management• the convenience aad need ■ of tM community to be ■ erved by the bank, and whether or not it ■ corporate power• are conaiatnt with the purpoaea of thia Act." (12 u.s.c. Sec. 1816).  ~:  Section■ 303.l, 303.10 and 303.ltJ/ of tha Corporation'• 11ul-■ and lesulationa implaunt the ba■ ic statutory provi■ iona and govern in large mea■ure the administrative procea■ ing of applications for deposit in■ uranca. Of particular oignificance to Examiner peraonnal 1a the proviaton of Section 303 ,14 (c) requiring, other thiqa, tha eatabliehment of a public fila in coonection with application■ for depoait illaurance cover as• by nav banka, The public file au■ t include, amon1 other thing•, the future earning~t■ and the convenience and needs portiou of the Field luainer I a inva■ tigation report. Application■ for depoeit insurance by exi■ tiaa bank■ are not expres ■ ly covered by Section 303.l4(c).  !/  Section 303.14 alao includea within it■ coverage, application■ for depoait insurance by new bank■, applications by State nmmember in■ured banka to e■ tabli■h branches and relocate uin and branch offices, and such other applications •• the Board of Directors deema appropriate.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 1 -  Apptioationa fo:r lhlposit (Revis-4 3-18-14)  I""""'"""  254 II.  Ri&ht•  of Applicants  An applicant has a statutory right to apply for deposit insurance and  to obtain full consideration of its application by the Board of Directors of the Corporation in light of all relevant facts and without prejudice. If all of the six statutory factors are resolved favorably, the applicant is entitled to receive deposit insurance coverage. In the event an applicat:!.on is disapproved,,!/ an applicant has a right to be info,.,ned by the Corporation of the reasons for disapproval.  III,  Obligation• of the Corporation  Under applicable law the Corporation is obligated to consider the aix factors enumerated in Section 6 of the Act in connection with every application for deposit inau"E"ance and, aa a measure of protection againat unwarranted and unjustified riak■, to conduct a full and thorough examination or inve■ tigation of each application. The Corporation hae formulated certain guidelines for admission, which are designed to ease administrative problems, aid in preventing arbitrary judgment, and assist in a ■ auring uniform and fair treatment to all applicant ■• These guidelines must, however, be administered in a manner that i■ consistent with the spirit of the Act, and the maintenance of a competitive and free-enterprise  banking system. IV.  Examiner's Responaibility  Whether the applicant is a proposed or newly organized bank or an existing bank, a formal applicationY for deposit inaurance coverage must be  filed with the Corporation. A copy of the formal application will be made available to the Examiner for use in the investigation. Although the application contains data on each of the six factors enumerated under Section 6 of the Act, reports of investigation are not to be limited to material supplied by the applicant. Reports of investigation should be factual, as to necessary information and represent the independent and unbiased findings of the Examiner. nie Examiner should not in any way indicate to an applicant the probable nature of his recommendations or discuss the applicant's chance of gaining admission to the insurance system unless specifically authorized to do ao by the Regional Director. Considerable reliance is placed upon the impartial reports of l'ield Examiners in connection with admission procedures. n.e Examiner's report should detail the relevant facts and data pertinent to each of the six statutory factor■• Thereafter, the Examiner should set forth under a separate topical heading his opinion as to whether the Corporation' a criteria under each of the statutory factor ■ have been met. A negative opinion on one or more of the statutory factors must be fully explained. and supported by the Examiner, and, where possible, the report ·should indicate whether and how the situation may be corrected.  !/  Under Section 303.14(1) of the Cot'poration's tlules and Regulations, in cases where the Board of Directors plans to deny an application and no hearing has been held, generally the Director of the Division of Bank Supervision will send to the applicant( ■) a written statement specifying the reasons for such tentative denial. The applicant then baa 15 days to file a written request to amend its application or for an opportunity to submit information in rebuttal. After filing that request the applicant baa 30 days to amend ita application or prepare it• presentation to the Corporation.  ll  See Section 304.3 of the Rules and Regulations of the Corporation for the forms needed and where they may be obtained.  Section U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 2 -  Applfoations for Deposit Insurance (Revised 3-18-74)  255 The Examiner should also include his general recOllnlendation relative to adaiasion and, if appropriate, a list of condition■ which he believ.ea should be imposed. As a rule, the CorPoration requires that applicants satisfy all criteria under each of the six statutory factors. In some cases, however, minor deficiencies in certain factors may be excused when they are more than balanced by conspicuous merits in others.  The admission criteria of the Corporation and the preparation of reporta by Field Examiners as relates to each of the six factors enumerated in Section 6  are discussed below. The Corporation's admission criteria for J'ropoaed or newly organized banks and existing banks are generally the same; however, pertinent aspects specifically applicable to admission of existing banks are covered in Part VI of this Section.  V.  Statutory Factors - Proposed or Newly Organized Banke A,  Financial History and Condition 1.  General  For evident reasons, proposed and nevly organized banks have no financial history to serve as a basis for determining qualification for deposit insurance. Some consideration may be given to the history of other banks presently and fomerly operating in the area of the applicant, if pertinent. Except to the extent that the management of the applicant hu been uaociatild with other banks and it ■ record in that connection is considered under the management factor, the financial history factor in connection with a new enterprise should not usually receive great emphaai■ •  Bank failures have occurred in this country in practically every size community. Past failures in a community should not, however, be a prominent conaideration in acting upon the application of a new bank. New bank application■ are to be judged u far aa poaaible upon their awn •rits relative to capital, management, and the other factors enu•rated in Section 6 of the Act. The standard of the Corporation relative to financial condition is that the general quality of an applicant'• uaeta must be satisfactory and at least on a par with that of the average State nonmember insured bank. Thia will, however, have only limited application in the case of a proposed or newly organized bank, since the assets will consist largely of cash, balances due fr011 bank■ and fixed aaaets. The Examiner should nonetheless verify and prove all assets and liabilities and include in his report: (1) a pro forma statement of the proposed bank a■ of the beginning of business, and (2) a schedule and appraisal of all assets with which the proposed bank intends to begin business. Fixed assets are of primary concern in analyzing the asset condition of a proposed or newly organized bank. These assets should be listed and described in detail. For exaple, the following elements are pertinent to an adequate description and evaluation of applicant's realty interests: the original cost of the bank premises at time of construction with a breakdown between land and building, original cost to applicant, date of conatruction, reason.ablenesa of purchase price, from wh0111 purchased, insurance to be carried, assessed value, prospective: or illlll!diate repairs or alterations, estimated useful life of the building as of the beginning of business, outstanding liens, tax status cosnpleteness of title papers, desirability of the location and prospective annual income and expense if the building is to be other than a onepurpose structure. Where it is known or detenained that one or· more of the proponents or their interests either own or have owned the property, careful review of prior transfers and other transactions should be made to determine that such transactions were negotiated on an "ana's length" basis. In fact, all transactions involving the proponents or their interest ■ and the new bank should be reviewed, with cOlllplete details Section U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 6 -  Applications for Deposit Insurancs (Revised 6-18-?4)  256 caamanted upon in the report. Ample infol'lllltion ehould also be reported on the fumiture and fixture ■ inveataent. Thereafter the relationship between the applicant's total investment in fixed useta and capital structure ahould receive coaaent. lf the leaaing of bank premi■ ea is contemplated either through a nal eatate subsidiary of the proposed bank or otherwise, the terma of the leaae are to be outlined in 80llle detail, including a description and eatiaated coat of any leasehold improvements. In such cases, the leaae qree•nt should contain a termination clause, acceptable to the Corpo-  ration. The Ex•ineT should evaluate and cOlllllellt upon vhethet' the new bank will provide procedures, security devices and safeguards which will at least be equivalent to the minimum requirements of the Bank Protection Act of 1968 and Part 326 of the Rulee and Regulations of the Corporation. In addition, if the new bank plans to utilize electronic data processing services for some or all of its accounting functions• proponent ■ should be appriaed of the need to furnish "Letters of Assurance" to the Corporation pursuant to the requirement ■ of Part 334 of the Rules and Regulation• of the Corporation. 2.  Temporary  Quarter■  application■ anticipating the uae of t•porary quarter■ pending con■ truction or -renovation of pemanent facilities• detail ■ ahould be  In  provided regarding the lo~tion of the site 1n relation to the permanent location, the exact add-reaa, the rental arTangeaent, the leuehold iapToveanta, estimated nonrecoverable coats upon abandonment, and evidence of the bonding cmq,any' a a,proval of opeTatlona in t-.porary quarters.  J.  Organizational  Expense ■  Applicants often employ professional assistance, such as attomeya, econoaic researchers and other specialist ■ to assist in the preparation and filing of an application for deposit insurance -coverage. A policy statement adopted by the Board of Directors of the Corporation on Auguat 25, 1972, requires that legal fees in excess of $5,000 be supported by a detailed account of the services rendered. All other organizational expenses ahouid be fully accountable and identified as to source, as well as receive colll81lt as to reasonableness. B.  Adequacy of the Capital Structure Under thia statutory factor, a proposed or newly organized bank should  have: 1. A minimum capital structure of at least $250,000 at organization; unless unusual circu11111tances dictate otherwise, applications offering less than this sum are not encouraged;  2. An initial capitalization to provide a ratio of unimpaired capital to total estimated assets of at leut 10 percent at the end of three years of operation; J. Basic paid-in capital stock generally comparable to the State average of basic capital to total assets for all insured banks;  4. SufftcJemt bdlance» in shareholder equity account(a) against which initial ■ tart up coats and foreseeable contingencieii can be charged in accordance with Stat• requirements. The adequacy of the capital structure of a newly organized bank related to its deposit volume, fixed asset investment and the anticipated growth in deposit liabilities. In mat cases the Examiner should use the three years of operation as a reasonable time frame for measuring depos'it  Section U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 4 -  is closely future first growth  Applications for Depooit IMuronce (RBIJiaed J-18-14)  257 in newly organized bank•. Accordingly, in as■ea■tng the adequacy of 1nit ial capital as related to proapective de'PO&it volume, the Exa111iner should develop a reasonable estimate of the deposit volume that a new bank may generate in each of the first three year■ of operation. The Exudner' • depo■it projections aay differ conaideTably from the estimate• provided in the proponent•' application,  feasibility study, or economic survey.  It is not unuaual to find that the pr-o-  ponenta I deposit projections ancl feasibility study are influencad by the capital atructure they propose to invest. The proponent•' deposit projection• •Y also be out-of-date or not fully suppo'E'table due to lack of adequate information and clocu•ntatlon. It baa been of assistance to Exainera in •king projections of loan and deposit activity of a new bank to have each proponent uke individual estimate■ of the total' amount of deposits he expect• the bank to generate at the end of each of the first tht'ee years of operation. The beat sources of inforaatlon to aaaiat the Examiner in formulating reasonable eatiutaa are local economic indicaton • population data, deposit and loan growth in other banks in the area, comments and observations of bankers in the area, the cmapetit:1.ve impact of other finmcial in■ titution■ • and the ability of the proponents to generate buaine■■ in the trade area. In the final analyaia • the eatiu.tad deposit voluae for a new bank'• third year of operation la highly aignificant because it servu the dual purpose of meaauring earnings capability a■ well u capital adequacy after projecting a reuonable operating period. The nu•er of shares of ■ tock and its par value u of the comaencement of business should be scheduled. The per share price of the stock should be stated and, in casea where an additional IIIIOUnt per share la uaeased to cover organizational and preopening expenses, that 11110unt ahould alao be identified. The component■ of the beginning capital atructure can then be allocated to capital ■ tock, aurplua, other segregations, and the organizational expense fund. It should be ascertained whether or not the State statutory l'linlaua capital requirements are mat and how evidence v111 be provided to the Corporation that capital fund• are fully paid-in prior to opening for buainesa,  If it eppeara thet the propoHd capital atructure will not ••t the Corporation's criteria, the Field Exaainel''• report ahould reflect fully the extent of and rea■ on■ for the inadequacy and recoeaend to the Corporation an a110unt which, in hie opinion, would be acceptable. Should the attitude of the proponents be receptive to a reque■ t for ■ upplying additional capital• the Examiner ■hould ao indicate thia fact in the inve ■ tigation report. C.  Future  Earniy■ Prospect■  Allowing a new bank to coaaence operation■ without some indication that it can be operated pTofitably, not only creates a potentially unsati ■ factory situation• but could also have a detriaental effect on othet' compettn1 banka. Usually the operation ■ of a new bank are not profitable for a least the fil'at yea!'. The Examiner should, therefore, make eatiute■ of operating incoae and expenaea for the first three yean of operation using, aaong other things, the projections of loan and depoai t volu•• ude in connection with the "Adequacy of the Capital Structure" factor.  In deternining future eaminga prospects, the Euminer auat eatimate the probable income from loans and diacounts, bonds and ■ecuritiea, ■ervice chargea and comiaaiona, and other source■ of income. Aaaiatance in this tuk uy be obtained from evaluating the applicant'• proposed lending policies and interest rates, the duland for loans in the area and types thereof, the probable nature of the bank'• inveat11ent policy, the aaopt of time and demand dt1:po11ita likely to he nr.tJulred, the prohahlr r.atapfttlttv• reaction from exif1ttnR bank ■• the econ01111ic condltions ln the community, the posaibillty· of future develoJ)Mftt or retrogression in the area• the apparent 1110ney-t1aking ability of the bank'• management, and the Corporation'• statistical data for banks operating in the same general area. In addition, estimates muat be made for expenses auch as aalaries and other employee benefits, interest, occupancy and equipment ou'tlays, electronic data procesaing service coats, and other current operating expenses. Aeaistance 1n aaking these projections may generally be obtained from the same sources used in projecting the various income categories. A review and comparison of original projections ad actual data for other recently organized operatinR banks 1n the same or comparable areas may be of assistance in projecting carninr.s and expense data.  Section U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 6 -  AppticaUons fol' Depoeit Inoumnce (Revised a-18-14)  258 . The report of investigation should include coments pinpointing any marked diveqence between the BUiiiner'• findinga and those presented ln the application, u well as the reuona for such variances. The Examiner should also c0111Nnt on the proponent• 1 plans for payment of cash dividends, bonuses, directors' fee■, retainer fees• etc., and the accounting system to be used, It is considered imprudent to pay dividends or bonuses du1:ing the formative years of operation unless they are fully earned and justified. As regards accounting syate•, tbe CoTpot'&tioo t'ecomends and UTgea use of the accrual method at the outset of operatione. As indicated previoualy, ·this portion of the investigation report is, by reuaa of Section 303.14 (c) of the Corporation' a Rules and Regulation•, public infonution.  D.  General Character of the Management  The quality of a bank's management ia vital and is perhaps the single l'IOSt important element in detemining the applicant's acceptability for depoait insurance. To satisfy the Corporation's criteria under this factor, the evidence 1111st support a management rating which in an operating institution would be tantamount to Satisfactory or better. In moat instances the management of a proposed or newly organized bank will not have: an operating record aa a functioning unit to assist the Exa11iner in foming a judpent; therefore, aanagement rating eaaentially bec011ea a question of_directly evaluating the individual directors and officers and then making a composite overall rating premised upon the individual analyses. The Examiner'• report of investigation should, therefore, contain a schedule giving the name. addreaa, approxiaate age, total liabilities and net worth of each director and officer and iuclud• with raapect to each the following information: 1.. Banking and Business EXJ,erience - The Examiner' a come.nts in thi ■ regard should detail present occupation or profession and past banking, buainesa, farming or other experience. The Examiner should include in his obaervationa, how auccesaful the individual baa been in his present and past activities and whether he haa been asked to resign frma a position or positions held or hu been aa ■ ociated with seriou■ business failures or debt coapromi ■ es. Aa a rule of thumb, success of the majority of an applicant's management in their present buaineaa endeavors is soma evidence of their ability to manage successfully the affairs of the proposed bank. In addition, the Examiner should indicate all firms, companies, corporat:tona, and organizations in which a given director or officer is substantially interested. If the facts denote that the bank is being organized primarily to finance the businesses or personal interests of certain officers and directors, particularly when the assets related thereto are likely to be of dubiowt quality, the relevant fact ■ should be fully covered in the report. 2. Proposed Duties and Responsibilities in Bank - The Examiner should outline the duties and responsibilities as well aa the title of each proposed officer and director. If, in any instance, the proposed duties and responsibilitiea of a particular officer are regarded beyond his capabilities, or if some other distribution of du.ties and reaponaibili ties aaong the several officers would be more effective than that contemplated, the Exallliner should set forth his opinions and reasons therefor.  J. ~ - Net worth figures on each director and officer will be available to an Examiner frcn financial statements filed With the application. In listing net worth figures in the report of investigation, the Examiner may state his opinion aa to the validity of the fir.urea and any pertinent information relating to sizeable liabilities.  Section U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - B -  Applications fozo Dspoait Insuzoance (Revised 3-18-74)  259 4. Extent of Stock Investment in Bank - Stock holdings of each director and officer are to be indicated. The successful operation of a bsnk requires a real interest in its welfare as well as a willingness to devote a substantial amount of time to its affairs. When directors and officers have a significant financial investment, genuine and continuing interest is more likely. 5.  Integrity of Management - Section 19 of the Act provides that,  "Except with the. written consent of the Corporation, no person shall  serve as a director, officer, or employee of an insured bank who has been convicted, or who is hereafter convicted, of any criminal offense involving dishonesty or a breach of trust • • • • 11  If it is found that  criminal proceedings have at any time been instituted or fidelity insurance cancelled with respect to any officer or director, or if there is any doubt concerning the integrity of any director or officer, a thorough investigation of all surrounding circumstances should be conducted and  the facts set forth in the Examiner's comments. 6. Familiarity With the Economic Life of :.he Community - Length of residence in the community or trade area of the proposed bank and degree  of familiarity with the major activities of the locale should be indicated with respect to each director and officer. The above information should be particularly complete with respect to  individuals who are likely to dominate the policies and operations of the I.an~. tn addition, comparable information should be included on any shareholder iottwr than a proposed director or officer) who is subscribing to 5 percent or the aggregate"' par value of stock to be issued. An Examiner should also in his report any information that may come to his attention concerning changes that may be made in the bank's management after commf!ncement of  more of include possible operations.  In addition, the Corporation has found that on occasion, s~bsequent to the approval of an.application for deposit insurance and prior to the actual opening of a proposed new bank, changes have occurred in the management or ownership. The Corporation is interested in being advised when such ct-~nges in manage:-aent/ ownership take place. Accordingly, in order to monitor such changes, the Corporation requires that the prospective incorporators advise the Regional Director in writing if changes in the directorate, active management, or in the o~~ership of stock of 5 percent or more of the total are made prior to opening. When conducting investigations, tbis notification should be stressed by the Examiner in any discussions with the proponents. Certain other information relative to the sale and purchase of the proposed bank's stock and the exercise of votinu rights may also reflect on the general quality and character of management. While these matters may also relate to the "Adequacy of Capital Structure" factor, on balance they are more appropriately treated herein. The Field Examiner should determine whether any cor.i.missions are to be paid in connection with the sale of the stock and st.ould confirr., that no loans representing applicant stock purchases will be refinanced by the bank. Any evidence that the bank is being organ~zed on a promotional basis should also be covered. Ownership control by several individuals or groups of shareholders as well as any contemplated or existing buy-sell, voting trust, or proxy agreements between various individuals or other entities, such as holding companies shoulci also receive comment. Copies of any such agreements should be obtained fro;;,1 the applicant or proponents involved. The Examiner should obtain a list of sto.::k subscribers as of the date of investigation including therein at 1.east the following: the number of shares per individual subscriber of 5 perc~nt or more of the .total. stock issue, all proposed directors and officers, the par Value and the purchase ?rice of the stock, and any financing arrangemcnt including the ~ource of financing an<l tl1c collalcral plc.·dgc<l on t~l! loans. It is c:<1:.t.•ctcJ th~t the Ex.:.arr.iner ¼'Oul<l colfment in <let.ill on .:my unsounU financing arraagc.ncnls, such as indivic!u.:il servicing ability and preft!rcntial rates particularly related to cc:n?Cnsatlng balanct:s antl other ..ibusc:=s. Ordinarily, finnncing of more than 75 percent of the purcha.sti price of stocl~ subscribed by any one individual, or aggrcg.:.te fina.:1.cing of stock subscriptions in excess of 50 percent of the total capital offered, is presumed to be excessive and may result in denial of the application under this statutory factor, unless support and justification for exceedino these guidelines as furnished are acceptable to the Corporation.  Saa~ior.. J   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 7 -  l.pp!iaation .fo-P ;)eposit Insurance (Revised 8-13-74)  260 In instances where a new bank is being organized by the principals of an existing bank and it is determined that the new bank will be located within the trade area of the existing institution, the Examiner should diacuBB the existing circumstances with the Re&ional Director, In other instances, where there is evidence that ·any proposed director or officer of a new bank engages in the sale of stocks, bonds or other similar securities, the Examiner should contact the Regional Director for guidance. Over the years, the Co.rporation has adhered to a fixed policy requiring that all applicant banks provide at least a five-member board of directors, even though the State law may, in some cases, permit a lesser number. On the bas:l:s of the facts and considerations detailed in the report of investigation, the Sxaminer should state, and factually support to .the greatest extent possible, his conclusion as to the management rating, A notation as to the type and amount of the insurance (fidelity, bur:;lary, robbery, etc.) to be carried by the bank should be included in the report under the management heading.!!} ~-  Convenience and ·Needs of the Comtnunity to be Served  Cenerally, there is a presumptive indication of need if the directors or orca;iizers of the ap]>licant are a responsible group of men, willing and able to supply a substantial and adequate amount of rooney to back up their judgment, and if the raanagcment of the proposed bank is competent, honest and familiar with the probler.is of the area to i>e served. However, consideration should be given to the adequacy of existing bank facilities in the conanunity and in nearby rival communities, for a bank is unlikely to fulfill a need if it is unable to command sufficient volume to maintain profitable operations. In this connection, the l:xaminer should endeavor to ascertti.in whether or not the services rendered by existing banks are satisfactory, and whether or not such institutions are ~£eting the le.;itimate credit needs of the community. In considering the question of need, it is important that the Examiner not adopt the viewpoint of banking institutions located in the co'mmunity, to the exclusion of other, equally persuasive viewpoints. As in other lines of business, existing banks may regard any new institution as unnecessary and as a potentially "harmful competitor." An unbiased conclusion in this connection requires impartial co:-.sideration of the opinions of the organizers of the applicant as well as those of the uanagements of existing banks. In addition, it is often necessary to solicit the vieu of representative business and professional men in the community, together with those of citizens of more modest means. The results of canvasses and surveys of local individuals and businessmen should be detailed in the report in order to assist !.n evaluating support for the !)roposed bank, the adequacy of present banking facilities, whether the legitimate banking needs of the com1u.:nity are being :: ..!t, whether and to what extent the new facility would be used, and the knowledge these persons have of the proponentsa In the final analysis, however, the value of any infor~.ation so obtained will depend largely on the Examiner's ability to discriminate between those views which proceed from intelligent and rational consideration of the real needs of the community and those which are mainly inspired by a false sense of community pride or selfish personal interest. A clear definition of the proposed bank's trade area is essential in deterr.iinins convenience and needs. A brief C:escription of the general area in which the proposed bank is to be situated and its location in relation to other prorr.inent nearby comr.iuniti~s, developments, or other irnporttant landmarks should be initially presented. The primary trade area as described in the application should then be discussed along with the Examiner's opinion of the validity of the  i/  \:.it!1 rc:spc:ct to fidl'..:l.ity covcrur~c, the Corporation's posil:ion is th:it appliCimts should subscribe to and r.iaintain sufficient coverage in relation to ~e?osit volume as will be at least equivalent to the minimum amount recommended by the Insurance and Protective Committee of the Ar.lerican Bankers Association and should have in force at all times a $1 million excess bank err.p loyee dishonesty bond.  Section U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 8 -  Application for De;,oait Inf~#! °"'!{,ea-,:~-J3~?4) '  ...  ,··  261 applicant's definition of the trade &rt>a. In some instances, the applicant may artificially draw its trade are.i bo1..r.daries so as to excfo,de factors which would be unfavorable to the proposal (ne.a:rby banks, depressed &reaa, etc.) and include others which would increase the attractivene~s of the proposed location (significant residential or co11111ercial developments, highly concentrated population area., etc.). The Examiner should be aware of this possibility and any differences between the Euminer 's conception of the trade area and that of the proponen·ca should be discussed fully in the report togethe~ with a description of the trade area as the Examiner perceives it. Once. the trade area has been defined, information regarding the following should be set forth:  1.  Economic Data  The principal industrial, trade, or agricultural activity should be deacribed aod annual values of principal products indicated. The presence and source of large payrolls in the area may also be an important consideration. The past and present volume of postal activity and the number ,md value of resider.tial and coni.Jt~rcial building perm.its can often be of considerable value in determining the vitality of the area. Figurea regarding retail~ sales from public so~rces or trade organizations are useful; however, if they are not available, it ::aay be possible to obtain sorae estimate$ of volurae in the. course of conducting a s:.irvey of the locale's busine&a establishments. lnfortil&tion rei;:srding 1'edical facilities and other professional services can be a useful indicator of the self-sufficiency of the comcunity or trade area. Statistical information on governmental• units--such as, assessed valuations, tax levies, bondec:! indebtedness, and tax CelinG_ueocies--and data on the educational environa,ent of the area are also· valuable indicators. Reports of investigation should not, however, be filled with pagea of statistics unless the figures are relevant to the area and to the application under consideration.  2.  Demographic Data  Population figures within the era.de area as well as the genert.l surroundin3 areas are significant determinants in considering convenience and needs. While the population as of the date ·of investigation is important, the Examiner should al~o !)resent data which establishes population trends as well as projections for the future. In sO::ie cases it is difficult' to obtain accurate population data for a particular trade area, as statistics combine portion& of several census tracts. In such instances, data showing the number of household units in the area may be a more appropriate basis for assessing reasonable population estimates.  J.  Competition  The Examiner should ir.clude a schedule of all banking offices likely to be affected by the })roposed bank, including the ru.me, location, and year established; total deposits, loans and capital; and the diatance and direction from. the proposed bank. site. Current bank. directories, st1&ttstical surveys a~1d summaries prepared by the Corporation, and recent call reports are a primary source of inforar.ation for this schedule. 'rhe aru bank.a should be listed in order of di1tance fron: the proposed bank site, rather th:l.n alp!:abetic:ally. Officials of these banks should be contuctod during the 1nvest1aation and aiven an opportunity to exj)r ...•ss their attitud4!s on the p-roposal. The Examiner ahoulci inform any bank.er~ desiring to express a formal objection to a proposal to so advise the Rc..cional Office in writing. 1'1w prob.J.l,le compcLi::ivc t!fftJCtM of ~ new biank propos:i.l should be Cully w1..•i1ih1.·d by the l!:x.:unim.:r. WhHc thl" number of b:mks operati11tio in tl11..• city or an•a Lo b1..~ St•rveJ is important in determining whether tht! add Lt Jon or a n1..•w bank may rcsul t in an ovcr!xlnkc.!d condition, consideratJon ~l.ould .:&!so be> glvc.m to posslble;= 1>roco111pct!tivi:: cuns.?quencl'.S flowing from Lht.i new lH;mk propu1ml, Ruch ur,; increas1.•d castm,,~r 11llrvica.:s and bl111kJn•; 1>1>Liu11u Lu rl•1t.idl!11I.H or thu nrt.•a. 'l'ht.•r~lorL!, .i.L ,h1 noc..::..tiary to furnish thu Corporation' a lloard of Directors with complete h,ctual data with respect to the probable .!.m.pact of the proposal on exiatir.a bank• and other financial in11titutiona in the community.  Seoti.on U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 9 -  Ap;_,Ziaatwn for D•posit  r.....,...""•  (R""•••d B-13-74)  262 4.  Other Supporting Data  The extent of new or proposed residential, commercial and industrial development and construction is a s_ignificant secondary consideration in resolving the convenience and needs factor. Plans for the development of shopping centers, apartment cot:1.plexes and other residential subdivisions, factories, or other major facilities near the proposed site should, therefore, receive comment. In certain instances the inclusion of niaps may be desirable to clarify comments, showing by appropriate identification the name and locatioii of each competing hank or branch and the locations of other important buildings, offices, shopping centers, industrial parks, :md the like in relation to the bank site. As in the case of the "Future Earnings 11 factor, this portion of the investigation report is also public information under Section 303.14(c) of the Corporation's Rules and Regulations. F.  Consistency of Corporate Powers  Nonbanking powers, other than trust powers, are regarded by the Corporation as inconsistent with the purpose of the Act, and the Corporation 1 s policies under this statutory factor have been established accordingly. For example, ?art 332 of the Corporation's Rules and Regulations prohibits the exercise of certain specific powers which are. inconsistent with the purposes of the Act, including, among others, guaranteeing or acting as surety for the obligations of others and insuring, guaranteeins or certifying real estate titles. Since the applicant will have agreed in it& application not to exercise nonbanking powers whether granted by charter or statute, an Examiner under this factor need only refer to this previously obtained agreement. The Examiner may, however, include additional comments if the terms of the agreement are not generally ur.derstood by the applicant or if he regards the agreement as being incomplete or amendment to the Articles of Association of Charter as necessary or desirable. G.  Miscellaneous 1.  Conflicting Applications  The existence of any conflicting applications to establish banking facilities in the immediate area should be indicated and receive appropriate co11r.1.ent in the Examiner' a report of investigation.  2.  Trust Department  If the operation of a trust department is contemplated, applicar:.t must also file with the Corporation Form 103, "Supplementary Information Relative to Application to th13 Federal Deposit Insurance Corporation for Consent to Exercise Trust Powers." This form will give the txaminer much of the information necessary for the completion of his report of investigation with respect to this phase of the applicant' & operations. If the proposed trust func.tions will materially affect the Examiner's findings in making a recommendation on any one of the six factors contained in Section 6 of the Federal Deposit Insurance Act I it may be advisable to analyze the prospects for the operation of the commercial and trust departments under separate sub-headings under any factor so affected.  3.  Number of '.i'e-llcrs' Windows~  The Exanthu•r should indicatL•, if ascertainable, the number of tellers' windows at which insured. dcpo1;its will be received.  4.  Additional DocuDlents  JC any of the t.lucumenls eseenUal foe full consideration of the application ·have not been submitted to the Corporation, the Examiner qh1•11 I ,I  l11qi 1-0,,1  thP 10 "l''"1"'11I 111 ~•• I I A\11111111 l  au1  h 1h,,,1111111111la al ll,t-  llhtl-  l it=Uil practical du.Le c1nd l:ihoUl.i.1 include a notation to that effect in hi• report.  Section U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 10 -  Application fozo Deposit I"8W'allCB .(Rsuissd 8-11-11)  263 VI.  Statutory Factor• - Exiating Banks A.  Introduction As indicated previoualy • the Corporation 1 s admisaion criteria for  proposed or newly o-rganized banka and for exiaeiDg banks are generally the same, Consequently, principle.a diacua■ ed under Paragraph V of this aection of the Manual will not be repeated herein, Prior to proceesing applications for existing bank& for deposit in■ urance coverage, Examiner ■ should familiarize theu:elves not only with the provi■ ionl of thi■ paragraph but alao Paragraph V of thi■ aection of the Manual. In the cue of an exiating bank, however, an examination is made of the on-going bank or ita predeceaaor institution and a report of examination 1■ prepared on the regular printed Corporation fona, with appropriate notation on the Cover indicating the apecial purpose of the examination. Under the "Examiner's Comments and Concluaiona" of the Supervisory Section of the examination report, the Bxainer 1a required to diacuea separately each of the ■ ix statutory factors. B,  Financial History  am  Condition  While the financial hiatory of an operating bank is uaually reflected 1n ita present condition, the buic cauae or cau■ ea for a bank's condition, whether satisfactory or unaatiafactory • should be analyzed and the rea■ on1 therefor ascertained. For example, a present aatiafactory condition of a bank may be the result of a merger, recapitalization, reorganization, etc., but the baeic problem necea ■ itating the merger, etc. may still aiat. Accordingly, where the financial hiotory of an operating bank hu not been succaaaful or 1a questionable, the Corporation generally requir• reuonable uaui-a.ca that the cauae or cauaea of any put difficulties of a ■ erioua nature have in large meuure either been overcome or ceased to exi■ t. In all cu. . , tbe date of pr:lmary or11111ization ohould be indicated, Another important feature in the financial hiatory of u, uiating bu,k which ■hould be covered ia :I.ta put attitude on the prompt recogu:lt::ton and current chergaoff of loaoea and the admini■ tration of dividend policie■ accordingly, In addition, •raera, con■olidatioDa, r ■capitalizat:tou, reorpnia.atiDILI, liability aa ■uaptiou, clepoa:lt waiver■, depoa:lt defer..nta, and aiailar eventa which are not recant 1hould be covered in tba esamillation report, but in le11 datail, With ra■pect to an operating bank•• financial condition, the Corporation cuatomarily requires that the general quality of ita net aaset ■ be aati■ factory and on a par with thet of the avarase State in■ ured nomumber bank, In appraising tbe value and quality of an applicant operating bank'• &1Hta, the a■- appraiaal and cla■■ification procedure■ and criteria are to be followed aa in raaular Corporation examination■, The "Swmury of Gro■■ Adveraa Cla111ficatiou" on page 2 of the report of examination, u wall a■ the rora 96, ahould include data on the quality of a bank'• net aaaat■, The l!xaminar ■hould ■umarise the information in "Examiner•• Comment ■ and Concluaion■" of the Superviaory Section of the audnation report under an appropriate caption. General coaaenta on the bank'• a■ set condition and problmu should alao be included, •• well a■ e s--■ ry of ''Violatione of Lawa and Regulation■," contingent liabil:l.tiu, exi■ ting lit:Lsation again■ t the bank, dividend and remuneration policiaa, and other matters which could affact the bank's condition,  c.  Adequacy of the Capital Structure  An exiating bank applyina for depo■ it inauranca ahould have capital of aufficient 11110unt to 11upport th■ voluae, type, and charactar of the buain••• preaently conducted, provide for the po■■ ibility ot lo■■ inherent therain, and permit the bank to continue to • • t the rea■ onable credit requir-nt ■ of the c:oanmity Hrved, The principlu nt forth in Section D of thia Manual are applicable here, A rouRIJ benc-rk which may be employed in evaluating capital adequacy ia a ratio of total adjuated capital to averaaa net uaeta which is currently, and after three year■ of operation- ia eatillated to 'be, equal to the average for all inaured banks. Of courae, the eatimate after three years of operation nece ■ aarily require ■ an e■ tillation of, deposit volume at that time. S.ati.on V   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 1l -  App Uaations for DBposi t InsUMnae (Revised 8-28-?4)  264 In addition, the baaic capital ■hould be ■ufficient to provide a ratio to total uaeta at lea1t equivalent to the average for all :lnaurecl baaka. Thu• ratio■ are, however, only to be Ulled u atarting point ■ in the evaluation of capital adequacy since ■uch ratio■ are not in. thuaelvu detel'llinative uul auat be integrated with all other relevant factor■ ■uch u the character of the bank'• manag•ent, the quality of it■ aaHt■ and ■o on. In the final anel.71:La, each cue ,...t be judgad on it ■ ow ■erit■, The examination report abould include on pege 2 • .,.. of the uceeury data for deteniining whether the applicant' a capital :La adequate. The -■ r ■hould alao auaari:r:e and auaaent the■e data 1n the "lxald.ner '1 Conclu■1ou ad Rec-ndationa" of the Supervieory Section of the -1nation report under the caption "Adequacy of Capital Structure. 11 If for any reuon • sub■ tantial incr...a in depo■it■ 1• cticipeted, the facte ahould be fully covered in the Bxllllliner'• c-t■, /my plca of the applicant with rupect to the bank' e capital atructure ■hould be detailed. rurthermore, if the proponent■ appear receptive to • requeat for 1uppl7ing additional capital, the Examiner ■hould ■o indicate in the -1nat1on report, It :La da■ irable to include under th:La caption, or u a ■upp1-tal page to peae B of the exaaination report, a co■plete or reaaonably co■plete 1:1.at of all 1hereholder1, their bold1np and ralated intereat ■,  D.  future  Barning■ Pro■pect■  Tbe eaminge capability of an u::Lat1ng bct :La reflected in ite earninp record. Ordinarily, an operat1ng but' 1 earn1np record ■bould indicate ability to pay all operating u:pen■ es with a Hfe -■rain for the ab■orption of loa•• and for the payment of r■a■onable dividende, For coaparative purpoaea, current eerninge ratio■ ■a:, be obtained froa the lut lmnual Report of the Corporation, If urning■ have not bean eufficict, ar... where 1ncoM -y be illproved or u:pen■ ea reduced should be noted, Tha principle• deacribed in Section r of th:La llanual ara applicable hare.  The income and u:p1111a fiaur• on page 4 of the u:amination report are boot fiaure■, If the B""111ner reprde the■- figure■ aa incorrect or ■:Lalead1ng becauae of improper account1ng for unearned dilcount■, failure to charge off loa•••, failure to depreciate properly fiud aa ■ete, or 11111lar daviatiou from accepted practicu, the ■attar ■hould be fully d:Lacu■ aed in the pr•entation of earnin11 data in the Superv:Laory Section of the u:aination report, Tbe Bxa■iner 1bould al■o c_,.t on the effact depc■ it in111rance CClffrage ■ipt have on the bank' ■ incoae and apeuu ill the future. B.  General Character of Management  -t  In the cue of an uiatinl bct, - • - t ■ay be evaluated both fl'GII the atandpoint of the bank' ■ condition and the v c t - point of • - t • • put pfffonaance •• reflected in th• booke aad recoffl of the bank, previoua u.atdllation reports of and correapondence fraa other bank ■uperviaor■, and :lnteraal ·baak record ■, such a■ committee and board of director■' llinute■• A ratina of SATISP.ACTORY 1e ordinarily nec••ar, to aat:Lafy the requir-te of th:La statutory factor. The rating of - - t :La d:Lacue■ed in Section Q of th:La llanual, Complete infor■ation OD ■anag-t will be included in the Supervi■ory Section of the report. In addition, a ■....,ry diacua ■ ion of :laportant upecta of thia infor■ation, toaether with infor■ation on director and officer indebtednu■ to the bank, ahould be included under th:La caption in the "-r• ■ ·Conclu■ iou and Rec-■ tion■" of tbe &uperv:Laory Section, ■hould  If the Bxa■iner doe■ not r _ . t the - t u SATISFAC'l'Oll?, he indicate whet change■ he believu e11ent:Lal to ·warrant ouch a rating.  Fidelity in■ urance OD active officer■ and -loyeu and other ind-ity protection should receive c - t to the u:tent uceaury under th:La captioned factor.  ■ tatutory  S.oti<m U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 1B -  AppZioationa f,n, Depont Ins""""°" (Rmead l-18-f4)  265 P,  Conveuence and R•d• of the eo-m1ty  The Corporation'• criteria under thi■ ■ tatutory factor are closely related to those outlined with reapect to the "Future laming■ Pro■pecta" factor. A going institution which is being successfully and profitably operated, and  which ha ■ a recognized place and established cu■ tOMl' relationahipa in its coaaunity, is for ■elf-evident reaaona convenient to and fulfilling the needs of the comuntty it aerves, A bank may, however, hsYa had inferior urning■ in the put and nevertheleaa qualify under thia ■ tatutory factor.  Any pertinent information vith respect to local ecODOllic .conditiou, population trend&, or unusual circ... tancea which has affected, or u.y affect, the c011111U11ity and the applicant ahauld be commented on under this caption.  G.  Conaiatency of Corporate Powers  Nonbanking power■, other than trust power■, are regarded by the Corporation as inco.iatatent with the purpoaea of the Act. In ■om State■, banb have been granted the right under their charter■ o-r by ■ tatute to engage in certain nonbaaking activities. The right to guarantee titles to real eatat•• to guarantee mortgages and mortgage participation certificates, and to issue various fonu of insurance are examplea of such nonbanldna power■• Many bub, however·. which po••••• auch power■ do no~ exerci■ e the.a. The examination report should indicate the character of any nonbaaking powers which an applicant institution poaaeasea • whether or not exerciaed. It abould also contain a full discussion of the extent of a bank'• noabanlting business and the nature and amount of any liabilities reaulting therefroa. In addition, examination reporte should include a diecueeion of any nonbanking activitiu which are ultra viree or beyond the charter, corporate, or statutory power ■ granted. It ia desirable• however, that this infonaation be aumarizad in the 11 Ezaminer'a Conclusions and Recomendationa" of the Superviaory Section under 11 Con■ iatency of Corporate Powers." The Corporation as a rule obtaina an agreeaent from an applicant in the fonu.l application not to exercille nonbanking pGWera after deposit iuurance hU been granted. Honetheleas • it 1a deairable to know the extent to which the institution has engaged in nonbanlting activities in tbe put• and the extent to which ita paat income was dependent upon auch activities. Moreover• the Examiner uy feel that the agreement incorporated in the application is not sufficiently CQIIPlete and that additional agre•enta or amenclaents to the Articles of Association or Charter are neceaaary • in which event he ahould eo state in hi• report.  H.  Miacellaneoua 1.  Truat Department  If the applicant operates a truat depart•nt, an examination will be conducted and a report of examination coapiled. The lxainer should c01111ider the condition and the pro■pect1 of the tru■ t department in developing th• conclu■ ion for each factor enumerated under Section 6 of the Act. Should tru■ t departMnt opera•tion■ be of ■ufficient influence in the final detemination of the Examiner'• finding■ on any of the factor■, it uy be advisable to analyze the co...rcial and the tru■ t operation■ under appropriate subheadings. 2.  Number of  Teller■' Window■  The Exaainer should indicate the number of teller■' window at  which insured deposits will be received. 3.  Docwaentation  If any of the documents e■ aential for full conaideration of the application have not been aubllittad ea the Corporation, the Examiner  Seotion U   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 18 -  AppZicationa for Deposit InaUMnee (R•,,..••<1 8-18-?4}   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  266 should instruct the proponent• to trannd.t auch document ■ at. the earlieat practical date and ■ hould include a notation to that effect in bia report. 4.  Source■  of Information  The l!xaminer ■bould indicate in bi■ report the ■ourcH of infonaation on aignificant point■ covered in bi■ comento. Durina the - ination, the Examiner ahould review r■porto of examination of other ■upervieory authoritiea and corrupondenca from the■e autboritiea.  - 14 -  AppU.oationa fol' Depa,n,t 1'neuZ'anae (RB'IJi.atld 8-18-?4)  267  FDIC fEDElol.L DEPOSIT INSUU.MCI COIPOU.110N  FOR IMMEDIATE RELEASE  PR-82-73 (11-12-73)  "THE FDIC VIEWS QUESTIONS OF CAPITAL ADEQUACY"  Address of Frank Wille, Chairman Federal Deposit Insurance Corporation  November 6, 1973  Before the National Correspondent Banking Conference   https://fraser.stlouisfed.org Federal Reserve Bank 86-817 of St. 0Louis - 77 -  of the American Bankers Association  San Francisco, California  18  268 It seems hardly possible to say something new on the subject of bank capital adequacy.  The literature is already extensive, bank  regulatory authorities have grappled with different views of capital adequacy over many years, reasonable men continue to differ and bankers still tend to reeist supervisory demands for more capital.  In my view, adequate capital is the least amount necessary for others to have confidence in your bank and its operations.  The  "others" you have to convince are large customers, other banks, investors and, in this imperfect world, bank regulators.  There is  no simple formula or rule of thumb that will assure outside confidence for all banks: there are just too many variables in achieving this status and, not surprisingly, too many instances where confidence is high but the apparent mathematical ratio is relatively low to conclude that a particular ratio is the "right" one for all banks. It has been suggested that the free play of the market should determine the adequacy of a bank's capital, and that the supervisory agencies should not presume to enforce a different judgment of  their own.  This approach presupposes, however, a much more  knowledgeable market than we have today - - at least for the vast majority of the nation's 14,000 banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Relatively few of these banks  269 - zhave more than 500 shareholders which makes them subject to the fuller disclosure requirements of Regulation F. an increasing number of  bank ■  On the other hand,  are members of holding company  systems which, on a con ■ olidated basis, are subject to SEC disclosure requirements.  But even assuming one-sixth of the nation's banka are  subject to Regulation F-type disclosures or to SEC requirements, these disclosures do not include all of the information available to bank regulatory agencies or all of the information which may be necessary for a market determination of the bank's condition. While the largest banks have become increaaingly open with financial analysts about management goals, performance and even adverse developments, the fact remains that the marketplace is either uninformed or imperfectly informed about most of the ~ation's banks.  So I question whether the market's view of capital adequacy  is really the answer -- even for the nation's billion-dollar banks. I'm certain it's not the answer for banks of lesser size or prominence. In a sense, the bank regulatory agencies are exercising for most banks the judgment as to capital adequacy which a perfectly informed market might be able to exercise.  In terms of the entire  universe of banks in this country, I think we do that job reasonably well although we can make mistakes just as the market can.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The  270 • 3 •  fact that bank earnings have been relatively high al'ld that be.nk failures have been relatively few in recent year&, deapite condderi\ble llhocks within the economy, suggests that we are at leaet viewing capiti\l adequacy today on a reasonable basis. Average capital ratios vary by size categories thra~ghout the broad spectrum of American banks.  The highest r;i.Uos are most  often displayed by the smallest banks (i. e,, those under $5 million in total deposits).  The 8 percent average ratio i;hows up most fre-  quently in the $10 million-deposit range, and  progre ■ s~vely  lower  ratios seem to be the rule as we go up from $i5 milUi:,n in total deposits.  And generally speaking, these average ratiQs have declined  moderately for smaller and medium-sized banks during the past 10 or 15 years.  This, again, is empirical evidence that none of the bank  agencies view the matter of capital adequacy simply in terms of some average nationwide ratio. For the largest banks, capital ratios have been declining even more rapidly in recent years. appreciably.  Overseas deposits have increased  That, plus active participation in the time "deposit  market, has resulted in asset gains by the large whole11ale banks that equalled or exceeded those of smaller banks,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Holding company  271 - 4 -  activities of some larger banks have resulted in overall operations with much more leverage than that indicated by the bank's own balance sheet. Detailed balance sheet data on banks and bank holding companies indicate that for year-end 1972 the 11 largest banking organizations had a ratio of equity to total resources of about 4. 5 percent (including loan reserves raises the figure to about 5. 4 percent).  Fi11ure1 for the big  Chicago banks are almost as low, and those for the major California banks are lower.  I suspect the comparable figure11 for 10 yeare ago  would have indicated ratios approximately double those of today for this same group of banks,  What accounts for the shift?  Partly it's  a rapid growth of resources and generally more aggreasive behavior by these banks.  Additionally, it may have to do with the relationship  between large banks and large corporate customers.  The latter are  no longer willing to maintain large active balances apart from.those required by loan commitments·.  However, as one consequence of  this, large corporations are no longer able to insist on high capi~al ratios by virtue of their balances and there is no advantage in wholesale banks maintaining such ratios.  This may all be very rational  and in the interest of a more efficient economy, but the acceptance of the resultant number. and ratios i ■ -.not ea•y for bank regulators.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  272 - 5 -  ffow then do we go ab'>ut evaluating the adequacy of capital in particular banks?  Our current instructions to FDIC examiners have  this to say about the use of ratios and the identification of the more important factors that enter into the evaluation: " , the Corporation has traditionally been concerned with the general level of capital.ratios, because of the close relationship between these ratios and the Corporation's risk. However, this emphasis on capital ratios, which simply measui:-e the ability of the banking system as a whole (or the average bank) to withstand unexpected lou1es or shrinkage in asset values, should not be taken out of context and misconstrued as a minimum standard applicable to individual banks. On the contrary, banks are sufficiently dissimilar as to the quality and character of their assets, the relative competency of their managements, and the relative stability of the economic environment in which they operate that it is never practicable to generalize on the subject of capital adeqna cy. If any generalization may be made, it is that the capital of any given bank should be sufficient to support the volume, type, and · character of tr>P business presently conducted, provide for the possibilities of loss inherent therein, and permit the bank to continue to meet the reasonable credit requirem.,nts of the area served. "In attempting to evaluate capital adequacy, there are several important factors that must be weighed and judged:  (a)   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Management - The ability, attentiveness, integrity and record of management, together with the ~oundness of its policie• are of major importance. Sound management, prudent policies, and effective  273 - 6 -  operating procedures are probably the key elements in the ovel"all riak equation of business enterprise, and it ia, after all, [as) protection against riak that capital plays its singular role in any bu1ine11 enterprise, (b)  ~ -  (c)  Earnings - The earnings capacity of a bank is of marked significance in assessing the ability of a bank to maintain an adequate capital position. The dividend policy of the institution is also of importance, a ■ is the willingness of management to recognize and absorb losses currently. Supervisors generally feel that earnings should first be applied to the elimination of losses and depreciation and the establishment of necessary reserves and that dividends should be disbursed in reasonable amounts only after full consideration has been given to those needs and othe.r factors impinging on capital needs.  (d)  Deposit Trends - If the trend of deposits is upward a.nd appears likely to continue, and if retained earnings have not kept pace with the growth in the size and the scope of the bank's operations, there can be little question that management should recognize its responsibility and make all reasonable efforts to augment capital through whatever means possible. The potential volatility of [the] deposit structure, on the other hand, adds another dimension of a different character to the analysis of a bank's capital structure.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The general character, quality, liquidity and diversi,fication of aueta, with particular reference to assets adversely classified, are necessarily vital factors in determining the adequacy of capital.  274 - 7 -  (e)  Fiduciary Business - The volume and nature of the busineu transacted in a fiduciary capacity are of significance in determining capital needs. Contingencies in this area, as well as the possibility of surcharges, must be carefully appraised.  (f)  Local Characteristics - The general type of clientele, stability and diversification of local industries or agriculture, and the competitive situation are important considerations,  "The question frequently arises regarding the importance of ratios in determining capital adequacy. As previously noted, capital ratios (or risk asset -ratios) are mert!ly simple, objective measures of the shrinkage in asset values a bank's capital structure can absorb at a given point in time, and, as such, are but a first approximation of a bank's ability to withstand adversity. A low capital ratio by itself, however, is no more conclusive of a bank's weakness than a high ratio is of its invulnerability. It would be hard to find much correlation between book capital ratios and the incidence of bank failure - that eventuality against which capital protects, but· does not prevent. Banks with high capital ratios have failed because of the low quality and/or unwise distribution of their as sets, while others with low ratios have survived because of a hyper-liquid condition. "Ratios may also have limited use as rough benchmarks, representative of industry practice and custom, and in that limited sense, may be useful as a starting point in evaluating an individual bank's capital position. In the average bank, with average management, the capital-asset ratio or the ri,k-as set ratio, when they go beyond reasonable   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  275 - 8 -  bounds, may be of importance in deciding that additional capital is necesFarv, even though existing asset problems are relatively minor. The relative degree of quality in a bank's loans, bonds, and other risk as sets, is a valid argument in relation to capital needs up to a certain point, but the validity of this argument decreases rapidly and disappears when the sheer volume of such assets completely overshadows the capital structure. On the other hand, certain banks have reasonable capital ratios but management' and asset weaknesses necessitate requesting additional capital. In other words, ratios alone are not conclusive, and they always must be integrated with all other pertinent factors. However, once this integration has been effected they do have a bearing, their relative importance increasing in direct relation to the degree of seriousness attached to management and asset problems, or conversely, decreasing in direct relation to the degree of management competency /ind' asset soundness in the bank under consideration. " The average capital-asset ratio approach has special relevance in the case of applications of new State-chartered banks for deposit insurance, on the premise that a nP.w entrant in the market should at least meet the capita I 8tandards of the industry in order to. obtain a license to compete.  At th., FDIC, we tend to apply industrywide capital  standards more rigorously in such instances.  As a general rule, such  new banks are expected to provide an initial capitalization sufficient in amount to provide a prospective capital cushion at the end of the first three years of operations al least equal to 10 percent of estimated   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  276 - 9 -  total auets at the end of that period.  This is roughly comparable to  e::lrlsting capital ratios of small l>anks with an added margin (of one to two percent) to compensate for (i) the increased risks accompanying the formation and development of a new bank and (ii) the historical bias of both examiners and applicants in under'!'stimating the deposit potential of new banks.  The Corporation has, in a~dition, adopted a  firm policy of not approving applications of propo11ed new banks with leu than $250,000 initial total capital, unleu special circumstances (such as a location in an isolated, unbanked community) warrant a leuer capitalization.  The rationale for this policy is that any new  bank should have the capability of generating deposit totals of at least two and one-half million dollars within three year1 to be auured of success in today's increasingly complex and competitive banking environment. The composition of bank capital, as you know, has undergone significant change within the past decade.  The old antipathy.toward  the use of debt capital has been displaced by a willingne11 among bank supervisor ■  to accept, in certain circumstances, subordinated debt  into the permanent structure of bank capital accounts.  However,  although debt capital offers added protection to d_epositors and   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  277 - 10 -  creditors, it is not a complete substitute for equity capital.  First,  it is fundamentally a debt obligation and must ultimately be retired in accordance with its terms, although we recognize, of course, that a growing, profitable bank can readily refinance maturing notes at or prior to maturity.  Second, interest on capital notes and debentures  is a fixed charge against future income that must be met~ whether earnings are available or not, and the payments necessary for debt servicing represent reductions of funds available for additions to undivid·ed profits or the payment of dividends.  In many respects,  therefore, debt capital represents the capitalization of future income. Finally, debt capital generally may not be used to absorb losses although it does provide an additional cushion for depositors and creditors if the issuing bank should have the misfortune to fail. Most supervisors today would interpose no objection to debt capital that has the following characteristics: (a)  A principal amount which is in reasonable propo.rtion to the total capital structure (our guide is about onethird of total capital and reserves);  (b)  An interest rate which is commensurate with prevailing conditions;   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  278 - 11 -  (c)  Sinking fund provisions (where they exist) that are adequate and a retirement schedule that is practical and realistic;  (d)  A principal amount that provides for the bank's reasonably foreseeable needs; and  (e)  The circumstances of issue support a general conclusion that the bank's best interests would be served thereby.  Some observers, including members of the FDIC staff, feel that the above guidelines are too restrictive.  They argue that the  limit of one-third of total capital in the form of debt is arbitrary and probably was developed because that figure approximately coincides with the borrowing limit of a national bank with an average mix of capital, surplus and undivided profits.  Why, they ask, should the  regulatory agencies place any limit on debt capital, as long as a bank has sufficient equity capital?  Far better, they add, to let the banks  and the capital markets decide appropriate debt levels, for insofar as debt gets out of line with acceptable market standards, the effect on borrowing costs should result in appropriate discouragement. This point of view has considerable merit, but also some limitations   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  279 - 12 -  insofar as it relies on the capital markets for an evaluation of the appropriate debt-equity relationship.  We are, however, reviewing  the subject at the present time with an open mind. An area of particular current concern relates to the capital position of banks and parent holding companies.  It has been suggested  that one of the reasons why banks are now eager to move into a variety of activities where they were not traditionally active or permitted to operate is a desire to increase leverage.  For the most part, acquisi-  tions of related businesses under the 1970 Bank Holding Company Act Amendments have not been accompanied by significant additions to equity.  This makes such entry very attractive so long as additional  earnings can be generated, for there is no capital c<ist associated with the incremental additions to earnings.  These expanding acti~ities of  banks and one bank holding companies may, of course, provide increased competition in markets for a number of financial services and there may be substantial benefits to the public.  However, insofar as they result  in thinner equity coverage, the concern of bank regulators will increase. Moreover, changes in the product or asset mix of banks and bank dominated holding company organizations might have additional implications for determining appropriate capital level ■•   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  While it is possible  280 - 13 -  for a bank to continue to function while its holding company is in financial difficulty, I don't think bank regulators can  a1 ■ u'Jlle  that  this will always or even usually be the case. In summary, the determination of the appropriate level of  bank capital in the individual case and on an industrywide basis is complex and does not seem to lend itself to the application of inflexible, rigid formulae.  Nevertheles ■,  the importance of making  such a determination both from a supervisory standpoint and from the vantage point of the banking industry, is self-evident.  In the  final analysis, the task of the Corporation in evaluating the capital adequacy of individual banks is to assure confidence in the nation's banking system without fostering an overcapitalized position which would be properly subject to criticism as an inefficient use o{ increasingly scarce capital resources.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  #  #  #  #  #  281  FEDERAL DEPOSIT INSURANCE CORP.ORATION·, Wnhi••"•· 'o.c. 20m  OFFICE OF OIRECTOR•OIVISION OF BANK SUPERVISION  R/D-62-76 (7-22-76) MEMORAND\JII TO:  Regional Directors  /  FROM:  John J. Early, DirectorJ,.e I Division of Bank Superv1a'ion  SUBJECT:  Liquidity Analysis  A 3-part procedure for the analysis of liquidity has been developed which  we believe will be of significant value in the advance detection of liquidity problems and the marshalling of corrective efforts. The first part is essentially a ratio of net liquid assets to net curre1~ liabilities and will be computed at each regular examination. As a guiq• to examiners, and pending further experience, a 20% "benchmark" ratio is suggested. When the ratio falls below the benchmark, further analysis, using the Cash Flow Projection schedule, is recoll1lllended. When a negative cash flow is projected using this second schedule, or if the examiner considers the total available funds to be insufficient, further evaluation and review with bank management is suggested, and a series of questions is provided in the Corrective Measures (third) schedule as a guide for the examiner in seeking corrective actions by bank management for indicated liquidity problems. A supply of temporary forms will be forwarded to you for use in examination  reports until such time as permanent report pages can be printed.  Additionally, a separate section of the Manual dealing with the subject of liquidity will be distributed in the near future. Henceforth, at each examination of commercial banks, the schedule(s} 1 to be inserted following the pages 2, will be utilized. Instructions for the use of these schedules are detailed below. Until more experience is gained concerning the liquidity ratio, examiners should exercise care in referring to the ratio in their comments and conclusions, although strengthening of the liquidity position should be sought at each examination where such action is appropriate.  The liquidity ratio, computed to the nearest tenth of· a percent, should be brought forward to the Sununary Analysis of Examination Reports (Form 96), where iJ will be typed in as line 83 until such time as the Form 96 can be revised.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  282 ~gional Directors  -2-  R/D-62-76 (7-22-76)  LIQUIDITY ANALYSIS Liquidit~ Ratio This part is to be completed at each examination and the liquidity ratio  cited in the examiner's liquidity comments on page A. ·For those items in the schedule not considered self-explanatory additional clarification is provided below.  l. Cash and demand balances due from banks (net reciprocal balances): The account should be the total -reflected on page 9 for 11 Cash and Due From Banks", excluding time balances due from banks, which are included in item 5c.  2. Securities: In those banks with heavy amounts of municipal securities, and where the liquidity ratio is only marginally acceptable, the examiner should prepare the Cash Flow Projection schedule, and if necessary, the Corrective Measures. 4. Securities purchased under agreements to resell within one year from date: The maturity date of the agreement is the deciding factor, not the maturity of the securities. Include when the terms of the agreement require resale within one year from the examination date. 5. Other money n1arket instruments: For item 5d incl~de any other applicable items not shown in items 5a, b, and c: Investment in a loan pool with an agreement to resell is an example.  7. Less: The smaller balance between Federal funds sold and Federal funds purcha!;ed: This permits the reflection of the bank's net positon. ·When a bank is both selling and buying, the smaller balance is netted against both assets and liabilities. If the bank sells only or buys only, then the deduction will be zero. If the·selling and buying amounts are identical, deduct one of the amounts. LIABILITIES 10b. 'l'he sm.'.lller balance between Federal funds sold and Federal funds purchased: See instructions for item 7, above. e. ~-term accrual and contra-entry accounts, total: Self-explanatory except item (2) which will include accounts generally described as those related accounts which appear on both sides of the balance sheet and have not been netted on page 2.  12. Liquidity Ratio (Net Liquid Assets as a% of Net Current Liabilities): This ratio will provide an indication of the industry practice and custom;   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  283 Regional Directors  -3-  R/D-62-76 (7-22-76)  it is not intended for use as a sole means of determining the adequacy of liquidity. The ratio is to be used as an examiner aid similar to the page 2 adjusted capital and reserves ratio. The ratio must be reported on page A in the examiner's liquidity comments, and it should be carried forward to Line 83 of the Summary Analysis of Examination Reports, Form 96.  MEMORANDUM ITEMS 13. Loan commitments expected to be funded within one yeat from date of examination: Lines of credit will not be included unless a formal agr~ement exists. Dealer draft authorizations and undisbursed loan proceeds could be included if expected to be funded within the time period. Also include securities purchase commitments oi- subscriptions in process.  LIQUIDITY ANALYSIS Cash Flow Projection This schedule is suggested as an additional examiner aid for use when the Liquidity Ratio is below the tentative "benchmark" or when otherwise del:, ;mined appropriate by the examiner. The projection contains a number of 11 estimates", including an estimate for the net increase in core IPC deposits, which are usually a major source of funds for banks. Theref~re, decisions regarding the availability or lack of funds (item 22) must include careful consideration of such conditions. For those items in the projection not considered self-explanatory additional clarificat.ions are provided below.  4.  Other money market instruments maturing within one year: paper, banker's acceptances, etc.  Commercial  5. Loan run-off anticipated within one year from date of examination: Probable run-off as determined by examiner after considering such relevant factors as fluctuations in loan volume, potential cash flow which could be generated from principal reduction of amortized loans and installment loan payments, or ability of major borrowera to actually repay loans maturing within one year. 6. Projected net increase in "core" IPC deposits for onP. year from date of examin.:ition: Core deposits as used here arc defined as those deposits which are not highly sensitive to rate changes, do not fluctuate sharply, and which exclude deposits reflected elsewhere in the projection. Most of the smaller demand accounts and consumer time accounts should be included in this category. 9. Other sources: Include non-operating items such as anticipated proceeds from sale of securities and fixed assets, collection of an indemnity claim, etc.   https://fraser.stlouisfed.org 86•817 0 • 77 • 19 Federal Reserve Bank of St. Louis  284 Regional Directors  -4-  R/D-62-76 (7-22-76)  12. Time deposits over 100M and other market-sens~~~ve time d~p-~-~~;_~_ maturing within one year from date of examination: Do not include such deposits which are pledged as security for loans unless such loans have  been included in the loan run-off projection (item 5). 13,  Other volatile public funds and large deposits not included in item 12:  Public funds by nature are usually extremely volatile; however, there are  some instances when such funds remain stable for long periods. 15.  Formal loan conunitments expected to be funded within One_~ear:  Show  net of amounts for formal take-out commitments and firm participation agreements such as those which may be encountered in construction lending and overlines, etc. 19. Other uses: Include such items as pending purchases of securities for which a formal commitment or subscription has been made, building expansion programs under contract, etc. 22, Available Funds: When the available funds total is negative or the amount is considered insufficient by the examiner, further analysis and review with bank management is warranted to obtain appropriate correcti\ measures. LIQUIDITY ANALYSIS Corrective Measures This schedule contains a series of questions designed to aid the examiner in obtaining a corrective program when a liquidity problem is apparent as well as to recognize those situations where management has made suitable provisions for an upcoming period of restricted liquidity. It is suggested that this schedule be utilized when the total for AVAILABLE FUNDS (ltem 22, Cash Flow Projection) is a negative amount or is considered insufficient by the examiner.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  285 LIQUIDITY ANALYSIS (Coslt Flow Proj•ctionJ SOURCES OF FUNDS DESCRIPTION  .,~our.T 10 ... ,.000·11  I. Cash ana dt'mand oalann~•s dut" from oank!'; ,iet of rec,nrocal balances)  2. ln\'t'!-lmrnt 1tradt• st'cunlu•.::. (Pl') mdlurin~ ,,11h111 one· yc-.n from date oi l"xammalrnn 3. Fcdt·rnl fund"' ,,old, and srcunlit'"' purchased under a,i:rl'C'mrnl 10 resell within one year from Lia.tr of  f';\dlnll1,ll\Oh  ·1. Othr, monev markl•t mstmmrnti,, maturm • within one ..(,ar Imm cla1r of exam1nat1on .i. Loan run-oft an11c1p,ued wilhin onr yrar lrom date ol examination 6. Pro1cc1rd Rt'l increase m "con·" IPC: drnns1ts for on<' vcar lrom rial<' of <'Xammatinn i. Salr ol capital m prorrsi,. nr anhnpalr-d w1thm one year lrom date ol rxamination 8. PioJcct<'rl alter ta>. opC'ratinx eammi;;s plus tixed.asst"t depreciation for the oneayur 1u•nod . foll1mmg l').an11na1mn dale  9. Othl'r ~muc<'s (dt'ticrrbe) availal>le within one year from cxam,nalion date  IO. Tnlal ;-r.,uc-c>s ol l11nds USES Of FUHOS DESCRIPTION  I I. O(hcial rhrrks outstanding (ovr.r JOfJ,\IJ 12. Time deposit~ over IOOM and 01he1 markct-scns1lJvr time deposi1s maluring within one year Cmm date n( examination l!t Othl'r ,·o\a11ll' public lunch• •nd large dc•pos11s nol included in 1IC'm 12, above 14. 1-· edcral funds p1uchascd, S<'cuntu•~ ~old under repurchase agreement, and other borruwmgs due within om• yC'ar horn date or rxammation (mclr,de principal payments dMe within one yeat on mr,rt(?'tU?r,-. aml flthrr lon~•trni1 1ridrhtr.1b1r.,.\) 15. l-'nimal !nan ",mmllmcnts l'Xp(•r1t•ri to II<' lund1•d within one yt"ar Imm date of rxaminatmn 1ti. Conw·nlmnal :md standby kll<"r., nl rredit expected to be drawn on within one yur from dat(' of ('ll.OlnllllilllOO 1,. E~11malt·d lo~~1•~ 10 fon11ni,;r11t l1•h1l1t11•~(PnP.!t' Z•a) TI. Subordmatcd nmrs maturm,; wnhm on<.' year lrom date ol examination 19. F.~t1matrd d1\·idt•nds 20. Othrr uses (tlrscribrJ w11hin 11111• yc•ar from examination  21. Total 11!->rs of funds 2~!. ,\\'AII.AKI.E ft:\U:-. (fotal 8flurcr.f o rDMMENTS   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  11iul,'> munis  totiil uses(){ funds)  -.· uwT•to1111,ooo·.,  286 LIQUID:TY ANALYSIS (Liqu,dity Ratio/  --------------  ASSETS  I. ( ,1'-h ,ind clcrn,m,! h,1!,1110·.,. d111• bom h,rnb,(11rl nf rcc1/m1caf lmlm1cr•~J ~- ,, (1111111'":  ,t.  1.. 1,11  111\t"-luwul  h. l':11-. <>I (m1n11-.1  1uadl''/H'  ,t))IC{l,IIIOl\((!Cprcuat1011)  (. I, ...... li\ ,d li,1hil1tH'" -.1·1111(·cl b\ tla·-..c d. Jkp11'( 1,11wn/,1d111-.,1f'd <"<IJJlldl and  r£",<'l\t",  I  i////llll1 j//·/  ':;,)  Total securities \. ~<·<u11t11•.., pu1lh-1.,1·d und1·r J~rt'('llH'nl~ to 1<  -dl within one yl'ar horn d.i.lt' nl c:,,an11nat1011  .'>. Oth<r nurn,·y m;uket 1n,trumen1 ... : .i. ( r,mme1c1al P"lH'l pur, h,1-.t•d h. B.mkt•1 ._• a.rc{'pl,rnce:-. c I 1111(' ( IJ'.., held  h<']d  l oto other money mar et in:;truments  fi • ...,\ /\ 10 r \I 7. l.c-.-.: lh,, '-111;1ll,·1  ha!,1111l· l1t'lwt·t•11  l·,·deral lund-. -..old and ft'dcral fund~ purch.1..,t'd LIABILITIES 1AMOUNT  .i..  (0..,,r000'i}  ·11m1· d('po,11, m.11tir111~ ,dH'f nne y('ar lrom date of c11.aminal1on, unlt•:-.:-, lht·1v 1:-. rl'avm lo hd1t'\\' lh1 ~ 1\111 lw 1qtl11ha1\11 ,00111·1  h. I h,· -.111,dk1 h,1l.111u· ht'll\('t'u Fc·d('r,11 lund:-. ..,old and Fednal fund., C.  e.  \!c111).~,1,;I' ,md nlht•1 !1lc·,,11m11,111,1n l.ong•lt'Llll .ll(fUj)  loni,;•l('fUI ,nd('hkdnt'":-.  ,rnd  urcha:-.ed  net ol paym('nh du(' "•th111 ont' y('ar lrom date  (Olllfd•,l((Qllnl:-.  ( II lk!t'n('(l 1,1:-. li,,ln1L1y  , '.! 1 (.onlr,l•Jf tounl-. and f1tlll'r rrl,,.,n1IH'):  Totol leu l i. \f ! I I \HIJ.[ 111.'i 1'.!.l.l(H llll I 'l K \ l 10 1.\ ('/ lur11d '" ,f't~ 1·qw1h  'i~ of nl'I cunl'ltl lrnhil1tu,;) MEMORANDA  13. I.OAN cor,,r,,1TMENTS E)(PECTED TO BE FUNDED WITH!N ONE YEAR FROM DAT£ OF E)(AMINATION  COMMENTS   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ////lltl/l//lllll1  u. CONVENTIONAL AND STANDBY LETTERS OF CRED+T EXPECTED TO BE CRAWN ON WITHIN ONE YEAR FROM OATE 0" E)(AMINATION  287  ~--·•-··----·------------------------,------1"""'"' ,. L.IC: 1JIDITY ANALYSIS {Corrective Measures) I. O.sc:r,be the, bonl.  2-  0  1  p,:,ltcy for l,qu,d,ty .-.nnagement, nnd comme,,I on -oknenes th,,re,n, or lack of such a pohcy.  Com""'"' woth •especl ,., man,:,ge1T1ent's plans tor the ,e1olut1on of an e•1111ng or potont,ol  hqu1d1ty probl-.  1 Can Hies of secur1t1es mnturong b,,yond one y,..., pn:,Y•ck 1ull,c119f11 funds? What effect will the recovr11t1on of "'°"ket dapreciotion hoYe on the bor,k's copilot?  4 Can port1-:,n1 ,.f the loan account be ,,-.,,1,ly ,,,.,,1,,.,,-d, tnther outr1ght or through port1c:1pohon? Is the quality of the ~•dol,o acceptable, ond ore pre110,l1ng 1ntereS1 rotes such as lo o.,n,d substnnltol u1scoulll upon sales? If substonhal ·discount - I d be uppor.,,,,, what W011ld the effect be on cop1tol?  S. Does tl'II! oi;inio ha"e ovo,1 11 1110 sources l<>r borrowing? Is tho bar,k etiga;ed c,ctively ,n sll'J1cltirtf l«ge CD depositors? Who!  ■ If.ct  boirow,ngs or CD's hove on 11om1n9s'  6. Are ,here avenues oiwn for fund, -.uch n-. ,h,. ~al.- of cap,lal, •oltc1t1ngdepo91h fr...., shoreholders ond lho:o, 1nto:ro:11S, 11tc.?   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -11 1nte,.st CDs! oi such  288 LIABILITIES I.  Introduction  The accurate determination of the bank's total liabilities and their proper accounting on the bank's books are among the primary functions of Examiners in conducting a bank examination. Determination of a bank's total liability posture, analysis of its component parts, and evaluation of apparent trends are essential elements in the determination of adjusted capital, capital adequacy, liquidity needs -- in short the overall condition of thP. bank. Careful liability analysis also imparts valuable insights into the general character and philosophy of the bank's management. Non-book liabilities and contingent liabilities have been previously discussed in Section E of this Manual, "Capital Account Adjustment ■ Not Shown on Books." This Section of the Manual ia concerned with direct liabilities, i.e., deposits, borrowings, and other liabilities. II.  Deposits A.~  Deposits are the raw material of banking -- money -- money to leni and invest. In most cases, 90 percent or more of a bank's. total a■-eta (or liabilities and capital) is derived from deposits. Thus, the compoaitionr distribution and trends of deposits have a profound effect on the liquidity, profitability and' capital adequacy of a bank. A "deposit" may be broadly defined as the unpaid balance of money or its equivalent received by a bank in the usual course of busine ■ s, for which it is obligated to give credit .!I Indeed, the significance of honoring a valid deposit claim upon presentment should not be minimized because inability to honor such a claim may be tantamount to insolvency and grounds for closing the bank. It is important, therefore, that a bank manage its assets and liabilities so that at all times it has sufficient liquidity to honor all valid depoait claims properly presented. Deposits may be classified and compared in a number of ways, e.g., demand versus time, private versus public, secured versus bns~cured, large versus small, stable versus volatile, and ao on. The different classifications and comparisons preaent different problems to the Examiner in teru of analysis and evaluation of a bank's deposit atructure.  Thus, interest sensitive large denom-  ination certificates of deposit require larger liquidity reserves than the generally stable personal savings account. Similarly the profitability of demand deposits is on a different level from that of interest bearing time deposits, although the generally higher cost of servicing demand accounts as well as their higher reserve requirements narrows the profitability gap to some degree. The risk of substantial declines in deposit volume is of concern to the individual bank in determining liquidity requirements and in formulating investment policies. Such risk is materially greater in certain banks than in others because of deposit composition, since some types of deposit• are more volatile than others. For example, public funds are generally J.e88 stable than demand deposits of individuals, partenerships and corporations. Savings deposits, which are less sensitive to changes in money market rates, are generally more stable than time certificates of deposit and time deposits on open accounts. The magnitude of aeasonal variation in deposit volume also differs among banks. The schedules on pages 8 and 9 of the examination report are intended to illustrate, and to facilitate an analysis of, the deposit and liability structure of the bank under examination. While the schedules are uaeful, they cannot  !/  For the statutory definition of "deposit", see 12 U.s.c. Sec. 1813 (1), and for the definition of various types of deposits, see section 329.2 of the Corpora"tion' s Rules and Regulations.  Section L   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 1 -  U.abi U. ties (Revised 11-1-73)  289 accommodate every c;onceivable situation encountered nor embrace all of the possible variations that may be experienced. In cases where unusual and extraordinary circumstances are found, as, for example, where a bank's deposit structure evidences abnormal volatility due to the presence of an excessive volume of large denomination or out-of-territory certificates of deposit, the Examiner may highlight the condition by -1nseicting relevant supplementary data on page 8-a of the examination report and by making appropriate coment under "Examiner's CoD111ents and Conclusions." A brief discussion of each of the deposit schedules contained in the examination report follows. l.  Trend of Deposits  While overall deposit trend 1s significant, the type of deposits involved in any growth or decline is probably even ..,re significant. A material increase in deposit volume may result from, among other thinga, the acquisition of a few large accounts, numerous small accounts, secured public funds, or negotiable certificates of deposit. Each type has its own impact on the stability of the deposit growth and presents its own considerations and poSEibilities. The main point is that hasty conclusions as to the reasons for and effect of a growth or decline in deposits are to be avoided. 2.  Distribution of DePosits  With the exception of deposits in a bank's own trust department, which are treated sepsrately in the report schedule, classification of deposits as to types of depositor is in accordance with the Instructions for the Preparation of Report of Condition on Form 64. Comparison of the volumes in the various categories at the current and previous examinations is helpful in explaining the overall deposit trend between examinations. Thia schedule is also useful in analyzing the appropriatene■ a of the asset distribution. 3.  Interest on Deposits  The extensive growth in the volume of interest bearing deposits since 1960 haa increased interest expense on time and savings accounts to the extent that it has become a major expense of doing busineBB. The rates paid on time and savings deposits are frequently an indicator of an individual bank's competitive posture in the market. Considerable variation in rates paid on time certificates of deposit and on time deposits open account may occur because of the rates permitted for different amounts and maturities. Where a change in the rate hu occurred between examinations, _indication of the former rate and date of change will facilitate a comparison of the average time deposits with the total interest paid each year on time and savings deposits. 4.  Large Depositors  It is not necaaearily true that large depoaits are leBB stable than smaller deposits, but the potential danger exists that withdrawal of large deposits may impose a serious strain upon a bank's liquidity position. Frequently interbank deposits and the time and demand balances of political units are also large deposits.  The schedule of large depositors ia designed to indicate situations where a small number of depoaitora own a relatively large share of the bank's total deposits. The percentage of a bank's deposits which is reasonably stable and which may, at the discretion of management, be invested in longer term coDlllitments will depend upon individual circumstances. The banker who is familiar with the personal and business affairs of his depositors and their ties to the bank will usually be in a position to make an informed judgment. However, banks with a concentration of deposits in a limited number of accounts may have to devise a loan and investment strategy somewhat different from that encountered by banks with no concentration.  Section L   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  2 -  Liabi Zi ties  _ (Reuised 11-1-73)  290 5.  Fluctuations in Loans and Deposits  Deposit volume and loan demand are subject to cyclical and seasonal fluctuations. Cyclical fluctuations, or swings in the business cycle, are due to various and sundry circumstances and are somewhat difficult to predict. On the other hand, seasonal fluctuations are largely due to local or regional factors, generally follow a repetitive pattern and can be predicted with reasonable accuracy. An alert banker will recognize and prepare for these seasonal fluctuations. To the extent that deposit lows and loan highs may have an adverse coincidence, seasonal fluctuations present special liquidity management problema. B.  Certificates of Deposit  Commencing in the early 1960's banks have increasingly looked to, among other things, the use of certificates of deposit (CD's) - in many cases lar.ge denomination negotiable CD's -- as a source of funds. These CD's have many of the features of borrowings and can be under certain circumstances volatile in nature. In most inst&nces, CD funds are acquired from States and political subdivisions, corporations or individuals, but may also be acquired from other financial institutions. The fundamental distinction between a CD as a deposit or as borrowing is at best nebulous. In the final analysis, whether any CD is in fact a deposit or borrowing depends upon the intention of the parties as evidenced by the operative facts, and, unless there is clear and convincing evidence, documentary or otherwise, that the CD has been used by a bank as a vehicle for borrowing, Examiners should reflect them as deposits in reports of examination.,!/ C.  Brokered Deposits  The use of brokered funds has been responsible for abuses in banking and has contributed to some bank failures, with consequent losses to the larger depositors, other creditors and shareholders. At times, these brokered deposits are placed in banks as an inducement to grant related loans, out-of-territory or otherwise. In many cases, the linked loans are not of acceptable quality, but the bank, in its eagerness to obtain the brokered money, either ignores or lowers its credit standards in making such loans. In addition, the usually highly volatile characteristics of brokered deposits creates additional pressure on the liquidity needs of the bank. Furthermore, the brokered money placed in a bank is not ordinarily a true compensating balance since the bank has no right to offset the unpaid balance of a loan against &IIDIS deposited by a third party. In some instances, money brokers advertise yields on time deposits in excess of the amount banks can legally pay to depositors. In those cases, the banks usually pay the maximum amount of interest allowed and the money brokers pay an additional sum which is collected from a borrower whose loan is then placed in the bank accepting the deposits. The advertisement of excessive yields on deposits solicited for Federally supervised banks (whether the premium is provided by the bank or by others) is prohibited by substantially identical regulations issued by the Federal Deposit Insurance Corporation and the Board of Governors of the Federal Reserve System. To the extent that a bank takes any part in these transactions it is considered to be evading the purpose of the interest rate regulations. Where the bank pays a fee to a broker and knows or has reason to know that the fee is being shared with the depositors, the bank is also in violation of the interest rate regulations to the extent the yield to the depositor exceeds the maximum permissible rate.  The Corporation is concerned that such activities can result in "unsafe or unsound" situations which could adversely affect the overall condition of the  1/  Indeed as a result of the intense competition between financial institutions for funds, the aggressive use of CD's as a means of acquiring funds has become coDDDOnplace in the banking industry. Thus, as a practical matter, drawing technical distinctions between CD's as borrowings and CD's as deposits is in large measure academic.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -  ,1 -  ··lti-n.1,i1it.(,~,~~ ,,,•.•• ,11· ..... ,  .  11.: ,_., ..,·.,  291 bank. The Corporation's concern is not directed to the many types of money brokering transactions in major centers of banking and finance that are and always have been quite legitimate. II I.  Borrowings A.  General  Until the 1960' s bankers generally co,.fined their loan and investment operations to funds obtained from depositors and shareholders and refrained from extensive use of borrowed money. Thia traditional viewpoint probably arose from an identification of borrowings with bank failure, despite the fact that, where the two have been associated, in a majority of the cases it was unsound assets which prompted the borrowing and caused the subsequent failure. Historically, the Corporation has recognized that borrowing by sound banks to 1111et unusual withdrawals due to general economic factors or temporary special circ1DDBtances is not only permissible but constructive. In the course of engaging in money market transaction■ and competing for funds, banks in the major financial centers have employed certain borrowing techniques as an effective management tool and as a means of enhancing profitability. The techniques largely involve short-term borrowings through the utilization of Federal funds and instruments closely resembling borrowings, such as negotiable CD's. The use of such borrowing or near borrowing techniques requires an especially skilled and knowledgeable management as well as the exercise of extreme care to avoid the pitfalls coincident with an overextended borrowing position. In evaluating the borrowing policies and practices of a bank, Examiners should avoid inflexible conclusions and hasty criticisms. A thorough analysis as to the purpose of engaging in borrowing activity and the exposure to risk inherent in such activity for the bank under examination must be made by the Examiner. The soundness of a bank's borrowing policy and practices should be weighed and judged in light of its liquidity posture, asset condition, capital adequacy, profitability and other relevant banking factors. Thus, for example, if a bank needs to borrow money because of inept asset management, the bank is subject to criticism. All borrowings of a bank are to be set forth in the examination report, regardless of the form of borrowing, or how or whether carried on its books. Furthermore, borrowings should in all cases be verified by correspondence with the lender as to (1) form of borrowing, (2) amount, (3) date, (4) interest rate, (5) due date, and (6) security pledged. Minute books should be reviewed to ascertain whether authorization for borrowings was specifically granted by the directors in each instance and whether authorizations were properly noted in the minutes. B.  Types of Borrowing Aside from borrowing on its own promissory notes, other collDllOn forms  of bank borrowing include Federal funds purchased, loans and securities sold with recourse or under repurchase agreements, mortgages payable, and securities borrowed.  1.  Federal Funds Purchased  Strictly speaking, Federal funds are balances on deposit· with Federal Reserve Banks which, together with vault cash, constitute the legal reserves that member banks must hold in a certain prescribed ratio to their deposits. However, the term has been broadened to include excess reserve balances held by nonmember banks. The lending (selling) and borrowing (buying) of these balances is a convenient method employed by banks to avoid reserve deficiencies or to invest their excess reserves over a short period of time. For the buyer or seller of Federal Funds the transaction represents a one-day commitment at a specific interest rate without the risk of loss due to fluctuations in mafke t prices entailed in buying and selling securities. Borrowings of this nature are normally unsecured unless otherwise regulated by State statutes. It is essential that these transactions  Section L   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 4 -  Liabi Zities (Revised 11~1-?J)  292 be supported by adequate audit trails along with written evidence that banks involved are dealing as principals. 2.  Loans and Securities Sold with Recourse or Under Repurchase Agreement  For a discussion of when a loan sold with recourse or under a repurchase agreement is a direct form of borrowing or a contingent liability, refer to Section E of this Manual, "Capital Account Adjustments Not Shown on Books", paragraph III (e) (1). Similarly, for diacussion of securities sold under repurchase agreement, refer to Section G of this Manual, "Securities", paragraph IX D. 3.  Mortgages Payable  Fixed assets of a bank which are subject to lien■, are reflected at book value net of depreciation with the amount owed shown as ''mortgages payable" and the details of each transaction fully detailed on page 7 of the examination report, Banks have increasingly employed new methods of directly and indirectly carrying their fixed assets. A popular Mthod used is to tranafer title to the property (real or peraoual) to au affiliated or subsidiary corporation formed for that purpose with s leaae-back arrangement to the bank, Thus, the mortgage or lien debt becomes the liability of the bank' a affiliate or subsidiary and the rentals payable become a fixed liability of the bank. Nevertheless, aince the instructions for the preparation of examination reports require the consolidation of certain bank affiliates and subsidiaries including those owning bank premises, the fixed asset investment and debt liability of the bank is fully reflected. 4.  Securities Borrowed  "Securities Borrowed" is a contra item on a bank's balance sheet. The borrowing of securities is usually for the purpose of obtaining securities to pledge against public fund deposits. Ordinarily it is not necessary to detail securities borrowed either 1n the schedule for "Other Liabilities for Borrowed Money" or under "Other Assets". However, borrowed securities should be verified with the lender and a detailed list retained in the work papers. IV.  Secured and Preferred Liabilities and Pledged Assets Banks have long been required to pledge certain assets to secure U.S.  Government deposits, and most States authorize or require the pledge of assets to secure State and local government deposits.  Also, in many States. bank trust  department funds deposited in its own bank are required to be secured by the pledge of assets, or they are designated as preferred deposits. In the event of liquidation, preference of one depositor over another, sometime& implemented by pledged assets, gives certain creditors immediate access to the bank's most liquid assets. The principal impact of pledging requirements is pledged securities are immobilized and unavailable to meet requirement is aggravated by the fact that the securing of volves the pledging of assets in excess of the liabilities  on bank liquidity, as liquidity needs. The liabilities often insecured.  If considered appropriate, a complete listing of public funds may be included in examination reports, Although tracing of such funds is not required, when the Examiner believes verification is advisable, it is suggested that a statement of the account be forwarded along with the tracer as with "due to" bank balances.  Section  L   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - s -  Liabi Zi ties  (Revised 1:t:1-73)  293 V.  Other Liabilities A.  Bank Acceptances and Letters of Credit  llefer to Section E, "Capital Account Adjustments Rot Shown on Books", paragraphs III (b) and III (c), for guidance as to the appropriate treatment of bank acceptances and lettell!'S of credit. B.  Accrued Taxes and Other !xpenaea  The caption for thoae liabilities is self-explanatory. All banks irreapective of size are required to report income taxes on an accrued basis. In some instances, a bank may improperly carry accrued taxes as a "reserve" account. However, accrued taxes are a liability and should be treated as such in the examination report under the above referenced heading.  For additional diacuaaion of tax liabilities, refer ta Section E, "Capital Account Adjustments Not Shown on Books," paragraph II (c). C.  Dividends Payable  Cash dividend• become a liability as of the date of declaration and the amount involved should be removed from Undivided Profits and transferred to "Dividend■ Payable", :lllllllediately after such declaration aad included as such on page 2 of the examination report.  a liability account, such as D.  All Other Liabilities  All other liabilities not previously discuaaed should be included in "All Other Liabilities" on page 2 of the examination report.  Section L   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -  (! -  LiabiU.ties (Revised 11-1-73)  294 LIQUIDtTY 1.  Introduction  Liquidity may be equated with the ability to meet credit and loan demands without realizing unnecessary losses in the conversion of assets or incurring needless expenses.  A thorough analysis of a bank's liquidity position  is essential in determining its overall condition.  Factors influencing the liquidity position of an individual bank include asset quality and structure, trend and distribution of liabilities, earnings trend, and capital adequacy.  Local and national economic conditionsx and  monetary polic~es of the Federal Reserve Board"are also considerations but the major concern is the attitude and ability of the bank's management. Seasonal fluctuations of loans and deposits are found in nearly every bank but they can generally be predicted with reasonable accuracy on the basis of past experience.  The long range economic trend (stable, declining, or  expanding) will have a significant impact on area demand for funds and availability of deposits.  Large deposits and borrowers of large amounts  may have a significant impact on short-term liquidity needs.  Competition  for the available money supply, with attendant rising interest rates, may cause an outflow of time deposits seeking higher yields.  Earnings, or lack  thereof, directly affect the ability of a bank to borrow as does knowledge by other lenders of the banks asset-capital-management features.  Consequently,  the liquidity needs of an individual bank will vary over a period of time, and the liquidity needs of no two banks will be identical. A thorough knowledge of these factors is necessary if bank management is to  accurately assess liquidity needs and establish policies for the structuring of assets and liabilities to meet those needs, yet provide maximum safe investment in earning assets.  The liquidity position of a bank influences  its overall earnin&s and profitability.  Too much liquidity softens earnincs  and not enough liquidity can result in significant losses from premature conversion of assets or borrowing at high interest rates.  Further, insufficient  liquidity can result in bank failure and is usually a contributing factor. Funds to meet credilor demands and justifiable loan requests may be provided from conversion of assets, acquisition of liabilities, or sale of capital.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  295 -2Assets which provide liquidity are those which can be converted to cash quickly with little risk of loss even in periods of fluctuating interest rates.  Such  investments include federal funds sold, short-term U.S. Government and agency  securities, high grade short-term municipals, commercial paper and banker's acceptances, and other relatively short-term creditworthy loans and investments. In certain instances, particularly in banks with a relatively high volume of instalment credit, a restriction of credit policy or moratorium on new loans may provide needed funds through loan "run-off."  Additionally, agriculture-  oriented banks may find that they can "place" a large portion·of legitimate credit requests with correspondent banks.  Acquired liabilities can take the  form of federai funds purchased, certificates of deposit, Eurodollars, shortterm promissory notes, securities or other assets sold under repurchase  agreements, subordinated notes and debentures, and commercial paper issued hy bank-holding companies. Attention is directed to the comments regarding borrowings in Section L of this Manual.  In addition to these remarks, the more conm1only acknowledged  dangers to a bank's liquidity posture flowing from improperly managed borrowing are borrowing short-term funds to grant or support long-term loans, excessive interest rate competition (both on rates paid to attract liabilities and rates charged on loans funded by high-cost purchased liabilities),  -,r.,d-  the potential of reverse funds flows resulting from l)Jl.,_I•  confidence crises •A tightening of monetary policy by the Federal Reserve Board or other reasons,  Even though a bank is properly investing borrowed  funds, it should be remembered that some reserve borrowing capacity should always be-.maintained for emergency purposes. 2.  Liquidity Management  It is evident the attitude, practice, and policies of bank management toward liquidity will have a substantial impact on bank earnings.  All banks should  have a well defined policy with respect to loan-to-deposit ratios, asset liquidity and liability structuring.  The essence of liquidity management  is to equate the probable earlier loss of income with subsequen~ higher cost of funds and possible capital erosion.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  296 -33,  Examination Procedures  Liquidity position and management policies will be evaluated during each regular bank examination.  Procedures for evaluating liquidity and sununarizing  findings in the Report of Examination are outlined below. a.  Liquidity Analysis:  liquidity,  As indicated, a number of factors influence  To determine the actual liquidity position of a particular bank,  careful analysis of those factors is necessary,  However, it must be realized  even when analysis reveals an illiquid position, serious complications may be avoided indefinitely unless a demand is made on the bank for substantial funds, Any analysis of liquidity must necessarily be concerned with the structure, character (volume of public funds, large CD's, uninsured amounts) and trend of deposits; seasonal fluctuations in deposits and loans; amount of primary end secondary reserves; quality and maturity of the loan portfolio; quality and maturity spacing of the securities portfolio; and the volume of secured liabilities,  Consideration must be given the bank I s borrowing record and  o..U,.t,;,,...t ..._.._.,  .c.  ability to borrow~. to the adequacy of its capital, and to its earnings record, which impacts significantly on its ability to market additional capital. Each of these areas is normally reviewed during an examination, and is reported separately in the Report of Examination,  Combined, they reflect the bank's  .liquidity position and provide subjective evidence of bank management's attitudes, practices, and policies for liquidity management, A three-part procedure is provided to facilitate the evaluation of liquidity during the regular examination process,  The three parts (Liquidity Ratio,  Cash Flow Projection, and Corrective Measures) are designed to be used as additional pages in the examination report,  The Liquidity Ratio schedule  will be completed at e_ach examination, while inclusion of the other two schedules is optional, depending upon the results of the Liquidity Ratio test.  The utilized schedules will be placed behind the presently used  pages 2 and their continuations.  As indicated, these schedules are intended  as aids for the examiner in the overall evaluation of the bank's liquidity position and management.  The contents are not necessarily all inclusive of  factors affecting liquidity and liqui_dity management which may become apparent to the examiner during the course of an examination, nor are the schedules intended as a substitute for examiner judgment·,·   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  297 -4b.  Reporting:  The examiner wiV suinmarize his findings for the bank's  liquidity position and liquidity management in appropriate comments on Page A of the Report of Examination.  The "Liquidity Ratio" computed in the first  portion of the cit~d procedures will be included in the page A c011DJ1ents, liquidity is considered a problem by the examiner, appropriate comment• will also be made on page 1 of the Report of Examination.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  'When  298 MANAGEMENT I.  Introduction  The quality of management is perhaps the single most important element in the successful operation of a bank. Indeed, in apparent recognition of its significance, Congress included the general character of management among the six statutory factors the Corporation must weigh when passing upon applications. Management includes, of course, both the board of directors and executive officers chosen by the board. The board of directors is the source of all authority and responsibility. In the broadest sense, the board of directors is responsible (1) for the formulation of sound policies and objectives of a bank, (2) for the effective supervision of its affairs, and (3) for the promotion of ita welfare. On the other hand, the primary responsibility of executive management is the implementation of the board's policies and objectives in the day-to-day operationa of the bank. While the selection of competent executive manl!gement ia critical to the successful operation of any bank, over time its continuing health, viability and vigor are dependent upon an interested, informed and vigilant board of directors. Thus, the Corporation looka primarily to the board of directors for the proper conduct of the affairs of a bank. The main thrust of th:La Section :La, therefore, devoted to the fundamental reaponaibil:Ltiea vested in bank director■• II.  Directors A.  Selection and Qualifications of Directors  The board of directors of a bank typically includes the community's most succeaaful and influential citizens. To be selected to serve aa a bank director ia regarded aa an honor, for it denote■ an individual' a reputation aa being successful in hia own affairs, public spirited, and entitled to public trust and confidence. It is this latter attribute -- public trust and confidence and the public accountability implicit therein -- that distinguishes the office of bank director from directorahipa in moat other corporate enterprises, for bank directors are not only responsible to the atockholdera who elected thl!II but they must also be concerned with the safety of depositors' funds and the pervasive influence the bank exercises on the community it serves. The various State laws governing the qualifications of bank directors give express and implied recognition of the public interest character of banking inatitutiona. These statutory qualifications usually require the taking of an oath of office, unencumbered ownership of a minimum amount of the bank' a capital atock, and residential and citizenship requirements. The office of bank director ia fur~her circumscribed and regulated by a battery of Federal laws and regulationa!l, which, among other things, bar otherwise honorable and successful businessmen -- investment bankers I for example -- from serving as bank directors. prohibit membership on bank boards of convicted felons guilty of crimes involving personal dishonesty or breach of trust (without the prior consent of the Corporation), and, under certain conditions, permit involuntary suspension or removal from that office. These statutory qualifications and restrictions have no counterpart in general corporate law and both illustrate and emphasize the quasi-public nature of banking, the unique role of the bank director, and the grave responsibilities of that office. The position of bank director is one, therefore, not to be offered or entered into lightly. Aside from the legal qualifications and restrictions governing bank directors, ideally, each director should bring to that position particular skills and experience which will contrl.bute to the composite judgment of the group; he should have ideas of his own and the courage to express them; he should have sufficient time available to fulfill his responsibilities as a director; and he should be free of financial difficulties which might tend to embarrass the bank.  !/  Refer to comments under the sub-caption, "Federal Banking Laws and Regulations. Restricting Service as Bank.Directors," page 6 of this Section of the Manual.  Section M   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 1 ~  Management (Revised 8-21-?3}  299 Other desirable personal characteristics include: (1) knowledge of the duties and responsibilities of his office, (2) a genuine interest in performing those duties and responsibilities to the best of his ability, (3) the capability of recognizing and avoiding potential conflicts of interest which might impair his objectivity, (4) sound business judgment and experience that facilitates his understanding of banking and banking problems, (5) familiarity with the community and trade area the bank serves and economic conditions generally, and (6) an independence in his approach to problem solving and decision making. The one fundamental and essential attribute is personal integrity. Its presence assures a well-intentioned, interested and responsible director -- one capable of assuming the important fiduciary responsibilities of that office and representing fairly and equitably the diverse interests of stockholders, depositors and the general public, alike. B.  Powers and Responsibilities of Directors  The applicable laws of the jurisdiction under which the bank is organized provide that the board of directors will manage the bank. Typically, each director takes an oath of office that he will faithfully administer the bank' a affairs and will not knowingly violate or permit the violation of any banking law to which the bank is subject. The powers, duties and responsibilitie■ of the board of directors are usually set forth in the applicable banking statute■ and in the bank' a charter and by-lava. Generally speaking, the power■ of bank director■ upon anterina office may be claaaified aa follows: th■  (1)  Regulating the manner in which all business of conducted.  (2)  Appointing, officers.  (3)  Paying such dividend• aa may properly be paid.  (4)  Honestly and diligently administering the  (S)  Observing the laws under which the bank is organized; that is, not knowingly to violate them, or permit others to do so.  diami■aing  bank ahall be  at pleaaure, and defining the duties of  affair■  of the bank.  Some of these powers are original, that is to say, they are not fir■ t performed by any other persons or groups of persona; while SOile are supervisory in their nature. But whether original or supervisory, none may be delegated. Some of the more important duties are to: set policies and standard■ for loans and investments; fix interest rates to be charged on various types of loans and those to be paid on time and savings deposits; consider earnings, expenses, losses to be taken, bonuses, dividends, transfers to surplus, adequacy of capital funds, and suitability of banking quarters; set procedures for verification and evaluation of assets, confirmation of depoaite and proof of other  liabilities, and control of earnings and expenses; and consider and take measure ■ for management succession to assure adequate replacement of executive officers. In the final analysis, the board of directors is charged with the responsibility of the conduct of the bank. It is not expected to carry on the details of the bank's business; the details may be delegated to the bank's off ice rs -- but not delegated and forgotten. The power to manage and administer carries with it the duty to supervise. Thus directors must periodically examine the system of administration which they established to see that it functions; should it become obsolete, it should be modernized; should the bank's officers fail to function as intended, they sl\ould be replaced; and last but not least, the directors must supervise the conduct of the business of the bank. Somewhat independent of the responsibility to provide effective direction and supervision, but nonetheless important, is the directors' responsibility to avoid self-serving practices and conflicts of interest. Bank directore must order their conduct so as to place the performance of their duties above their purely personal concerns. Wherever there is a personal interest of a director which is adverse to that of his bank, the situation calls for the utmost fairnea■   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 86-817 0 -  -  ?, -  Nanag""'6nt (Revised 8-81-?:S)  77 - 20  300 and good faith in guarding the interests of the bank, Accordingly, a director muaL never abuse for personal advantage his influence with respect to the bank's management, nor wrongfully employ the confidential information available to him concerning the bank's clients, Of course, the same principles with respect to self-serving practices and conflicts of interest apply with equal vigor to the executive management of the bank, C.  Supervision by Directors  One of the most important functions of a bank's board of directors is to provide effective supervision over the bank's affairs, Its responsibilities in thi ■ area lie not so much in doing as in seeing that its policies are being adhered to and its objectives achieved. Indeed, it is the failure to discharge the supervisory duties which have led to bank failures and personal liability of directors for losses incurred. These responsibilities can best be discharged by establishing procedures calculated to bring to the directors' attention relevant and accurate information about the bank in a consistent format and at regular intervals. hom thi■ critical point, the rest of a director'• job unfolds. Any director who kaepa conta.porary on the basic etati■ tics of hie job -- resources, capital, loan-deposit ratios, depo■ it mix, liquidity poaition, general portfolio composition, loan limits, loan lo■aes and recoveries, delinquencies, etc. -- haa taken the fir■ t and indispenaable step in discharging his important reaponaibilitiaa. It is essential, therefore, that directors insist on receiving pertin■n~ information ■bout the bank in concise, meaningful end written form, and it i■ in the but interests of executive management -- indeed, one of its important respon■ ibili• tie■ to see to it that directors ere kept fully informed on all important utters and that the record clearly reflects that fact, Thia critical need for and dependence on information n■ cea■arily in· volvea • concern (and reapcinaibility) for the integrity not only of the specific information furnished but of the integrity of the system that ■uppliea it. All one writer on the subject has aptly observed: "It also mean■ ■ concern with aya• tema and procedurH which fill the claaaic three-fold teat of keeping temptation from the weak, opportunity from the ventursome, and auapicion from the innocent. It means a concern that bank examinations are not ellierciee■ in futility but rather valuable sources of admonition, intelligence and insight. And it means a concern with the legal framework within which the bank must operate." The conduct of directors' meetings in a businesslike and orderly manner is a significant aid to fulfillment of these responsibilities. Thia requires, among other things, regularity in attendance. Phydcal presence iteelf is necceaaary. and a director can get into more trouble by absence (without just cause)  than by attendance, for absence, like ignorance, is no excuse. Moreover, his attendance should be an informed and intelligent one, and the record ahould show it, If a director diBBenta •from the majority, he should, for hie awn protection, inai ■ t on hia negative vote being recorded. Careful and consistent preparation of an agenda for each directors' meeting not only facilitates the conduct of such meetings, but alao provide& the directors reasonable assurance that all important matter■ will come to their attention. Although lists of agenda items will undoubtedly vary from bank to bank, the following items fairly well typify the contents of such a liat: 1. Comparative statements of condition, monthly reports of income and expense, and significant ratios and percentages, including yield• on major categories of assets.  2. A list of all important loans made by officers or the Loan Committee since the last previous meeting, with special consideration for loans to directors, officers, employees and their interests. 3. Applications for loans exceeding the del,.gsted authority of of• ficers or the Loan CoDlllittee and which require approval of the board. The application should be in a systematic form and give full details  Section M   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - s  ~  Management (Revised B-22-13)  301 including but not limited to specific collateral, appraisal mark.et value, purpose of the loan, maturity, interest rate, of funds for repayment, total indebtedness to the bank, and experience with the borrower. Space should be provided for to denote their individual approval or disapproval.  or source previous directors  4. Overdue loans, overdrafts and cash items not in process of collection. 5.  Loan participations sold to another financial institution.  6. All investments in or sales of securities made since the last previous meeting. 7.  The bank's liquidity position.  8.  Tellers' "Over and Short" account activity.  9, Periodic reports of examination, recommendations, criticisu, and correspondence of superviaory authoritiea. 10. The distribution of commissions and bonuses on insurance sold on bank premises and on bank t:lme. 11. All charge-offs to determine statue, present recovery potential, and hasibility of further collection efforts, and charge~ffs at least annually of all known losses. 12. Designated depositories for re■erva fund• and evaluation of correapondent bank relationships. 13.  All types of insurance carried by the bank.  14.  All major contracts into which the bank proposes to enter.  15. The bank's internal controls, audit program and external security measures. 16 •  Personnel policies.  17.  Actions of other standing Committees.  To carry out its functions, the board of directors may also appoint and authorize committees to perform specific tasks and supervise certain phases of operations. In most instances the name of the committee, such ea Loan Committee, Investment Committee, Examination Committee and, if applicable, Trust Comittee, identifies its duties. Of course, utilization of the committee process does not relieve the board of directors of its fundamental responsibilities for the actions taken by those co11111ittees. The Examination Committee deserves special attention in this context. There are few ways that directors are better able to inform themselves of their bank's condition and problems than by their own examination. An actual handling of the assets and a first-hand inspection of the records often give directors an acquaintanceship with their bank that cannot otherwise be obtained. Even the most cursory directors' examination is often better than none. When these functions are properly exercised and a:i:e integrated with the Committee's res.ponaibility for careful review and consideration of official reports of examination and correspondepce from supervisory agencies, the Examination Committee can be an effective instrument of sustained supervision. Of course, there is no substitute for periodic unannounced audits conducted by qualified independent auditing firms in effectively monitoring the integrity of the system that generates, catalogues and delivers the information on which the board is so vitally dependent in the performance of its supervisory functions. Perhaps, in response to the increasing complexities of automated banking and a greater awareness of the potential consequence .,f unfulfilled responsibility in this area, enlightened directorates, even among smaller institutions, have to an increasing extent added the independent outside audit as an essential and integral part of their supervisory overview of the bank's affairs.  Section M   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 4 -  Manayement  (Revised 8-21-?3)  302 D.  Legal Liabilities of Directors  In general, the directors and other corporate officers of a bank may be held personally liable for: (1) a breach of trust, (2) negligence which is the proximate cause of loss to the bank, (3) ultra vires acts or acts in excess of their powers, (4) fraud, and (5) misappropriation or conversion of the bank's assets. From the standpoint of imposing directors' liability where the facts evidence that fraud, misappropriation, conversion, breach of trust or the commission of ultra vires acts may be clearly shown, a relatively simple situation presents itself to the extent that liability obviously exists. Difficulties usually arise, however, in cases involving negligence (or breach of duty) which fall short of breach of trust or fraud. Directors' liability for negligent acts is premised on (1) conmon law principles for failure to exercise the degree of care which ordinarily prudent men would exercise under similar circumstances, and/or (2) noncompliance with applicable statutory law, either or both of which proximately cause loss or injury to the bank. Statutory liability is fairly well defined and precise. Common law liability, on the other hand, is somewhat imprecise since the failure to exercise due care on the part of a director depends upon the facts and circumstances of the particular case. A di rec tor' a duty to exercise due care and diligence extends to the management, administration and supervision of the affairs of the bank and to the use and preservation of its assets. Perhaps the most common dereliction of duty by bank directors is the failure to maintain reasonable supervision over the activities and affairs of the bank, its officers and employees. The following have been found to constitute negligence on the part of directors: (1) an attitude of general indifference to the affairs of the bank, such as failing (a) to hold meetings as required by the by-laws, or (b) to obtain a statement of the financial condition of the bank, or (c) to examine and audit the books and records of the bank to determine its condition; (2) failure to heed wamings of mismanagement or defalcations by officers and employees and to take action appropriate to the situation; (3) failure to adopt practices and follow procedures generally expected of bank directors; (4) tuming over virtually unsupervised control of the bank to officers and employees in reliance upon their supposed fidelity and skill; (5) failure to acquaint themselves with examination reports showing the financial condition of a c0111Pany to which excessive loans had been made; (6) ssaenting to loans in excess of applicable statutory limitations; (7) permitting large overdrafts in violation of the· bank's by-laws; (8) nlaglecting to require a bond of a cashier who had custody of all of the funds of the bank; and (9) representing certain assets as good in a report of condition which assets were called to the directors' attention as doubtful by the primary auperviBor nth directions for their immediate collection or removal from the bank. In the final analysis the liability of the bank director for acts of negligence rests upon his betrayal of those who reposed trust and confidel\ce in him to perform honestly, "diligently and carefully the duties of his office. While the applicable principles involving directors' negligence (or breach of duty) are easy enough to state, their application to factual situations presents difficulties. In essence, the courts have judged the conduct directors "not by the event, but by the circumstances under which they acted"! and have generally followed what may be called the rule of reason in imposing liability on bank directors, "lest they should, by severity in their rulings, make directorships repulsive to the class of men whose services are most needed; or, by laxity in dealing with glaring negligences, render worthless the supervision of directors over •.• banks and leave these institutions a prey to dishonest executive officer■" .J/  01  The following quotation represents a brief recapitulation of the law on the subject (Rankin v. Cooper, 149 Fed. 1010, 1013 (C.C.W.D. Ark. 1907)): "(1) Directors are charged with the duty of reasonable supervision over the affairs of the bank. It is their duty to use ordinary diligence in ascertaining the condition of its business, and to exercise reasonable control and supervision over its affairs. (2) They are not insurers or  lf 1/  Briggs v. Spaulding, 141 U.S. 132, 155 (1890), 35 L. Ed. 662, 672. Robinson v. Hall, 63 Fed. 222, 225-226 (4th Cir. 1894).  Section M   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 5 -  Management (R11ui.aed.. B-21-73)  303 guarantors of the fidelity and proper conduct of the executive officers of the bank, and they are not responsible for losses resulting from their wrongful acts or omissions, provided they have exercised ordinary care in the discharge of their own duties as directors. (3) Ordinary care in this matter as in oth"r departments of the law, means that degree of care which ordinarily prudent and diligent men would exercise under similar circumstances, (4) The degree of care required further depends upon the subject to which it is to be applied, and each case DRJSt be determined in view of all circumstances. (5) If nothing has come to the knowledge to awaken suspicion that something is going wrong, ordinary attention to the affairs of the institution is sufficient, If, upon the other hand, directors know, or by the exercise of ordinary care should have known any facts which would awaken suspicion and put a prudent man on his guard, then a degree of care commensurate with the evil to be avoided ia required, and a want of that care makes them responsible, Directors cannot, in justice to those who deal with the bank, shut their eyes to what ia going on around them, (6) Directors are not expected to watch· the routine of every day's busineaa, but they ought to have a general knowledge of the manner in which the bank' a business is conducted, and upon what securities its larger lines of credit are given, and generally to know of and give direction to the important and general affairs of the bank. (7) It is incumbent upon bank directors in the exercise of ordinary prudence, and as a part of their duty of general superviaion, to cause an examination of tha condition and reaourcea of tha bank to be made with reasonable frequency," E,  Federal Banking Laws and lt.egulationa Restricting Service aa Bank Directors 1.  Federal Deposit Insurance Act Restriction•  Section 19 of the Federal Depoait Inaurance Act (12 u.s.c. Sec. 1829) provide• that, except with the written consent of the Corporation, no person shall ■erve ae a director, officer, or employee of an insured bank who baa been convicted of any criminal offense involving dishonesty or breach of trust. Section 8 of the Federal Deposit Insurance Act (12 U,s.c. Sec. 1818) .provides for the removal or auapenaion of directors, officers and others under certain prescribed circumstances (Sea Section V of this Manual for treatment of Section 8) • Many States have aial.lar statutory provisions. 2.  Securities' Brokers  With certain exceptions, Sect;ion 78 of Title 12, u.s.c., provides that no officer, director, or employee of any corporation or unincorporated aaaociation, nor partner or employee of any partnership, and no individual employed or engag!E!d in the general brokerage business shall serve at the same time as an officer, director• or employee of  a bank which is a member of the Federal lt.e■erve System. Thia prohibition does not apply to nonmember banks. Neverthelesa, in applications fer Federal deposit insurance, which contemplate securities' brokers serving as directors of banks, the Corporation may require written assurances designed to maintain s separation of their roles. To preclude the poBSibility of improprieties or conflicts of interest, auch assurances may also be required of securities' brokers who are elected directors of operating banks. 3.  Interlocking Bank Directors  The restrictions on interlocking bank directorates provided by the Clayton Act, and extended to member banks by Regulation L of the Federal Reserve Board (12 en Part 212) , are not applicable to insured nonmember banks. However, where a director of a nonmember bank also serves as a director of a member bank, the provisions of Regulation L may apply. ·  Section M   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 6 -  Management (Revised 8-21-?llJ  304 F.  Advisory Directors  The by-laws of an increasing number Jf banks contain provisions for mandatory retirement of directors and officerb upon reaching a certain age, e.g., 65 or 70, Some State supervisors have promulgated regulations along the same line. In the absence of such restrictions, a naturally sensitive situation develops where the value of. a director may be steadily diminishing due to the infirmities of age, Oftentimes such an individual does not volunteer retirement, and the bank may be hesitant to seek it. Some banks have met this situation by establishing a position of honorary director or similar title upon the reaching of a predetermined age, Generally, the honorary director attend• board meetings as he wishes and offers advice on a limited participation basi■ ; however, he has no formal voice or vote in proceedings, nor doee he usually have the responsibility or the liabilities of the office, except where there may be a continuing connection with a previous breach of duty as an official director. Directors of "One Kan  G.  B.tlnka"  Superviaory authoritie■ ilre properly concerned about the "One Man Bank" wherein the bank'• principal officer and ■tockholder dominate• all phase• of a bank'• policiee and operations. Often this situation etema from the personality makeup of the principal officer, but is ueually abetted by an apathetic board of director■, Many bank director■ when firet elected have little or no technical knowledge of banking and feel dapandent upon othar ■ more knowledgeable in banking matters. When this feeling becomes deep ■sated and widespread, a managerial vacuum ie creatad which an overly aggre ■■ ive officer may fill and achieve, thereby, a position of dominance. Thie development i■ facilitated by the fact that director■ are very oft■n nominated by bank officar■ to whom they feel indabtad for the honor, even though atockholdara elect th•. Over the year ■ an officer can recoaiend 80 many of tha diractors on a bank's board that his influence tend■ to dominate the group, There are at lea■t two potential dangers inherent in a "Ona Man lank" situation: namely, (1) incapacitation of the dominant officer may deprive the bank of competent manag811ent, and, becau■e of the iaediate need to fill the manqarial void thus created, may render the bank wlnerable to diahon■■ t or inc011p■tent replac-t leader■hip; and (2) probl• cues re■ulting from mismanagement of ■uch • bank's affairs are more difficult to ■olve through the normal course of supervisory afforte designed to induce corrective action by the board. R.  Compensation of Directors Director ■ are entitled to bank bu ■ ines■, and,  to rea■ onable compensation for the time spent attending at the discretion of the board, directors serving on principal cOlllllittees might proparly receive extra fee ■ for the additional work. III.  Changes in Control  From time to time, probl- have ■risen stenaing from the acquisition of control of in■ured banks by irreeponaible or untru■ tworthy per ■ ona. To alert the Federal banking qenciee to a chang■ in control of insured banks under their respective jurisdictions, the Congress in 1964 enacted the present section 7(j) of the Federal Depo ■ it Insurance Act (12 U.S.C. Sec. 1817(j)). Under this statutory provi■ ion, the president or other chief executive officer of any insured bank ia required to report promptly to the appropriate Federal banking agency the facts about changes occurring in the outstanding voting stock of the bank which will result in control or a change in control of the buk. The tera "control -•n• the power to directly or indirectly direct or cause the direction of the management or policies of the bank." A change in ownership of voting stock which would re■ ult in direct or indirect ownership by a stockholder or an affiliated group of stockholders of leSB than 10 percent of the outstanding voting stock is not considered a change of control. However, any doubt aa to what constitutes a change in control in a given instance must be resolved in favor of reporting the facts to the appropriate Federal banking agancy. a■otion  It   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 7 -  M:inaqement (Revised 8-21-78)  305 Section 7(j) of. the Federal Deposit Insurance Act al ■o establishes reporting requirements in c■ses where a loan or loans are -de by any insured bank which are or will be secured by 25 percent or a,re of the shares of the voting stock of any other insured bank. In such cases, the president or other chief executive officer of the lending bank must report the fact promptly to the Federal banking agency of the bank whose stock secures the loan. No report is required, however, where the borrower has been the owner of record of the stock for one year or a>re, or the stock is that of a newly organized bank. Whenever there is a change in control, each insured bank is also rerequired to report promptly to the appropriate Federal banking agency any changes or replacements in the chief executive officer or directors occurring in the next 12-month period, including in its report a statement of the past and current business and profeeaional affiliations of the new chief executive officer or directors. The three Federal banking agencies are required to furnish each other with copies of the reports filed with each of them, Through such notification the supervisory agencies are provided an opportunity to investigate those changes in control which might be inimical to the bast interest ■ of the bank or its depositors. The law does not require supervisory approval of changes in control of nanagement or confer any veto power over bank ■al-■• The intensity of the investigative follow-up to changes in control is geared to what the Corporation know■ or hes reason to believe concerning the new ownership and is thorough with reapect to new and unknown owners. The provisions requiring notification of the banking agencies of changaa in control have prompted certain bonding companies to add an endor•-t to their blanket bond requiring similar notification, lxadnar■ should be alert for the inclusion of such an endorsement, and when it is found, should acquaint banker■ with the possible consequences of failure to report promptly to the insurer any changes in control. IV.  Indebtedneaa of Directors I Officers and Their Interests A.  Management  Loans  Loan■  to directors, officers, and their interests 1111st, of necessity, be cloaked in circwnspection. The position of director or officer is no license to special credit advantages or to increased borrowing privileges. On the contrary, it increases his borrowing responsibilities. Moreover, bank directors bear greater then normal responsibility in approving loans to fellow directors, officers, and their interest&. Such loans should be reasonable in number and dollar volume, both individually and collectively, and should be -de only after evaluation by accepted credit standards applicable to all loans. They should involve no preferential treatment, especially with respect to interest rates, maturity terms, amortization requirements, or the quality  and amount of collateral pledged. !!_/ Management loans should be judged upon their own merits and classified accordingly. They should not be adversely claaaified merely because they are management loans. In smaller centers particularly, a bank directorate ia often composed of many of the ..,at reputable buaineaamen of the community. Their businesa operations will, in many instances, neceaaiatate bank loans, and these will ordinarily be 8""'ng a bank' a beat asset■ • Sinca directors usually do much of their deposit business with their bank, this carries with it an obligation to meet their reasonable credit demands.  Of course, bank policy which provi4es to all personnel or to all members of a class of certain personnel legitimate fringe benefits aesociated with employment in the bank is not intended to be included within the prohibition with respect to preferences.  Ssctlon N   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 8 -  Management (Revise'd 13-4-?3}  306 On the other hand, there are many inetance• where i-.proper loan• to officera, directora, and their intereata have reaulted in aerioua loaaea, Unfortunately, when the eoundneH of a unaa-nt loan became• queetionable, a ..i,arraaaing eituatlon often reeulta. Management loans frequently are not eubject to the • - frank diecuaeion uda of other loan■• Bak directors •Y -ant to auch loana 'llhen the loan• are knovn to be unwarranted rather tha oppoae a cloae peraonal or buaineaa friend, Moreover, directors 'llho aerve on a board in order to increue their opportunitiea for obtaining bank credit are reluctant to object to credit exteneiona to their colleagues,  Many banking 1 - , recognizing the potential danger of aanagement loana, have placed lillitationa on their uae. Some boards alao take apacial precaution• in connection with manag-t loane,  a.  Loana to Peripheral  Intareet ■  Aa a general rule, extenaiona of credit to relatives of the 11111U1gement ad to fraternal, charitable, and other aimilar organizationa with which the unageaant uy be aa■ociated need not be listed in reports of examination, ••laing there 1a no legal liability on the part of director• or officers,  However, vhen auch credit■ total a aubetantial aount or are of inferior quality, they ehould be noted, It ••t be recognized too that the proceed• of a loan to a vife, brother, or aon of e director or officer uy in fact be for the benefit of that director or officer, If the..Ellllllliner baa reaeon to believe that auch ia the cue and that the loan is acc-dation borrowing, he should uke a through inveetigation, Occaaionally, directors or officer■ will participate with other local people in an acc.......tation endorument of a loan to a civic, fraternal or religioua enterpri■e either on a full or limited liability baaie, If the endoreement ia full and unqualified, then the entire aaount vould be included aa director and officer liability, although duplicatione vould be in-volwd llhere 110re than one director or officer of a bank participated. At ti-, howver, the endor■era clearly limit their liability to a apecific ...,,..t which if parmiadble under applicable laVII, would limit thi■ indeb teclne- ■ to the ...,,..t of the ue.-d liability, The credit quality of euch a loan vould, of courae, be appraiaed on it• own merit■, eub■ tantial  Inetancea ari■e where c-paniea or corporations mey be regarded both of a bank and aa interests of manag....,nt. In order to avoid duplication, extensions of credit to auch c~aniea and corporation■ should be lieted and extended only in the schedule on "Affiliates," A direct loan to a bank director or officer aecured by aaeigned etock of an affiliate ehould, hCllf8ver, be llhown in the schedule of indebtedness of directors and officers with a __,randua notation on the affiliate schedule, (For a di■ cuBBion of affiliate■ and the liaitationa applicable to loans to affiliates, ■ee "Section N - Affiliates" of this Manual,)  aa  "affiliate■"  V.  Examination Procedures  In the course of conducting an examination, Examiners oust seek to ascertain the extent to which directors are discharging their duties and reaponeibilitiea, A review and analysis of the following data will be of assistance to Examinera in accomplishing that task, A,  Articles of Incorporation and By-Laws  The Examiner should read the articles of incorporation and by-laws at the initial examination of a bank, A brief transcription of the important provisions of both should be made and retained with the summaries of the minutes of directors' ..,etings. At each subsequent examination, the ExBllliner should refer to the transcriptions of the articles and the by-laws.  Seati.01.1 }I   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 9 -  307 B.  Shareholders Meetings  The minutes of the shereholders' meetings should also be briefly transcribed by the Examiner. The uterial covered in the tranacription should include, BIIIODg other thing■, the nlllllber of shares of each cla■a of stock ¥Oted at the last election of the directorate, whether or not proper notice and proxy requirements were. followed and whether the actions taken by the shareholders were 1n all re■pscts in conforaity with the law. c.  Directors' Minutes Book  The directors' al.nutes book should contain a record of all official action taken by the board at regular, apecial, and annual meetings, auch a■ the approval or ratification of all loans granted, investments purcha■ed and sold, and other transactions of an important nature. Thus, the Exaat.ner should review and make a brief transcription of the directors' minutes book early 1n the examination, conaencing with the first . .et1ng held following the last examination. The transcription sheet should 11st all directors, including those elected or appointed since the la■ t aX811ination, and an indication of the attendance record of each. Thereafter, a brief re■- of board action taken on at l ■ a■ t the following items ahould be included: 1.  Loan■  2.  Securities  and  Discount ■  Mde.  transaction■•  3.  Cash itellB, overdrafts, expenaea and over and ahort  4.  All insurance coverage.  account■•  5. The last report of exaination of and correap1111danca from the supervisory authorities. 6.  Any audits.  In addition to describing briefly such customary actions of the 'board, the transcription should briefly chronicle unusual board action■, such ea: 1.  Actions amending the by-laws •  ·2. Dividend declaration■, including the data declared, 811Dunt, and payment date. 3.  Building plans or  4.  Problems in¥Olving potential losses.  purcha■ ea.  In many instances if the board utilizes the comaittee concept, the directors' minutes will merely indicate, v1 thout detail, that a certain comitee report was read and approved. In such a case, it will be neceaaary for the Examiner to review and briefly transcribe the minute■, if any, and -report of auch c:omittee.  Section M   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 10 -  ~ement ( R e ~ 1'~-73)  308 SUPEll.VISOltY SECTION The Supervisory Section of examination reports include■ information on the following: (1) man■ g-nt and control; (2) competition; (3) matters exclusively of intereat to the Corporation and to succeeding Bxainers; (4) subjects which are controversial due either to the nature of the subject or to the lack of aubatantiating facts; and (5) other aspect■ of an exam:l.nation which aay beat be left unsaid in tha open section■ of exmination report■• The open c011111811ta should not make any reference to• information in tha Supervi■ory Section. Thia could compromise it ■ confidential atatua.  I.  Coments and Conclusions (Paga A)  The "Coaaent■ and Conclusions" of the Superviaory Section ahould normally be confined to appropriate remarks on the following:  1.  The rating of manquant, baaed upon a short aupporting ..-ry.  2.  The per■on(■) with whom examination findings were diacu■aed.  3. Coaaenta of the Examiner relative to supervisory action to be taken following the eUllination. Reference aay be made to manag-t change■, capital, dividend policy, liquidity, general aaaat condition, or other matters. 4. Circ111111tance■ pointing toward ujor policy adjuatant■ or operational changaa which woulcl not otherwiae be kDOIID to the Corporation. S. Amplification of certain aatters included in the open aection that require additional information of a confidential nature to provide better understanding. (Care ■hould be taken to avoid pointleas duplication.)  6. A.  Aay departure from the scope of normal examination procedure.  Management  Rating■  The definitive rating of management (directors and principal officers) represents the essence of the Examiner'• finding■• It ia not only of material benefit in examination follow-up, but also carriaa weight in the consideration of varioua kinda of application■, i.e., for branches, changes of location, ezerciee of trust powara, retirement of capital, etc. Accordingly, the management rat:1.n& auat reflect careful and thoughtful analyaia, and ■hould g1ve con■ ideration to the extent and character of the reaponaibilitiea faced by the aana1-t in the aiven situation. The five management ratings which may be a■aigned are GOOD, SATISFACTORY, FAIR, UNSATISFACTORY, and POOlt. The rating given in a particular case ia to be shown in the ''Bxaid.ner'a Co,ment■ and Conclu■iona", and should be supported by a ahort s.-ary ■t■tement. The name(■ ) of the individu■ l(a) of priury importance in the management auat be stated and concise estimate made of hi ■ (their) ability. Weakne■aaa should be noted. The following definition■ of the five ratings are offered as aeneral guides in assigning ratingo: 1. GOOD 1a the highest rating and ia indicative of aanag■-ent which ia exceptional and outstanding in almost every reapect; 2. SATISFACTORY represent■ management which ia coapetent and able to operate a bank along generally safe linea; 3. FAIR management is neither entirely ■atiafactory nor unaatiafactory, and ia of only med.iocre ability or character; 4. UNSATISFACTORY haa reference to a 1111118..,....t of pnerally inferior ability or character, or which may be definitely losing around;  Ssoti.on  Q   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 1 -  309 5. POOR is the l0118at rating and appliea to a hazardous 118J18gement situation. B.  Factor. Cona1clerecl in Rating lfanaaeMnt  Ho exact for.ala exiata for the precise rating of -aement. The best that can be done is to recognize the varioua dimenaiona by which 11111111gement reveals ita perfo1'1118Dce, and to evaluate them along a acale that cullliDates 1n an overall rating. Fundamental is the nece■■ity to evaluate - a - n t in the situation in which it ia found, and not in IIOIIB hypothetical situation. There are uny circumatancea that illustrate this principle, For exampls, a 118J18gement could be above average in a 811811, uncomplicated bank but mecliocre at best in a large institution; a given 118J188-t could be wholly aati■factory in a bank with traditionally aound policie■ but be unable to cope with a aerioua problem situation in anothar bank; an ultraconaervative 118D88elllellt could capably operate a bank that i■ larply a depoaitory but would be loat 1n a reaaonably competitive bank; a 1118D8g81181lt that had difficulty in a ralativaly ■tatic economic area might do well in operating a aillilarly-aiaed bank with:ln or on tha fr1nge of a dynamic growth area; and a 118D8881181lt can look aood when all i■ favorable but lo••• it• luater when adver■ity atrik■a,  Beyond thia, there are certain specific :lnto account:  factor■  that need to be taken  1, Tha ovarall affactiveu■a of •••.....,• a■ ahown by it ■ g8D8ral and tectmical ability, ita uperienc■ and capacity, and it■ pneral attitude nd character;  2. Tha a-■ ral condition and perforunce of the bank, teking care that tlut -agemnt rating doaa not contradict the evident condition of the bank; 3. Attendance to tha c«-mity; 4.  raaaonabl■  and legitiwate cradit needa of the  Ability to uat reaaonable co-petition;  5. Tha aiae of the bank, recognizing that nallneaa ia not 1n itself ground for a law 118D88_,,t rat1ng, Bulliner■ ahould recognize that a aowevbat higher level of IU!winiatrative ability and technical COlllpetence is required to 118D8ge ■ucceaafully the affairs of a large metropolitan in■titution than ia required in the caae of .-all baDka;  6. Tha quality of a bank'• records and it■ :lnternal routine ahould not be &1ven esceaaive amphaaia in rat1ng it■ IUD8881118Dt;  7. In uking hi■ judpunt, the Bxciner ahould guard apinat being influenced by paraonal prejudic■a or en uncooparative attitude OD the part of IUD88-t; and 8. The rat1ng given at the preced1ng .....-ination abould not be conatraining. c.  Meneswnt Cbu.aaa  Tha inability or umrillinpeH of the wanaa-nt in a weak bank to br1ng about 1mpr-t frequently defeat■ tha afforta of supervi■ors to effect change■ in unaati■factory situation■, In ■uch caau, 1mprOV81181lt in a bank's condition sometimes requiraa a change in unas-t, or intarnal ahift■ in duties  and  ruponaibilitie ■,  llac-ndationa for change■ in a bank'• wanagement, ahift■ in reaponaibility, or other illprovement■ relativa to personnel are to be confined exclusively to the Superviaory Section of the all8Wination report. lfanagewent changes are utter• which require the cloaest cooperation 8WOD8 the supervisory authoritiea and Exa-iners generally should not di■cuH -enagewan• changes without consulting the Regional Office.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - z-  8upel"l)i.aozoy Section (Rsvi.eed S-11-76)  310 All management changes recoaencled aa desirable or neceBBary by Examiners must be supported by definite reasons, It must be shown that the present management of a bank is responsible for certain specific policies which are seriously and adversely affecting the bank'• condition, and that correction of these policies or condit.ions is not possible under the present leadership. Since it is easier to recommend than obtain a dgnificant change in management, this approach must be viewed aa a last recourae, and reaorted to only after real effort& have been made to aeek improvement in managament policiea without actually changing personnel, D,  ManaHrial Succeaaion  Proviaion for managerial succeHion is important, but the lack thereof should not be overly emphasized in the evaluation of management. The particular circumatancea ahould be cloaely evaluated, If, for e,umple, the bank has a liberal aalary acale and ia willi.ng and able to pay for the bank officer it wants, probably no difficulty would be encountered in finding a auitable replac-t, If, on the other hand, the bank baa a restrictive aalary program or the position is unattractive for other reasons, the job of replac.,....t ia more difficult. It is particularly difficult in small bank■ with limited potential and little earning■ capacity, unlea ■  Examiner■' coaaents concerning lack of manaaeaent succeaaion ahould, the aituation ia a arave one, b■ confined to the Supervi■nry Section,  Directors'  B,  Meeting■  A bank' ■ board ia responaible for aeeing that the bank i■ properly operated, and important matters needing corrective action can often be resolved by direct presentation to the convened board prior to the clo■e of the examination.  While a copy of each report of examination is forwarded to the bank's board of directors, ton often that group gives it very limited conaideration. A glib managing officer moreover can at times misrepresent· critici■ma to the directors and delude them into believing that the Examiner baa ezagaerated the ■eriousneaa of hia findings. Thia can result either from an intentional effort at deception by the chief executive officer or because he baa not fully comprehended the meaning of critici■ma azplained to him by examining peraonnel. Bxcept in instances where authority baa been delegated by the B.egiona:l Director, the Examiner should consult with the B.egional Office before calling a board -•ting, Ordinarily, meetina■ with the board of Director ■ ahould be bald at the conclusion of all examinations of problem banks, A -•ting of the board may alao be required when experience and instinct tells the Examiner a likelihood exists that the bank will be added to the problem list or will be earurked for other special supervision, Additionally, where there is a substantial volume of claBBified aaaets, low capital or other areas of :Important criticina, a board meeting may be desirable. Thia is particularly trua when the trend baa been unfavorable and previous adaonitions have gone unheeded, In states where the supervisory authority makes it a practice to hold board meetings at each examination, the Examiner should feel free to participate in any such program. Moreover, an Examf.ner should always accept invitations to attend board meetings,  II.  Manaaeaent and Control (Page B) Question 1  The control of a bank often determines the quality of bank management and ultimately the condition of the bank, Accordingly, a full re■ponae to Question 1 on Page B, which relates to financW control of the bank, is essentW, In suspect or problem aituations, the names and holdinga of important shareholders who are not directors, officers, or employees, ■Dd the names and holdings of other ahareholders closely allied or related to directors, officers,  Ssotion·  Q   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - ;s -  ~ s o e y Ssotion (ll9!Jissd 6·11-?8}  311 eaployees, or other important shareholders, provide valuable information and should be inserted on a schedule following Page B, usually•• a condensed list of all stockholders with annotation aa needed. In all cases where an individual actually exercises control of management, without bearing a title sa a director or officer, he should be listed and adequately described on Page C following the usual treatment of director ■, officers, and employee ■• At timaa the controlling element in a bank is one dominant individual who may or may not have a significant financial interest in the bank. Whether such domination 1a beneficial or harmful, it is important that examination reports indicate its extent, character, and effects. In the case of banks which are significantly low in capital, more complete treatmant of the matter of stock ownership and financial responsibility of shareholders is necessary. Question 7 Thia question ia designed to point up aituations in which directors rely upon certain active officer■ or directors to manage the bank. Anawera should be consistent with coments contained on Pages A and C. Question 8 Any general lack of harmony among directors, officer■, and employees should be noted hers, and specific instances of serious friction should be described in detail on Page A. When disharmony has been reported in prior r6porta of e:118111ination, the Examiner ahould be particularly alert to indications aa to whether the situation hsa improved or worsened. Question 9 Of paramount importance is the executive management structure of the bank. Any indications of approaching changes in unagement personnel should be reported with reasons therefor being given if known. Question 10 Coalllenta with respect to either exceHive or inadequate compenaation paid officers and employees should be baaed on the Examiner's opinion of the abilities of the personnel, the size and earnings position of the bank, ita competitive employment situation, amount of t:lme devoted to the bank, and other circumatancea. Specific notation of instances in which certain personnel appear to be overpaid should be made. It 1a recognized that all coaaents 1n connection with the adequacy of compenaation will be -rely opinion, but it is important that such opinion have a solid bsaia of fact and not be predicated upon liku or dislike■ for certain individuals. Quution 11 Aa indicated elaawhare in the Manual, close review of -tensions of credit to atockholder ■, directors, officer■, employee ■, their interests, or affiliated organizations is of vital importance.  III.  Directors, Officers, and l!mployeea (Page C)  The treatmant of bank management on Page A of the examination report ia in general terms. In this schedule on Page C, however, treatment of the management is more in terms of details aa to the abilitiee and duties of the specific individuals who are directors and principal officers of the bank under examination. There will be times when considerably more detail will have to be given on Page A with a crosa reference to Page C to avoid duplication. Thia schedule is of great importance to the Regional Office in that it provide• valuable background information which is helpful with respect to conferences and other corrective efforts. It also gives field Bxaainera advance knowledge concerning management and facilitatu the examination process. In addition, the schedule enables succeeding Examiners to anticipate aituations and to avoid embarra■-nt and unnecessary diacuaaiona with uninformed member■ of a bank's ·staff.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 4 -  Supez,v{.so~y Saotion (&aviaad S-11-?/S}  312 The financial responsibility of bank director■ and principal officers •Y be • very important consideration, In prea■nting financial data, it i■ important that an l!zaminer indicate the source of hi■ infor•tion and hi■ opinion of ita reliability, IV.  Miscellaneous Information (Pagea D and Dl)  The pages on miscellaneous information in the Supervisory Section of the Report contain 18 questions. Comments concerning a f - are ■et forth below.  Question 5  (a). Unusual factors, such ■a a crop failure, lo■a of a leading local employer, cut-throat competition, or an ovar-banked situation should be described here. (b). A declining trend in deposit volume, whether absolute or relative to other banks similarly situated, -y reflect a ahortage in the deposit accounts of the bank. Many large defalcations have been aiplalecl by such a trend,  Question 6 Large deposits have in the paat beea a fertile field for bank embezalera. Queation 7 Average■  that are  inconai■tent  with prevailing  rate■  •Y uulicate de-  falcation, Queatiqn 9 The scope of an examination, including proofs, -y vary according to (1) the internal audit program of the !lank, (2) the ■cope and reeeacy of any external audit, (3) the scope of State baminer respoaaibility on concurrent.,...... inations, (4) aasigned 111111power and ■illilar factors.  Queation 10 The temptation to embezzle funds received on charged-off -t ■ i■ discouraged somewhat by adequate controls. The a■ aeta should be kept under dual control. Question 11 The disposition of Doubtful or Lo■ a classifications ude at the la■ t exlllllination should be investigated. Such claasificationa should be r...,ved froa the bank's book a■aeta (except at a nominal value for control). Care should be taken that they have not baen transferred to other catagoriea; for uample, a criticized unsecured loan to instalment or collateral loans, or a ca■h item to a suspense account. Question 13 All agreaients or conditiona to which a bank ia aubj ■ct should ba listed here. Unfillacl conditions or understanding■ arise fr011 adai■■ ion to.depoait in■ur­ ance, capital retirements or readju■ taenta, changes of location, e ■ tablialment of branches, mergers and other action■ approved by the 'FDIC or State authority. Aa long as there ia any contingency which aay require a specific performance by th■ bank, Examiners must continue to describe the condition in tile report. Queat:Lon 18 Examiners should set forth at this point all augge■ tiona which might prove helpful at future examinations, including suggestions as to cut-off points. Great care ""1st be exercised in stating unconfirmed auspiciona. Statement of the facts which generated the auapicions should suffice.  S.o#-on Q   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 6 -  313 Proper and :baecliate aealing of certain records or aHeta 1a sometimes deficient becauae of unfailiarity with the bank's ayst... , lJlforution as to the t:lme of posting various accoUDts ca be v"ry helpful, especially in automated banks, even though it may duplicate or update information conta:I.Ded in the EDP Questionnaire. Any peculiarities of the bank'• cash balucing procedure should be atated. Knowledge of approxilllate t:lmes of arrival and departure of officers ud employees, particularly tellera, aaai■t in pl&lllliDg the -1Dation, Cut-Off Point The cut-off point on the various categories of lous 1a helpful to the nut Examiner, especially on a routine examination. The scrutiny of overdue loans, lous on which.interest baa been added, loans which appear to be supported by collateral of dubious value ud/or marketability, ateady loans ud other suspect it... ia not lillitad by the cut-off point at the current -1Dation,  Seotion  Q   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  - 6 -  SupeffiBOZ'/1  Seotion  (Rni.ssd s-12-?JJ  314 FF,DERAL DcPOSlT l!ISlll!AIICfi CORPORAl'lOII DIVISil)N OF »ANK SfJl'ERVISION WASIIING'l'ON  General Memorandum No. l SUBJECT:  Revised October 1976  PRIORITIES, FREQlll,;llCY AND SCOPE OF EXA.'!INATIONS  Introduction The rapid growth in number, size and complexity of the banks falling under the Corporation's supervision mandates periodic reappraisals of the approach to the examination function in order to most effectively deploy resources, marshal! efforts in the appropriate areas, and maintain technical competency in the face of increasing sophistication in operating and management systems and ever changing economic and.banking environments. The purpose of this memorandum is to set forth the policies of the Division with respect to examination priorities 1 frequency, and scope; to clarify those areas allowing Regional Director discretion; and, at the same time, to provide for some uniformity of approach.  Banks Presenting Supervisory or Financial Problems The first priority has been, and will continue to be, effective surveillance and supervision of those institutions which present either supervisory or financial problems. Henceforth, it will be the Division's policy to conduct at least one full-scope examination every twelve months of each state nonmembe~d bank presenting supervisory or financial problems. Additional examinations or visilations in such banks are encouraged to the extent believed necessary by the Regional Director. Further, the scope of any follow-up examinations or visitations as well as the format of the report which will be prepared will be at the discretion of the Regional Director. However, in this respect, it is felt that follow-up examinations and/or visitations should focus on the particular problem area (e.g., loans, liquidity, violations, consumer compliance, etc). Banks not Presenting Supervisory or Financial Problems An examination, either full or modified (modified examinations are defined in the following paragraph), of each state nonmember insured bank which does not present supervisory or financial problems will be conducted at least once in each 18-month period with no more than 24 months between examinations. At the discretion of the Regional Director, and within the guidelines scheduled below, alternate examinations of banks which do not present supervisory or financial problems may be conducted on a modified basis.  Modified Examinations A modified examination approach and format may be used only in these banks: a.  with assets of less than $100 million;  b.  which have been operating for three full years;  c.  whose management was rated Satisfactory or better at the last examination and where there ha.s been no change in control as defined in Section 7(j) of the FDl Act or in the chief executive officer;  d.  which had an adjusted capital and reserves ratio at the last exRmination of at least 6.5% (mutual s.1vings banks must h.1.ve had an adjusted surplus ..1nd reserves r.atio of at least 6.0%) and avail.:iblc information indicates that ratio h.:as not fallen because of growth, insufficient earnings or o.ther developments;   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  315 e.  with  a  record of acceptable internal routine a11d controls and  an l•ffectivc internal audi L pr-Ogram or an annual outside audit consi.dcrcd adequate in scope and performance by a qualified  public accountant, correspondent bank, or other qualified firm; f.  which have the suggested fidelity coverages;  g.  which have an acceptable earnings record; and,  h.  which do not appear as exceptions on the most recent edition of any computer generated monitoring systems utilized by DBS unless the reason for such exception is known to the  Regional Office and docs not require a full examination and such reason is recorded in the bank's file. At examinations of banks meeting the above criteria, pages 1 through 4, the Officer's Questionnaire 1 page A and D-2, Compliance Reports, and Form 96 should be completed. (At the top of the appropriale column on the Form 96, the word 11Modified 11 should he typed inL In those banks which frequently file branch applications, or if an application is expected to be filed in the near future, page 8 should be prepared. Further, the scope of the examination may be curtailed. Full use should be made of the bank's ETJP and management reports, sampling should be utilized wherever possible, and proof and verification procedures may be eliminated or substantially limited unless circumstances indicate additional effort is needed in these areas. Additionally, the volume of loans subjected to analysis may be reduced, and less important branches need not be examined. Emphasis at these modified examinations should be placed on management policies and performance; the evaluation of asset quality, alignment and liquidity; capital adequacy; and, compliance with applicable laws and regula· tions. Where adverse trends or other justifications appear, appropriate revisions in the conduct of the examination should be made and report Schedules added. Larger Banks In those banks with assets.of $100 million or more, all report schedules which are presently in use and are applicable to the given bank will continue to be included in the examination r·eporL l-.There the fixed asset investment is moderate in relation to capital, there are no statutory violations with respect to fixed assets, and absent other problems of significance, fixed asset schedules may be omitted from these examination reports. Further, examiners are instructed to assess the quality of management systems and reports as well as audit and control functions, and where it is permissible to do so without compromising the integrity of the examination, utilize the output of those systems. Cash counts and proof and verification procedures may be omitted in those banks where it is appropriate to do so, and branch offices which do not have a significant volume of important assets need not be examined; however, in the latter instance, conditions at these offices should be reviewed with management prior to the conclusion of the examination. Related Banks If believed desirable in the op1n1on of the Re·~onal Director, simultaneous examinations may be arranged of all closely related banks or subsidiaries of bank holding companies, requiring coordinatUon with other bank regulatory agencies. The type of examination employed in each bank at simultaneous examinations will be at the discretion of t.llte Regional Director unless precluded by the guidelines for modified examinat~ons. Automation and Sampling Techniques It is expected that the Corporalion's automat~d bank examination programs and monitoring systems will be used wht>rt•vt.•r p,c,1.sible in an effort to provide increased efficiency and consPrve mnnpower. Tl1i5 use should include the scheduling of examinations as well as th~ir conduct. Further, sampling techniques should be used wht.~rever•possible.  88-817 0 • 77 • 21   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  316 -3Visitations It is expected that visitations will be frequently used as an investigatory and supervisory tool for those banks which show adverse trends, eill1cr at examinations or through a monitoring system, and to gauge cn1n1>liance wilh provisions of cease and desist orders. Further, visitations subsequent to management or ownership changes should be used to assess the attitudes and abilities· of the new managcmcnt/own.:!rship if the principals are not already known to the Regional Office. New Banks In addition to the required periodic examinations, it will be the policy to conduct a visitation at each new bank quarterly during the first two years of operation (visitations need not be held during the quarter in which an examination, either by the Corporation or the State authority, is conducted). The purpose of these visitations is to gain some measure of the performance of management and the direction in which the bank is headed. At the discretion of the Regional Director, findings of the visitation may be reported in either memorandum form or exami.nation report format.  Data Facilities Evaluation of data facilities operated by insured State nonmember banks should be performed concurrently with the regular examination unless the Regional Director instructs otherwise. Whenever possible, the Regional Director should arrange with other supervisory agencies for concurrent evaluations of independent data centers, except that they may be evaluated on a.rotating basis with other interested Federal agencies at the election of the Regional Director. The Regional Director may join in control evaluations of ~ational and State member bank data centers, or their affiliated organizations, which provide services for insured State nonmember banks, when the respective supervisory agency invites FDIC participation. Guidelines and rules for examination of automated centers can be found in Appendix C of the Manual of Examination Policies. Trust Departments Separate examinations of larger trust departments are encouraged, relying upon management and control systems •to reduce audit-type functions where the integrity of these systems has been validated. Coordination with State Authorities Scheduling of all examinations, particularly follow-ups, and visitations should be coordinated with State authorities to minimize duplication and the burden impos~d on banks. Examinations of Nonbanking Affiliates, Holding Companies, National Banks, and State Member Banks Examinations of nonbank affiliates may be comducted at the discr~tion of the Regional Director, but examinations of holding ,ompanies, National banks and Member banks may not be conducted without the priOI' approval of the Washington Office.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  317 The CHAIRMAN. All right, sir. We will have questions for you in just a minute. First we will go to Mr. Bloom. Mr. Bloom, we are happy to have you. Go right ahead. STATEMENT OF ROBERT BLOOM, ACTING COMPTROLLER OF THE CURRENCY, ACCOMPANIED BY H. J'OE SELBY, FIRST DEPUTY COMPTROLLER OF THE CURRENCY FOR OPERATIONS, AND JOHN SHOCKEY, CHIEF COUNSEL  Mr. BLOOM. Thank you, Mr. Chairman. I'd like to introduce two of my colleagues I have with me. To my immediate left is Mr. H. Joe Selby, First Deputy Comptroller for Operations, and to his left is Mr. John Shockey, our Chief Counsel. I won't read the entire statement, Mr. Chairman. I would request. that it be placed in the record along with the appendices. The CHAIRMAN. Without objection, your statement will be placed in full in the record. [Complete statement follows. The appendix to Mr. Bloom's statement may be found at p. 1105 of this volume.]   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  318 Statement of Robert Bloom Acting Comptroller of the Currency I appreciate this opportunity to discuss the condition of the National Banking System and the GAO report on Federal supervision of banks with the Committee today. My testimony will cover four basic areas: (1) The condition of the national banking system; (2) The status of national banks requiring special supervisory attention; (3) Measuring capital adequacy, liquidity and bank management; (4) The GAO report recomme~dations.  I am attaching to my statement; as Appendix A, the detailed statistical data requested in the Chairman's letter of November 15, 1976. I.  These data have been previously furnished to the Committee.  The Condition of the National Banking System In his statement before the Committee on February 5, 1976,  the former Comptroller of the Currency stated that, despite the economic problems which the country had recently experienced, "the national banking system  • is sound and prosperous."  The accuracy  of this observation has been confirmed in 1976. During 1976, the condition of the national banking system improved significantly as the economy continued its recovery fromthe severest recession since the Great Depression of the 1930's. Reflecting the halting pace of the economic recovery, national banks grew slowly during the first half of 1976, but grew much more rapidly in the second half, particularly in the fourth quarter.  Comparing  adjusted December 31, 1975 data to preliminary and virtually complete December 31, 1976 data, total domestic and foreign assets grew 9.3 percent, net loans grew 8.4 percent, U. S. government investment securities grew 13.2 percent and total capital grew 10.l percent.  As a result, the  total capital to assets ratio increased slightly from a December 31, 1975 figure of 6.2 percent, adjusted for reporting changes, to 6.3   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  319 percent on December 31, 1976 (see Tables 1 and 2 and the graph of key ratios in Appendix B), Earnings and loan losses are two important measures of the health of national banks.  Net income as a percent of total assets was .65  percent in 1976, virtually the same return on assets as in each of the three preceding years.  Loan losses as a percent of total loans  improved slightly in 1976, declining to .56 percent from .58 percent in 1975.  Although the loss rate remains high compared to prior years,  the continued improvement in the economy and the health of business firms should cause the loss ratio to continue its fall toward more normal levels. Key indicators of the ability of national banks to respond flexibly to changing economic conditions show little change from 1975. The loans to assets ratio, an indicator of the degree to which bank financial resources are committed to lending activity, declined slightly from an adjusted 53.9 to 53.4 percent.  This decline was complemented by an  increase in holdings of U.S. government investment securities relative to total assets from 9.5 to 9.9 percent.  The ratio of cash items plus  U. S. government investment securities to assets, a traditional measure of bank liquidity, remained unchanged at 27.8 percent. These ratios, by themselves, do not reveal the full extent of 1976 improvements.  Dependence on interest-sensitive funds declined and  deposit stability improved as demand deposits and large denomination certificates of deposit decreased and time and savings deposits increased.  National bank access to funds was ample as demonstrated by  the availability of federal funds at low rates.  In short, these  changes increased the liquidity of national banks and enhanced their flexibility.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  320 As an indication of the breadth of the improvement during the first 6 months of 1976, 18 of the 19 national bank peer groups used by our National Bank Surveillance System to monitor the condition of national banks, showed increases in the return on average assets. Gross loan chargeoffs as a percentage of loans declined in 17 groups and end-of-period assets times end-of-period capital declined in 18 groups (see Table 2 of Appendix B). Coverage of net loan chargeoffs by current earnings before taxes and loan loss provisions, a key indicator of a bank's ability to absorb loan losses, showed wide improvement exceeding 10 times losses in 18 of the 19 peer groups.  In the remaining  peer group, net chargeoff coverage was 3.9 times losses. The 12 largest national banks, which hold over 40 percent of the assets and deposits of all national banks, also showed some improvement during 1976 but not as much as smaller national banks.  These large banks  were hit harder by the 1973-75 recession and, as a consequence, it has taken them longer to work out their problems.  More suhstantial improve-  ments in the condition of the 12 largest national banks are likely in 1977. Total net income of the 12 largest national banks was $1.5 billion in 1976.  Year-end 1976 data also show that the rate of return  on average assets increased from .55 percent in 1975 to .56 percent in 1976.  Net chargeoff coverage remained at 3.9 times loan losses;  however, gross loan chargeoffs as a percent of average loans worsened from .69 percent in 1975 to .85 percent in 1976.  A bright spot  was the improvement in the ratio of total capital to assets from 4.6 percent in 1975 to 4.8 percent in 1976.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  In addition, an analysis  321 of the 12 largest national banks revealed that: --Total assets increased $23.9 billion, or 9.0 percent to $289.7 billion; gross loans increased approximately $12.3 billion, or 7.9 percent, to $168.1 billion; and total deposits increased $14.9 billion, or 6.8 percent, to $233.6 billion. --Loan loss reserves increased $55 million to $1.5 billion and reserves were 1.36 times net chargeoffs in 1976. --Total capital increased $1.72 billion, or 14.0 percent, to $14.0 billion; $880 million came from the retention of earnings, $190 million from new subordinated note and debenture issues and $650 million from new stock issues and other additions to equity capital. --Total capital to asset ratios increased in 9 of the 12 banks. As the economic recovery continues into 1977, further improvement  in the condition of national banks, especially the largest ones, is likely.  Because of the improvement in liquidity, earnings and capital  that has occurred over the last two years, national banks are in a position to support economic expansion. II.  Banks Requiring Special Supervisory Attention A history of the OCC's methods of identifying banks requiring  special supervisory attention has been previously submitted to the Committee.  OCC considers its "problem" banks to be those banks that  are receiving special supervisory attention and the continued liquidity and solvency of which are in question.  Our professional staff rates  the condition of these banks as either "critical" or  11  serious. 11  A  detailed description of the characteristics which we consider in placing a bank in either of those categories is furnished in Appendix A at pages 40 and 41.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  322 As of December 31, 1976, there were 23 national banks in the "serious" and "critical" categories combined.  Of these, five, with  total assets of $1.689 billion and deposits of $1.396 billion, had a combination of weaknesses and adverse trends constituting a nearterm threat to liquidity or solvency.  At the time of our February  5, 1976 testimony before this Committee, there were seven such banks, with total assets of $1.669 billion and deposits of $1.359 billion. The remaining 18 "problem" banks, with total assets of $8.635 billion and deposits of ~6.074 billion, exhibited weaknesses which could lead to insolvency if not corrected, but they were in no immediate danger.  Twenty-one banks, with total assets of $9.856  billion and deposits of t.6.242 billion, were in this "serious" category at the time of our last testimony on this subject before the Committee. In addition, OCC reviews, monitors and provides special supervision to a number of other banks having adverse performance characteristics but whose failure prospects are remote. a "close supervision" designation by the OCC.  Th'y are assigned  As of December 31,  1976 there were 124 banks under ",close supervision," compared to 57 banks at year-end 1975.  The increase in the number of banks being  monitored does not reflect deterioration in the national banking system.  The increase is, instead, largely the result of a number  of OCC procedural, policy and timing ch~nges, as follows:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  323 (1) The 1976 downgrading of some 39 banks resulted from adverse 1974-1975 economic conditions captured for the first time in 1976 examination reports.  This  time lag has been inherent in the bank examination process. (2) Some banks, which would ordinarily not be of concern to the occ based on their individual conditions, were nevertheless added to the "close supervision" category and followed for the first time in 1976 because of their affiliation with parent holding companies which were experiencing financial difficulties. (3) The Washington unit, whose sole responsibility is to identify such banks, analyze their problems, and insure that corrective measures are taken, did not become fully staffed and operational until early in 1976.  This,  together with improved procedural and review processes, had led to the identification of more banks for inclusion in this category. (4) The National Bank Surveillance System, since it became operational in the summer of 1976, has enabled the Office to detect adverse trends at an earlier stage and thereby   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  324 to single out banks for revi- and monitoring which would have escaped such early special attention under preexisting procedures. In addition to these categories of banks requiring special supervisory attention, our n- monitoring systems are designed  to  alert us, at the earliest possible stage, to incipient weaknesses in any national bank.  A bank having a temporary adverse trend is  not automatically considered a "problem" bank.  Rather, each bank  is analyzed individually to determine the cause of the trend and the appropriate remedial action. In recent years, we have greatly increased our capacity to assure the best efforts of both the agency and the banks to correct problems, but no competitive system can be completely fail-safe. There must be some room for innovations based on bank management judgments.  From time to time, therefore, failures will occur.  We believe that some failures are an inevitable and acceptable cost to  preserve a healthy, competitive and responsive banking system.  III.  Capital Adequacy, Liquidity and Bank Management OCC has developed significant new tools to measure and monitor  the traditional indicia of performance -- capital, liquidity and management.  The National Banking Surveillance System (NBSS) combines  computer based analysis of national bank performance statistics with bank examiner experience.  A typical NBSS report with a brief  glossary of terms appears in Appendix c.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  325 It may be helpful to the Committee to provide a brief comparison of our new procedures with earlier practices.  Supervisory rating of a  bank's capital adequacy, liquidity and management has always required the examiner to engage in a complex series of subjective judgments based only in part upon ratio analysis.  Capital and liquidity ratios alone  do not necessarily indicate the financial condition of a bank, but they are useful when calculated frequently and observed in relation to other ratios and trends.  However, it is our experience that capital and  liquidity ratios are usually lagging indicators of existing problems. To judge properly the health of the national banking system, this Office now tries to identify leading indicators of potential problems. CAPITAL ADEQUACY Past Examination Procedures:  In the past, techniques for measuring the adequacy of capital have varied somewhat from region to region and even from examiner to examiner. Quite properly, the ex!lllliner did not base his entire analysis of the bank's capital adequacy on ratios alone.  He was also directed to evaluate  subjectively such factors as quality of assets, quality of management, liquidity, earnings, ownership, occupancy needs, volatility of deposits, operational procedures, and capacity to meet the community's needs. This subjective process was, and is, as important as the calculation of objective ratios.  In making these complex judgments, however, the  examiner lacked significant current information on the performance of the bank under examination relative to that of other banks operating in similar environments.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  326 If the examiner felt that the trends in capital adequacy were adverse, he commented on the situation in the report of examination's confidential section addressed to the Regional Administrator. Discussion with bank management was not mandatory.  Examiner mandated board  meetings typically were not held until the situation was considered serious. Current Examination Procedures: In the current examination, the examiner must follow well-defined procedures leading to a conclusion about the bank's capital position. That conclusion is supported by detailed work papers and the conclusion is discussed in the open section of the report of examination presented to the board of directors.  The examination in general and specifically  the adequacy of the bank's capital position are thoroughly discussed with both management and the board of directors at a meeting required at the conclusion of each examination. In addition to the review of a bank's capital position during the examination, a trained analyst in the regional office reviews quarterly NBSS data on banks exhibiting the most significant changes or unusual performance. bank's capital adequacy.  That review includes an analysis of the Thus, review or tracking of a bank does not  wait until the next examination. Each condition of concern indicated by the analysis of capital adequacy is investigated by the regional office and monitored on the Action Control System.  That system requires the regional office to  report the bank's progress or lack of progress toward correcting the conditions of concern at least once a month.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  A capital problem usually  327 can't be corrected after a bank is in a serious condition.  But a  potential capital deficiency, detected in this "early warning l!YStem," is more likely to be corrected under the procedures required by the Action Control System before a crisis occurs. LIQUIDITY Adequate liquidity can be defined as a bank's ability to provide funds to its customers, including borrowers, in response to reasonable demand.  A liquidity ratio should measure all liquidity requirements  against all sources of liquidity.  However, all liquidity demands and  sources, by their nature, are not recordable in the traditional financial reports produced by banks. Unrecordable factors include the ability of the bank to secure new liabilities as needed and its ability to liquidate certain assets.  These are qualitative factors which cannot  be captured by ratios. Past Examination Procedures: In the past, our analysis of a bank's liquidity position was based primarily upon a single traditional ratio.  A bank's net liquid  assets were generally deemed acceptable by the Office if they exceeded 15 percent of net liabilities.  If a bank's liquidity dropped below  that point, additional analysis of the bank's recorded assets and liabilities and their contractual maturities was usually performed. This analysis included a somewhat subjective review of the bank's liquidity position as well as the composition of its deposit structure. Procedures for·making these subjective judgments were not formalized; thus, there was some undue dependence on the ratio.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  328 Current Examination Procedures: Recognizing the limitations of trying to analyze a bank's liquidity with a single, static ratio, comprehensive analytical procedures encompassing the entire area of funds management are now in effect.  Those work programs entail a careful weighing of the bank's  historical funding requirements, current liquidity position, earnings, stability of sources and uses of funds, anticipated future needs and options for reducing funding needs or attracting additional liquid fundc. As far as quantitative measures are concerned, we continue to use the basic liquidity ratio, but it is complemented by NBSS data which enable the examiner to analyze trends within the bank and significant variations from peer group averages. Since liquidity sources are dependent upon the confidence that others have in the bank, an analysis of the factors affecting that confidence is important.  One of the principal trends affecting such  confidence is a decline in the bank's earnings.  NBSS is designed to  monitor earnings and significant changes in assets and liability composition on a quarterly basis.  All banks selected for priority  review through analysis of the quarterly call reports are reviewed, with subsequent follow-up of all problem areas.  Continued improvements  in NBSS will be geared toward improving our methods of quantitatively measuring the bank's liquidity position. MANAGEMENT Past Examination Procedures Examiners were previously required to state their evaluation of management in the confidential section of the report of examination.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  329 Their written comments were usually preceded by one word captions of "Excellent," "Good," "Fair" or "Poor."  The primary officers and  directors were listed with a narrative evaluation of each.  Examiners  were told that those evaluations "should reconcile with the bank's condition.•  Instructions recommended that, "When an unsafe management  is encountered the examiner should take pains to nail down the indictment both in the open and confidential sections of the report.•  In practice,  however, comments pertaining to unsafe management appeared all too frequently only in the confidential section. Current Examination Procedures: Current instructions to examiners state: Examiners must not restrict their appraisals to the past and present • • • the determination of what the management will do for the bank in the future is most significant. Senior management should be judged by the sufficiency of earnings to date and by its plans for the bank's assets and liability mix to achieve both maximized future earnings and a strong liquid future condition. These views are now presented to the bank's board of directors. The leading indicators and significant ratios tracked by NBSS on a quarterly basis all reflect the actions of bank management.  Banks  which are designated for quarterly priority reviews by NBSS are analyzed in detail by regional specialists.  Their recommendations for immediate  investigation usually require discussion with bank management. Adverse evaluations of bank management from reports of examination or from the more frequent NBSS reviews can be placed in the Action Control System.  Any condition of concern placed in the Action Control  System requires review of corrective progress at least once a month.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  330 We believe that the regular distribution of NBSS Bank Performance Reports to national banks will make a significant contribution to the improvement of bank management.  This distribution will begin shortly.  Samples of the Action Control and Bank Performance reports are attached in Appendix C. IV.  GAO Report As I have previously testified, we have little difficulty with  many of the recommendations of the GAO report.  Many of the rec011D11en-  dations endorsed, in some measure, procedures and approaches which the Comptroller's Office was already taking.  Thus GAO rec0111111ended that  the OCC invite the FDIC and the Federal Reserve System (FRS) to evaluate jointly the OCC's new examination procedures with the goal of incorporating our new concepts, after proper testing, into their approaches. We have provided such orientation.  The latest edition of our revised  examination procedures is being made available to the other agencies as it comes off the press.  Our new "small bank" examination procedures  have just been released for field testing and have been forwarded to the FDIC for their review.  Perhaps most significant, the Interagency  Coordinating Committee has formed a top level staff subcommittee composed of the Director of Banking Supervision and Regulation, FRS; The First Deputy Comptroller of the Currency for Operations; the Director, Division of Bank Supervision, FDIC; and the Director, Office of Examination and Supervision of the FHLBB for the purpose of coordinating, on a regular and continuing basis, the examination policies and procedures of the four agencies.  One of the first assignments of this new group is to  explore approaches to development of uniform criteria for the identification of "problem" banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  331 GAO recommended that the Federal Reserve System and the Comptroller's Office develop a single approach to country risk classification.  We are continuing to work with the FRS to develop a coordina-  ted program in this area. GAO made certain recommendations about how the FRS and the occ might combine their foreign examination efforts to better utilize examiners and facilities.  There are some legal obstacles, but we  are receptive to the idea.  In particular, I have requested that  senior examination officials on my staff explore, with their Federal Reserve counterparts, increased coordination in matters of mutual interest such as minimum standards for foreign exchange operation and country risk analysis.  I have also asked that in such exchanges  they specifically review the advantages and disadvantages of joint overseas examinations. With regard to the GAO recommendation that all supervisory agencies establish more aggressive policies for using formal actions, we believe that statistics quoted in the GAO report are adequate testimony to our increasingly aggressive posture.  However, formal actions taken  under the Financial Institutions Supervisory Act are only part of the story.  As I pointed out in  my  testimony before the joint session of  committees of the House, the present formal enforcement powers of the agencies are inadequate in a number of respects.  Improvements recommended  by the agencies have been contained in a number of bills before committees of the present and past Congresses.  However, bank problems arising  from managerial incompetence and poor economic conditions cannot always be solved through cease and desist actions.  88-817 0 - 77 - 22   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  When we conclude  332 that formal action will assist in rehabilitating an institution, we will use it.  I suspect that increasing use of the formal enforcement  tools will continue and, perhaps accelerate, particularly if legislation granting the agencies additional flexibility in this area is enacted by the Congress.  For most institutions, however, we believe that recent  improvements in the examination process, including better communication with bank directors and methods for early detection of adverse trends, will achieve an even greater impact. The GAO recOIIDUended that, where possible, the bank regulatory agencies coordinate and combine their examiner training efforts.  The  OCC has contacted the FRS on the development of common courses and has responded positively to the FDIC's proposal for establishment of a joint training facility in Rosslyn, Virginia. GAO specifically reconanended that all agencies jointly staff a group to analyze national shared credits.  That recOIIDUendation has  met with positive response from all three agencies.  Examiners from  the three agencies, meeting in joint session, will analyze and classify such credits.  The results of those joint meetings will be binding  on both national and state member banks.  The FDIC shares its respon-  sibility in this area with state agencies, and its inclusion in this process promises to be more complex. included.  Nonetheless, the FDIC will be  We anticipate that this program will begin in early May.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  333 'Dhe CHAIRMAN. Thank you very much, Mr. Bloom and Mr. Barnett. You gave the impression, Mr. Bloom, ,that you feel that Jam Smith's report of last year whic:h indicated the banking system was in good shape was right and that the situation now is even better. I wonder if t.hwt's the case. Mr. BarnetJt gives us a series of criteria by which we can judge the condition of the banks and let's run over them. They include capitaliz11Jtion, loan losses, liquidity, number and size of problem banks, classified assets, number of failed banks and earnings. Now itJhe banking system remains undercapitalized, seriously undercapitalized, on the basis of the rule of thumb we have been given. The Federal Reserve Board suggests that capital should be about 8 percent of assets. 'Dhe large hanks particularly are very far short of that. Your big banks are around 4.9 to 5 percent, a little better than they were but not much. The loan losses ,at the large banks have increased. The number and size of ,problem banks has increased even though we have had 2 years of recovery. It's not better. It's worse. Much worse. Classified ·assets as a percentage of capital ,are up. The number of failed banks has broken ·all recent records, at least since the great depression and since ,the FDIC was established. Now it's true that liquidity has improved and it's true tha,t earnings are up, ibrnt of course that's a product not of regulation but it's the product primarily of the business cycle. The fact is, we had a recovery of a couple years. Of course earnings are up. Everybody's earnings are up and of course we have an improvement in liquidity in view of rthe economic situation. But in every other category it seems the si,tuartion has not .improved; it's gotten worse and it's gotJten far worse than it was 5 or 6 years ago. There's not only a recent adverse trend but there seems to be something of a long-term adverse trend. Mr. BrnoM. Mr. Chairman, my comment was directed at a comparison over the past year. The events in 1976 I think are favomble in virtually every one of Mr. Barnett's categories and I'm especially interested in your comment ,that ;these improvements were due to business cycle changes rather than improvements in regulation in your opinion. I cert11Jinly think that the converse of that is ,also true. You certainly can't hold regulators responsible for ·the tremendous buildup in classified loans •any more than you can hold the Department of Agriculture responsible for the drought in the F ar West or the aviation agency responsible for all the air disasters which unfortunately may occur. Of course the condition of banks is responding to conditions in the economy. 'J1he CHAIRMAN. Well, the GAO 1indica,ted-and I'm going to go into that in some detail-in many, many cases the examiners were able to highligiht the weaknesses but then they didn't a,ct. They didn't act in time. They ooted too l11Jte. You say it's better to have moral suasion and to have conferences and so forth. You have a cease and desist power and ·that cease ,and desist power, as you indicated yourself, has not boon used. You say that you can't do these things by relying on legal,ities, that you have to rely on suasion. Maybe you do. But I just wonder if you and the otJher ,agencies are being tough enough. The tro-g.ble is that rthere are two difficulties here as I see it looking at it from my viewpoint. No. 1, all regulating bodies tend to he, if not the captives of the ,industry they regulate-1   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1  1  334  Mr. BwoM. I categorically disagree. The CHAIRMAN. I'm making a general statement. All regulating bodies tend to be-Mr. BLOOM. I don't even agree wiif:ih that. The CHAIRMAN. Well, let me finish. Whether it's the SEC, CAB or FTC, they tend to be influenced very much by the people they regulate, 1Jhe people they see, the people they approve, the people who work in the industry they come from, and there is tha,t tendency we have to be aware of in all regulating bodies. We have seen that kind of deterioration in many of them. Now in tJhe second place, you have a peculiar kind of ,a regulating situation with respect ,to the banks. You have not one regulating body; you have three, as Dr. Burns has pointed out, there tends to be a competition in laxity here. There certainly is a tendency the more lax the regul3;ting body, the more 'popular it is with the people you regulate. Mr. BLOOM. I would repeat Dr. Burns' reaction-The CHAIRMAN. Let me finish. Now I'm chairman of this committee and I will be delighted to have you speak out any time I finish, but if you will permit me-I permitted you to speak at length without interrupting you and you will have a chance to speak out. Now what I'm trying to say, if you will give me a chance to say it, is that we have this double problem here. We have three regulating bodies. You have had a situation documented by Dr. Burns when he spoke in Hawaii in which you have some banks which opt out from under the regulation of a regulating body which they consider to be firm into a regulating body they consider to be less firm, and he cited several instances in New England, for example, where he said the weakest banks have done that. Now I think that this does suggest that you have an unusual problem, without any criticism of you-and I think that on the basis of ~verythi_ng I have seen and heard, Mr. Bloom, you have done a good Job, I thmk a much better job than has been done by your predecessors. I don't mean to demean Mr. Smith in particular, but your predecessors. Under the circumstances you have made very good improvements. Some have been cited by GAO and others as unusually good. What I'm saying is we have a situation we're going to look at honestly and fully in which the regulators in general as far as the hanks are concerned leave something to be desired. Now if you would like to respond, go ahead. Mr. BLOOM. Mr. Chairman, this myth that we hear about banks moving from one regulator to another in order to escape supervision is just that. The instances that Dr. Burns was talking about of banks leaving the System obviously involved banks leaving the nationa] banking system. You can't remain a national bank and convert out of the Federal Reserve System. H the Comptroller's Office has been as attractive a supervisor to banks as you seem to feel and as you indicated, I think, in some exchanges with Dr. Burns yesterday, you certainly wouldn't have banks leaving the national system to go into the State system to presumably stricter regulation in order to save a few dollars, a comparatively few dollars in reserve earnings. So I don't see the logic of that. The CHAIRMAN. Well, now; Mr. Bloom, in the last G y••ars the fact is that virtually all switches by banks over $500 million in assets have   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1  335 been from the State member-at least from the State member system under the jurisdiction of the Federal Reserve to the national banking system under the jurisdiction of the Comptroller. Mr. BLOOM. That can't be-we'll gladly supply numbers. This is a matter of numbers, of course, and we will supply them for the record, but Dr. BurnsThe CHAIRMAN. You can't supply them orally? Can't you tell me orally? Give me some examples. Mr. BLOOM. I think in total assets the balance is probably the other way. We probably lost more assets to State systems in the past couple years, I believe. I'll have to get the numbers on this. It's either very close or negative as :far as national banks are concerned. That's what Dr. Burns is concerned about. The CHAIRMAN. I'm talking about the big banks where mer~rs are important and where regulation is of particular peculiar sigmficance. [The following material was received from the Comptroller's Office:] COMPTROLLER OF THE CURRENCY, ADMINISTRATOR OF NATIONAL BANKS, Washington, D.C., April 6, 1977.  Hon. WILLIAM PBOXMmE, Chairman, Committee on Banking, Housing and, Urban Affairs, U.S. Senate, Washington, D.C.  DEAR MB. CHAIRMAN: This is in response to your letter of March 18, 1977, concerning the record of conversions of banks from the state to the national system and vice versa. As I stated in testimony on March 11, the record does not support the conclusion that state banks generally convert to the national system to secure less stringent supervision. During the 1960's there may have been some banks which converted to the national system to take advantage of the innovative rulings issued by then-Comptroller James J. Saxon. It is also possible that in the late sixties and early seventies some banks decided to convert because of some of the Comptroller's interpretations of the Bank Merger Act, or .his ,branching and chartering phiiosophies. On the other hand, some state banking authorities, given their structural and political environments, may have been protective of established bank and non-bank financial institutions. The Oomptroller has permitted new entries to improve competition and expand ,banking services to the public. Regardless of the motives one may ,attribute to conversions over this period, it is clear, however, that in recent years -the trend in conversions has been decidedly in the direction of state charters. The facts speak for themselves. As the enclosed chart shows, in 1972, the national banking system experienced a net loss of eight banks ; in 1973 a net loss of four banks; in 1974 a net loss of seven banks; in 1975 a net gain of two banks; in 1976 a net toss of 20 banks; and in 1977 (through March 15) a net loss of three banks. Thus, in every year since 1972 with the exception of 1975, the national banking system has lost members to the state system. The trend in assets has also reversed ; the national banking system is now losing ,assets at a fairly rapid rate, and several additional :banks have already advised us of their intention to convert out of the national system during the next few months. In the lost 14½ months, the national banking system has lost $1½ billion in assets more than it has gained. If the First Pennsylv,ania Bank, N.A., the only bank with assets in excess of $1 billion to convert in the last five years, were excluded, the last 38½ months would show a net outflow from the national banking system of almost $2 billion in assets. Not only do the statistics refute the contention that any significant number of state hanks are converting to national status, the record also suggests that the Comptroller has taken as strong or stronger regulatory stances in recent years as the other agencies. For example, the ComptI1oller issued 12 CFR 23, which requires directors and principal officers of national ,banks to file statements of business interests to enable ,bank examiners and directors to detect potential abuses; the Comptroller's 12 CFR 18, which requires that Annual Reports with substantial financial data be sent to shareholders of banks not regis-   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  336 tered under the •Securities Exchange Act of 1934, is not duplicated a:t the other agencies. The Comptroller's regulation requiring the use of offering circulars for the sale of debt or equity securities, 12 CFR 16, is unique among the agencies (although the FDIC several years ago proposed a similar regulation that remains under study). Only the Comptroller has proposed reguiating the distribution of credit life insui,ance income to bank officers, directors and controlling stockholders. The recent GAO report similarly recognized the Comptroller as the leader in new and stronger examination techniques and enforcement actions. We have (1) spearheaded the analysis and criticism, if appropriate, of large national credits shared by several banks and of country credits; (2) designed and implemented new examination procedures which go into the depth of bank management and operations to an unprecedented degree; (3) established a most effective and comprehensive examination of hank activities which impact upon consumers; and (4) used the formal enforcement powers granted ,by the Financial Institutions Supervisory Act as much or more than the other agencies. This rerord does not support a view of the Comptroller as a lax supervisor. 'I1hese supervisory positions are significant because the essential issue posed by your inquiry is not whether the banks hoped they would receive less stringent supervision after converting, but whether they did, in fact, receive less stringent superv-i:sion. In this regard, the General Accounting Office reviewed our files on seventy conversion applications (the applicable portion of its January 31, 1977, report on the three Federal bank regulatory agencies is attached for your information) and its analysis confirms ,that the Comptroller does not permit banks converting to national charters to escape appropriate supervisory actions. Addressing the point of whether the Comptroller actually p,ro"l'ided less stringent regulation, the GAO repor,t states "Supervision was usually consistent because OCC addressed the problems identified hy the previous regulators" (page 3-10). In addition, the head of the GAO's task force performing the bank study, Mr. Layton, discussed this issue with the· Honorable Tom CorC'Oran on February 1, 1977 on the record before certain subcommittees of the Committee on Banking, Finance and Urban Affairs and the Committee on Government Operations: "Mr. CONCORAN. Thank you, ]\fr. Chairman. "As a new member of this su'bcommittee and the Congress, I was not involved with starting the study, but I do com.mend you for the product. "I do have questions on charter conversions which I would like you to elaborate on. · "You have analyzed situations where State chartered banks have switched to a national charter, thereby chang"ing the supervisory agency. Often this switch was made either to (1) avoid supervisory actions or (2) seek approval of a branch or merger application. "In the first case, your report appears to conclude that the 000 usually takes the same supervisory action proposed ·by the previous regulatory agency; is that accurate? "Mr. LAYTON. Yes; basically. They are aware of the problems either based on their own examination or by looking at the examination report of the previous agency. They may have dealt with the problem slightly differently, but they were generally aware of the problem and did take actions to deal with it. "Mr. CoNCORAN. Would this then draw us to the conclusion that switching for that reason is no longer a problem? "Mr. LAYTON. In the cases we looked at, that is ·the conclusion we reached." Your letter also requested information on each of the banks with assets in excess of $500 mill-ion which converted into or out of the national system. The enclosed chart includes the names of the banks and their assets as of the effective date of the respective conversions. We have reviewed the correspondence files of eac-h bank and find few references to the motivations behind the converi;dons. The information with which we are primarily concerned in a conversion application is specifically related to the condition of the bank, the same highly confidential information that is derived from bank examinations. Complying with your suggestion that we delete confidenti'al portions of materials in our files and submit the remainder for the recoro would thus provide nothing 1mbstantive nor meaningful. I suggest that if the Chairman ,st;m desires to review the corresp,ondence in our files relating to conversions, we mnke arrangements for review of this correspondence on a confidential basis by the Chairman or his designee.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  337 However, five specific cases out of the 178 conversions into -and out of the national system in the last five years do not provide a sufficient data bases upon w'hieh any reasonable generalization as to quality of supervision could be drawn. The GAO's review of seventy conversion applications for national charters does provide an adequate base, and we believe that the GAO's conclusions should satisfy the Committee's concerns. With this background and in order to be as responsive as possible to your request, we have presented below what we believe to be an accurate summary of the indications of reasons for these five conversions as contained in our files. The Committee should realize, however, that there may exist underlying factors of which ,ve were not apprised. (1) Commerce Bank of Kansas City, Missouri (state to national). The bank believed that the state aullhority's narrow interpretation of state law was preventing the bank from engaging in activities permitted national banks. The bank also believed that national bank examiners were better at examining large banks than were examiners of its former supervisor. (2) First Pennsylvania Banking and 'frust Company (sta.te to national). This bank believed that the state banking authority was influenced by protectionist views of both bank and non-bank financial institutions, whereas the Comptroller was more objcetive and competition-conscious. The bank also believed that the supervisory attitudes of its former Federal regulator were more stringent than those of the Comptroller. Representatives of the Comptroller were in communication with the Federal Reserve prior to the conversion, and I can assure this Committee that in fact the bank is receiving appropriate and no less stringent supervision than it did before. (3) Bankers Trust of South Carolina, N.A. (national to state). This bank converted from a national charter as a necessary step in leaving the Federal Reserve System to free its non"interest bearing reserves. Please refer to the enclosed copy of a portion of the bank's proxy statement. ( 4) Central Trust Oompany (svate to national). The file contains no indications of motivation for the conversion, or of prior supervisory problems. The bank subsequently expressed its view that the national bank examiners performed the most thoroughly professional examination the bank had ever undergone, including that provided by its own independent public accountants. (5) United American Bank, N.A. (national to state). Although our files do not include documentation, we were advised by this hank that it left the nationlal system to escape what it considered the burdens of certain proposed regulations which would only he applied to national hanks, and as a necessary step in leaving the Federal Reserve System to free non-interest bearing reserves. As you suggested, I request that this letter and the enclosures be included in the recorcl of the March 11 testimony. Sincerely, ROBERT BLOOM,  Acting Oomptroller of the Ourrency.  Enclosures. NUMBER OF BANKS AND ASSETS GAINED DR LOST BY THE NATIONAL BANKING SYSTEM DUE TO CONVERSIONS, JAN. 1, 1972, THROUGH MAR. 15, 1977 [Dollar amounts in thousands[ National banks converted State banks converted to to State charter national charter Year 1972 _______________________________ 1973 _______________________________ 1974 _______________________________ \975 •.. ----- -- -- .. -- .•.. -- ...... -- . 1976 _______________________________ 1977 (through Mar. 15) _______________  Number  Amount  Number  24 20 19 11 29 6  $862,792 540,314 2,005,290 278, 119 I, 594,605 629,379  16 16 12 13 9 3  Net gain or (loss)  Amount  Number  Amount  $1,561,964 599,592 5,593,399 1,418,291 285,587 419,614  ~8) 4)  $699, 172 59,278 3,588,109 1,140,172 (1, 309, 018) (209,765)  <p (20) (3)  CONVERTED BANKS WITH ASSETS IN EXCESS OF $500 MILLION ,JANUARY 1, 1972 TO MARCH 15, 1977  1. June 30, 1972, Commerce Bank of Kansas City, Missouri, converted into Commerce Bank of Kansas City, National Association. Assets were $686,592,813.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  2. May 22, 19'74, Jl'irst Pennsylvania Banking & Trust Company, Bala Cynwyd, Pennsylvania, converted into First Pennsylvania Bank, National A,ssociation. Assets were $5,164,150,852. 3. December 9, 1074, Bankers Trust of South Carolina, National Association, Columbia, South Carolina, converted into Bankers of South Carolina. Assets were $587,004,999. 4. December 20, 1974, Central Trust Company, Cincinnati, Ohio, converted into Central Trust Company, National Association. Assets were $804,854,174. 5. November 1, 1976, United American Bank, N.A., Knoxville, converted into United American Bank in Knoxville. Assets were $505,384,744. Condition of banks applying to convert  An OCC examination or investigation was performed for 54 of the 70 conversion applications we reviewed.' Fifty-one had deposits under $100 million and three had deposits over $100 million. OCC reviewed earlier bank examination reports or contacted the applicant's previous Federal or State agency for about half of the 70 banks, including the 16 which OCC did not examine firsthand. Thus, in all 70 cases, before deciding on the conversion applications, OCC either did its own examination or investigation, or reviewed previous examination reports. Although several banks accepted for conversion had some weaknesses, most were rnted by OCC or their previous agencies as sound in every respect. Two banks with weaknesses were approved because they were affiliated with bank holding companies which OCC believed would improve their condition. A third bank had been designated a problem bank by FDIC, which waS' considering issuing a cease and desist order to prevent the diversion of profits through a management service contract. After examining the bank, OCC gave preliminary approval for conversion, without knowing about FDIC's proposed action. OCC believed the bank had no serious problem and had been assured by its president that the contract's objectionable provisions would be rescinded. Before OCC gave final approval for conversion, FDIC notified OCC of its proposed action, and OCC granted final approval with the understanding that the bank agree to correct problems in the management contract. Because the problems were not fully corrected after conversion, OCC entered into a formal written agreemenf with the bank about 7 months later to confirm the bank's planned actions to correct the problems. Another bank with known problems was also accepted for conversion. Memos in the files indicate that OCC was aware of this bank's problems, had met with FRS before approving the application, and took its own actions to encourage the bank to correct the problems identified by that agency. All four applicants for ·state-to-nation.al charter ronversions that OCC rejected from January 1972 through April 1976 were very small banks with deposits ranging from $800,000 to $3.6 million. One bank was turned down because OOC's examination revealed a poor overall condition. Two other banks had sought a relocation which OCC believed should not be approved ; one of these al!':o had not obtained the additional capital recently recommended by its State and Federal supervisors. The final application was disapproved because the bank appeared more interested in expanding through branching than in correcting operating weaknesses. General 000 aoeement on applications  OCC reviewers at the regional office and headquarters generally agreed with one another on conversion applications. The Comptroller desagreed with more than one stafl' member on only 1 of the 68 conversions from January 1972 throui?h April 1976. Single recommendations were contrary to the finial decision on only two other applications. Reviewers thus agreed much more often on conversions than on new charter applications. RECENT CHANGES TO  occ's  CONVERSION PROCESS  The Haskins & Sells · study addressed OCC charter conversion policies and procedures. The public accounting firm said OCC should (1) require an applicant for conversion to a national charter to give reasons for the conversion and (2) assure itself the conversion iR not the result of supervisory pres,sure from other bank regulators because of illegalities or unsatisfactory banking practi~.<1. Several of the study's general recommendations about OCC's haudling of apolications for new banks ·and structural changes also apply to the conversion 1  One applicant withdrew before any OCC evaluation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  339 process. These include (1) policy statements and decision guidelines, (2) better application forms, and (3) better guidelines for receiving, verifying, and reviewing applications. OOC addressed the recommendations about conversions with a set of policy statements and revised application forms and procedures. OCC began using the policy statements and forms on November 1, 1976. According to OOC's policy statements, it will ordinarily approve conversions which are consistent with a sound national banking system. Conversions should not be motivated by supervisory pressures from other supervisory agencies. The bank's general condition should be satisfactory and managers should have demonstrated ability to supezwise a sound bank. Serious problems will normally preclude approval. Disapproved applicants will lbe told the reasons for rejection. OCC's new procedures do not, however, define the method of obtaining information on the factors to be considered. Certain procedures should be part of the process ; for example, contacting the applicant's current Federal and State regulatory agencies. By reviewing recent bank examination reports and talking with the appropriate regulators, OCC will have all current supervisory information and will be better able to evaluate a bank's condition and its motives for conversion. OCC officials intend to closely monitor the implementation of the new pr_ocedures and, as they gain experience in using them, make changes to insure their effectiveness. The new conversion application now requests a bank's reasons for applying for conversion. The new procedures require an examination of the applicant unless specifically waived by a regional administrator. If the examination is waived, the region must provide a written justification to be reviewed by the Comptroller. NATIONAL-TO-STATE CONVERSIONS  State conversion policies  Of the 24 State agencies responding to our survey, 15 provided information on their policies, criteria, or procedures for reviewing national-to-State charter conversion applications. Several respondents stressed they have had little or no experience with bank charter conversions. Five states indicated they use the same or similar procedures and criteria as for new bank charter applications. Nine States fully examine a lbank before deciding. Of these nine, two also apply the same criteria applied to new bank charters. The remaining State explained that statutes require an investigation· to assure that depositors are protected and legal requirements are satisfied. California, Michigan, and New York review OCC examinations of applicants as part of their conversion review process. Only California indicated it would waive its own examination if satisfied with a recent OCC examination. Few States presented their policies regarding acceptance of national-to-State c~nversions. Michigan and Georgia stated conversion requests should not be the result of supervisory pressure and, a~ong with Oklahoma, specifically indicated that converting banks should be in sound condition. National banks convert to withdraw from FRS National-to-State charter conversion applications are not evaluated by OCC, and the agency's files do not contain information on banks' motives for such changes. However, according to FRS, the major reason that banks have given up national charters is to avoid maintaining assets in the non-interest-bearing reserves required for FRS membership. National banks are required by law to be memlbers of FRS, but State banks are not. According to FRS, only 2 of the 73 national banks converting to State charters from 1972 to 1975 retained membership. Also, stockholder proxy statements available for 11 converting banks indicated that 10 gave up national charters to withdraw from FRS. The other bank converted to a State charter to prepare for a planned merger with a State bank. Even though some national banks have converted apparently to avoid FRS reserve requirements, other factors have influenced national banks not to convert and State member banks to maintain FRS membership. State reserve requirements for nonmember banks offset some of the disadvantages of the FRS requirements. Forty-nine States have asset reserve requirements, and over half of these States specify that the reserves are to be maintftined as vault cash or non-interest-bearing demand deposits at other banks. These bal.ances can also be used to compensate for various correspondent banking services. Only 3 States allow all the reserves to be maintained in selected   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  340 interest-bearing assets, and 18 other States permit part of the reserves to be invested in certain short-term assets. , . Member banks also receive advantages such as access to the F RS_ d~scount window free shipment of coin and currency, and use of FRS safekeepmg facilities. '1n addition, FRS membership helps banks attract interest-free demand deposits from banks that ,are seeking corresp0ndent bank services. A recent study by the Conference of State Bank Supervisors quantified the benefits and drawbacks of FRS membership, concluding that some banks profit more from membership and some from nonmembership. Apparently,_ most of the banks which converted from national to State charters had determmed that they were not receiving net benefits from their membership. CONCLUSIONS  Before OCC had policies governing conversion requests, several banks appear to have converted to national charters to avoid supervisory action by another regulatory agency. Supervision was usually consistent because OCC addressed the problems identified by the previous regulators. Other banks converted to obtain more favorable consideration of requests for branches, mergers, or other structural changes. OCC approved many of these requests after separately considering their merits. State banks also converted for reasons unrelated to supervisory disagreements, such as to have the same type of charter as affiliated banks or to obtain the prestige and Federal Reserve-related banking powers of nation.al banks. OCC's recently established policies and its requirements that State banks explain their reasons for wanting a national charter should help _it make better informed decisions about whether a bank should be allowed to change supervisors. More importantly, they should help OCC to accomplish its basic objective-maintaining ,a sound national banking system. CONVERSION TO A STATE CHARTERED BANK  The Board of Directors has unanimously approved the conversion of the bank from a national bank to a bank organized under the Code of Laws of South Carolina of 1962, as amended, and the termination of its Federal Reserve Bank membership. The Bank's membership in the Federal Deposit Insurance Corporation which insures deposits up to $40,000 would be continued as at present. Conversion to a state chartered bank would permit the Bank's withdrawal from Federal Reserve Bank membership, since only national banks are required to be members of that system. This non-member status will free approximately $25,000,000 in reserves now required to be held on deposit with the Federal Reserve Bank and which are non-income-producing assets. Most of the freed funds would be invested in obligations of the United States or agencies of the Federal Government. Approximately $2,000,000 would be used to increase cash balances with commercial banks and these deposits, along with the cash and amounts _due from other commercial banks presently maintained, would·be adequate to meet banking needs and the reserve requirements required of a nonmember South Carolina chartered bank. It is anticipated that the income -from these investments would contribute materially to the income of the "Bank, serve to strengthen the capital position of the Bank and enh,ance service to the Bank's trade area. Lending rates available to the Bank on a small portion of its lo.ans as a national bank will not be available to it as a state bank. The effect of this is not expected to be material.  Mr. BLOOM. We haven't had a big bank enter the national banking system-I guess First Pennsylvania is probably the last one. That's some years ago. There has been considerable attrition the other way, and I suspect we have lost more assets than we have gained _The 9HAIRMA~. M~. Barnett, you didn't ·as I recall-perhaps I missed 1t-you d1dn't_m your statement.have any generalization as to th~ status of our bankmg system or how 1t compares now with the situation 5 or 6 or 8 years ago, whether it's improving or not, what we hav~ to_be concerned about Would you like to make that kind of generahzat10n now?   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  341 Mr. BARNE'J.TI'. 1',.,.ell, my generalization I think in my statement, Mr. Chairman, was that it's in reasonably sound condition, reasonably sound were the words I used, and much better than the past year or two. I did not make any attempt to generalize with the position 6 or 8 years ago. I would think 6 or 8 years ago it was considerably stronger, in great part because the economy was stronger. Now whether it was really stronger or whether some managements were starting to make decisions that have. come home to bother us at this point is conjectual. I just couldn't say. At some point, as I tried to say in my statement, banking either because of competitive pressures or because of new innovations in management techniques in banking have moved into riskier postures. That's happened over the past 10 or 15 years. The CHAIRMAN. One of the riskier postures they have moved into that was highlighted yesterday and Dr. Burns indicated considerable concern about-and I think rightly so-is the great increase in foreign loans. As you know, the large banks particularly are much more heavily in foreign loans. Something like $45 billion of loans to the lesser developed countries by U.S. banks, a total of $250 billion in foreign loans altogether. As he pointed out, in many cases those foreign loans have been sound and the record to date on those foreign loans has not been bad. When we look at the situation particularly in lesser developed countries which are so dependent on imported oil, for instance, which has had a very adverse serious effect on their economy, and they are so heavily in debt now and their economies are so relatively weak, it seems that we might have a serious problem in the coming years and t.hat the banking system might have been weakened by their deep involvement there. How do you feel about that~ Mr. BARNET!'. Well, we don't see many of those on a regular basis in the State nonmember banks, Mr. Chairman. In Coordinating Committee discussions I have participated and listend in on discus..c;ions about some of these situations that you're describing. I could really only speak secondhand. The CHAIRMAN. Of course, as Chairman of the FDIC, you have the responsibility for all the banks. Mr. BARNETT. In a sense. Well, we don't see any great number of banks that are on our problem list because of a serious concentration of bad foreign loans. We just don't see it. There are some. What I believe Dr. Burns said, which I would support, is that you have to take a look at the individual loans; that many of these loans, though in a country where perhaps the country credit is not outstanding, the loans are to industries that are really relatively sound. But I wouldn't want to make a generalization about trends there. I think the Federal Reserve and the Comptroller are much closer to those trends than we are. The CHAIRMAN. How do you explain the fact-and I'd like both you gentlemen to respond to this-that the FDIC problem bank summary that includes all commercial banks--State nonmember, national and State member banks-shows that the total has increased in the last year, a year in which you say that the situation has improved i   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  342 On January 1, 1976, the total problem banks represented 2.3 percent of total assets of all banks. By July 1, 1976, halfway through last year, that percentage had more than doubled to 5.7 percent of total assets. And on January 1 of this year it's increased by another 50 percent to 7.3 percent of total assets. In other words, it's gone in only 1 year from $25 billion to $74 billion. Mr. BLOOM. I would think it was due to several factors, Mr. Chairman. First, the time lag in the examination process. We still in 1976 were picking up banks which were strained by the real estate recession of 1974. Second, partially I think as a result of your own efforts and our own efforts at self-improvement, our abilities to spot problems and our severity in this regard have increased unquestionably in the past couple years. So that I think the increase in the problem bank numbers may reflect not so much a deterioration of the banking system as an increased awareness and severity on the part of the regulators. The CHAIRMAN. One of the criticisms, Mr. Bloom, yesterday that we heard from the General Accounting Office was the fact that there had been a failure on the part of regulators-I'm not singling you out-but of all regulators to meet with the board of directors. I'm talking about the examiners. I think in something like 10 percent of the cases where they had difficulties they had met with the board of directors. They met with management and talked with management about it, but not with t,he board, and the board of directors being the bosses of management people who are fundamentally responsible £or the bank are the ones that make the correction. Can you tell us how many of the board of directors of the 12 largest regional banks which hold 40 percent of the deposits of all national banks you have met with to discuss capitalization since you have been the Acting Comptroller? Capitalization, as I pointed out and as I think you would agree, is an important element in determining the soundness of our banks. Mr. BwoM. Well, as part of our written standard instructions we require an examiner who does a bank to meet with the board of directors of each national bank at least once a year, and very often-I'd say more often than not---One of the components of those meetings would be a discussion of the adequacy of capital. Of course, in a large majority of cases the c&.pital is all right. There's no great problem about it. But where there is a deficiency in capital, that surely would come up at these meetings and we include the largest as well as the smallest as far as these board meetings are concerned. We meet with the boards of the big banks .. The CHAIRMAN. Did you meet specifically w.ah these 12 largestFirst National City and Chase and so forth? Mr. BLOOM. I doubt if we've gotten all of them in the past year. This is a new standard operating procedure. I can find out. [The following information was received from the Comptroller's office:] During 1976 OCC officials met with the full Board of Directors at one of the 12 largest national banks, and with committees of the Board of Directors at each of the other banks in this group. The Board committees involved were either the executive committee or the committee responsible for audits and examinations (denominated by the various banks as "audit and examination," "audit," or "examination" committees). A 11 of the banks, the appropriate Regional Administrator was the senior OCC representative and was accompanied on three occa-   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  343 sions by an Associate Deputy Comptroller from the Washington Office, and at the twelfth, the examiner-in-charge of the most recently completely examination was the senior OCC official.  The CHAIRMAN. Here's where the problem is it seems to us. The large banks are the ones that seem to have the need for improving their capitalization. They average less than 5 percent of their assets in capital and it seems this is where the improvement is needed. Let me just quote briefly from the GAO report. On page 20 of the GAO report they say, "The agencies rarely meet with board of directors of banks generally. Very often they did not meet· with those banks with major problems." And it would seem that this would be a very useful technique because there is an indication that the bankers do have considemble respect for the examiners. They feel that they are highly competent, that their advice is useful. Independent appraisal is a matter that's very useful to them in appraising the soundness of their own bank and they respect the opinion of the examiners. Mr. BLOOM. We have had almost a universally favorable reaction from bankers on this policy of mooting with the board; not completely because the relationships of boards of directors and daily management of corporations-banks and nonbanks-varies somewhat from corporation to corporation. It's a delicate balance with directors supposed to be responsible for policy but not interfering in the actual day-to-day management; and depending on the ownership and the type of institution and the size of institution, there could be quite a variation in the relationship between the board of directors and ts active management. We must, of course, tread lightly in the sense of not interfering with the satisfactory relationship. The CHAIRMAN. Well, I think that's correct, but I would think any serious deficiency should properly be called to the attention of the board. Mr. BwoM. No question about that, and where we have a problem bank we would have no hesitation-as a matter of fact, we would be derelict if we didn't meet with the board of directors. The CHAIRMAN. Mr. Bloom, there also was an expression of concern by the GAO with respect to the foreign operations of the banks. There didn't seem to be any uniform approach between the Fed and the Comptroller in this area. The GAO said in its report that the Fed and the Comptroller independently evaluate the soundness of loans to foreign governments and businesses, and I quote, "loans to the same foreign borrower were rated differently by the va,rious Reserve banks and the Comptroller." Isn't it dangerous to continue with this system in the light of increased foreign loans~ Wouldn't it be better to have some uniform system on that~ Mr. BLOOM. Yes, it would, and we are continuing discussions to try to achieve that. Part of the problems is in the law. We have a situation where the Federal Reserve has the authority to approve the opening of foreign branches but the Comptroller he.,s the responsibility of examining the continued operation of those branches. The estabiishment of the examinin~ forces are under different laws. But within the statutory framework we are doing everything we can to achieve a uniformity on loan classification.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  344 The CHAIRMAN. Mr. Barnett, the ratio of total ciapital to risk assets for member banks ranging in size from $500 million to $1 billion supervised by the Federal Reserve is 10.9 percent. The ratio for national banks and for State nonmember banks supervised by the Comptroller and the FDIC in this category respectively is only 9.8 and 9.3 percent. The FDIC has the lowest percentage. The Federnl Reserve benchmark for capital adequacy using that measure is 12.5 percent. So all three agencies are low, but why are the Comptroller and particularly the FDIC so much lowed They are all below the safety standard here. Mr. BARNETT. Well, I don't know where the Federal Reserve gets their benchmarks. I can't comment on that. Generall, we have been the agency that has higher capital ratios than the other agencies and in fact we carry the reputation in the field among State nonmember banks that FDIC stands for forever demanding increased capital. The CHAIRMAN. There again it makes it very difficult for us if you fellows can't agree on a benchmark. It would seem to me that you could agree on what would be a reasonable relationship. Mr. BARNETT. I would like to hear John Early's comments on the risk assets because we do generally have higher ratios in our banks than other banks. Mr. EARLY. Well, simply that we see capital as a relative concept and it's related to risk and there are two important factors, growth and quality of assets; and where the bank shifts its assets from a nonrisk basis to pliacing them at risk again more capital is required, and I think our capital ratios are running 8.2 and the risk side I think is about 11 percent, which I think is quite adequate. Mr. BwoM. Mr. Chairman, I don't think there's any mystery as to why the capital ratios of the insured nonmember banks ,are higher than the State member and national banks. It's a function of size. The CHAIRMAN. I'm giving the same size for all. These are statistics on banks that range from $500 million to $1 billion in all categories and the figures I got did not-of course, for those banks the FDIC had a 9.3 ratio. Mr. BARNETT. I'm sorry I didn't focus on that, Mr. Chairman. I think we do have a response to that. "\Ve have about 20 banks in that size range and in those 20 banks we have five or six banks that are capital problems to us. Now they have 50 'percent of the general category. Three of those banks are in a particular local market that has particular problems at the present time and I can't explain that in greater detail now, but ,ve recognize that and we have been working on that and we think we are seeing some improvement. But I think :from the standpoint of the relationship with Fed ratios it probably is because we have those 20 in that category and 5 of those are problems that we are working with, 3 of them being from one particular local area. The CHAIRMAN. Mr. Bloom. Mr. BLOOM. I just wanted to make the point that, of course, the smaller banks traditionally have had to have higher capital ratios, I think, because of the discipline of the marketplace. I think the marketplace is probably the strongest influence on the maintenance of capital. Regulators, as powerful as they are under existing law, are not nearly as important a force in this as what the market demand. Of   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  345 course, the existence of deposit insurance no doubt permits banks to maintain confidence with lower levels of capital by far than they would if it weren't for the deposit insurance. The CHAIRMAN. You are right that the marketplace has the most decisive effect, but the marketplace obviously doesn't work all the time. That's the reason we have had the very large increase in number of bank failures and this big increase I referred to in problem banks. When it's not working because the capital is deficit, it seems to me that's the point when it's necessary for the regulators to move in and insist on a correction. Mr. BwoM. When a bank loses confidence in the marketplace, it's too late to save it with additional capital. The CHAIRMAN. Are you saying that you're helpless, impotent, nothing you can do with respect to inadequate capitalization? Mr. BLOOM. No, not at all. I'm saying that it must be spotted very early on, and capital itsel:f is meerly a symbolic think. A bank's capital never saved a bank from failing. The capital ratios are there to preserve the confidence of the public in the institution. Banks are so highly leveraged that a difference between 0.8 -percent or 0.9 percent is never going to make the difference between viability or failure. It's the perception of the market as to the strength of the institution that-The CHAIRMAN. That's certainly a good generalization. That's true. I would agree. But the fact is that the real reliance that depositors have in a bank, one :fundamental arithmetic, firm and objective reliance is the amount o:f capital they have to protect against a recession situation where loans deteriorate and so :forth. Obviously, i:f you have a 20 percent capitalization there's a whale o:f a difference between that and having a 3 ,percent capitalization because you can have that much deterioration in your loans and still be covered and banks 8till won't become bankrupt. Creditors are far less likely to suffer. So it would seem to me that maintaining a reasonable capitalization is an essential discipline and where the banks have inadequate capital situation it's necessary not simply to say that's the market but :for the regulators to step in and insist on retrenchment, insist on :following policies to increase their capital. Mr. BLOOM. I agree that it's one of our most important :functions to maintain the adequate cushion against losses in these institutions, but it's only in the unexpected situation that the capital actually serves that immediate function. Proba:bly its more important function is the one that we were discussing, the maintaining of the confidence of the marketplace. The CHAIRMAN. Let's see if we can reach an agreement on the baseline standards for determining capital adequacy. The Federal Reserve suggests total capital to assets should be 8 percent and total capital to risk assets 12½ percent. From your testimony it appears that neither o:f your agencie..c; use those base standards .. Shouldn't the three agencies have a common definition of capital adequacy and shouldn't the Federal Reserve base standard apply to the three agencies or, if absent that, another agreed upon benchmark. Mr. BLOOM. This is one of those subjects that's been the subject of symposia among bank examiners and 1bankers ever since I guess we can remember. There's a constant effort to reach agreement on benchmarks   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  346 on this and I think as far as a descri1ption of adequacy for the system, wo should be able to. That's one of the things which we hope this new examiners' group will focus on. But in terms of individual institutions it's quite meaningless because a bank with utterly inept or, even worse, dishonest management, could never have enough capital obviously, whereas the same size bank in the same community with expert management with integrity could get·by with a very small number. The CHAIRMAN. Of course, I'm talking about minimums. I think that's right. You have situations where, as you say, the bank can get by with perhaps the minimum, but it would seem to me certainly if you're going to avoid the kind of unfair competition obviously the more heavily leveraged bank has an advantage over the less heavily leveraged bank, and it seems to me that kind of advantage is likely to persuade some banks to move into unsound positions absent effective and uniform regulation to prevent that kind of unfair competition. Mr. BwoM. Well, I don't see why, as far as a benchmark type of thing, we can't reach agreement. I would hope that we would. The CHAIRMAN. That's right. What this comes down to, the reason for this line of questioning, as you know I have introduced legislation and the legislation may not be right-certainly it can be improved, but it would unify the regulation process into a single agency. You suggested that you now have a unifying system in which you attempt to reach agreement, but that it has no authority, as I understand it. It can't require the Federal Reserve and the Comptroller and the FDIC to work together with respect to these matters. Senaor Stevenson has introduced a bill, I think suggested by Governor Burns, that would provide a stronger authority. Somewhere, it seems to me if we're going to improve our regulatory process, we have to achieve some degree of uniform operation or a unified single agency, as Governor Robertson recommended and as I have introduced. Would you like to comment on that, Mr. Barnett i Mr. BARNE'IT. Sure. My reaction is that there are great dangers in a unified agency, great dangers. I think that we have seen just in the last couple years the three Federal agencies-we can't forget the other 50 State agencies either-but the three Federal agencies have in fact been competing. I think they are competing ~uite well, not trying to get banks into their system by being less diligent supervisors, but by trying to create new techniques for examinations, trying to create new training techniques. I'm not sure that some of these new ideas would surface in a single agnecy. That to me, Mr. Chairman, is the real danger I see in the single agency concept. The CHAIRMAN. Now isn't it true, as former Federal Reserve Governor Sheehan said, that the divided responsibility between three Fed• eral agencies causes delays of solving problem situations such as the Fran:klin i The Comptroller determines whether the national bank is solvent or insolvent, but his decision can't be made in a vacuum. Your agency, the FDIC, must determine whether a payout or takeover will result in less cost to it. Meanwhile, if a bank in distress is large enough the consequences of a failure could have a ripple economic effect, so the Federal Reserve is put in the position of advancing funds which may be in reality, if not in law, to an insolvent bank to keep it afloat.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  347 This causes delays in arriving at a timely solution and if you say the single agency isn't the solution, how could we handle it? Mr. BARNE'IT. Frankly, the Franklin situation was handled quite well. There was an extraordinarily large bank in which a successful purchase and assumption was effected and it appears as though at least the agencies involved are not going to lose any money in the long-range outcome of that because of the bidding procedure that was established. The CHAIRMAN. Then you dispute Governor Sheehan's idea? Mr. BARNE'IT. You can characterize it any way you might with a single agency be able to move in more rapidly. My fear is if you move in more rapidly in this area you might create chaos because it was a relatively peaceful acquisition of such a large institution in trouble. The CHAIRMAN. $1.7 billion from the Federal Reserve? Mr. BARNETT. $1.7 billion advance, and we paid back $1 billion of that already. The CHAIRMAN. $700 million to be paid back? Mr. BARNETT. Plus interest. Mr. BwoM. I think that if we had had one agency and a crisis like that occurred, it seems to me that that agency would find itself in what you might almost characterize as a governmental conflict of interest situation, if it was at the same time the insurer and the examiner and the authority that had the power to declare the institution bankrupt. The CHAIRMAN. You might be right. I've never proposed that. I have not proposed that you have one firm that runs monetary policy and is also the insurer and also is the examiner. The Robertson proposal that I have introduced is a proposal that would simply consolidate examination. It wouldn't consolidate the insuring function too, or some of the other functions. The monetary functions, for instance, would be separate. Mr. BwoM. On the matter of consolidating examination, I think the thing we have to strive to do is to maintain what we have now of individual innovation and competition, so to speak, between the smaller agencies, and yet achieve a greater unity as far as the final result is concerned. The CHAIRMAN. Senator Lugar. Senator LUGAR. Mr. Chairman, I have just one question. Recently there has been at least some talk about a revolving door at the Comptroller's Office, meaning that examiners work only for a short time for the Comptroller, before going to work for the 'banks they formerly supervised. Do you have any comment on these accusations? Mr. BLOOM. Senator Lugar, I think the facts themselves are the best comment I could make on that. I would refer to an exchange of correspondence that I had with the Chairman about 6 weeks ago in which he ·asked for the names of the top officials that had left our Office in the past 16 years, and where they went. And I supplied that information, which I would like to have put in the record in answer to your question [seep. 351] It showed some remarkable facts which I hadn't been aware of until we assembled this information. The Chairman asked for the records of people who served as Comptroller, Deputy Comptroller, Chief Counsel, or regional counsel. 86-817 0 • 77 • 23   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  348  And we came up with 33 individuals since 1960 who had served in those capacities, and those 33 people had a grand total of Government service of over 1,000 years, 1,005 to be exact. And their average Government service was 30.45 years per man. I might say that the four who served as Comptroller averaged 2'7.'75 years each of Government service. Now all I can say is if that is a revolving door, as far as our Office is concerned, it has got 'to be the slowest revolving door in history. Senator LUGAR. Mr. Chairman, I apologize for not having heard the rest of 1the testimony that preceded this. But did you have in your testimony, gentlemen, today, any reflection of the problems of international loansi Yesterday, in visiting with Arthur Burns, I asked some questions in relation to his testimony that related to 'the fact !that he felt that the OPEC countries had shifted essentially to the banking system of this country the responsibility for credit evaluation and also the opportuni'ty for using the deposits. But the net effect, at least as I gathered, was some concern by Dr. Burns that $45 billion worth of loans are now being given by American banks to LDC's. I wonder what comment you might have or where do you think we are headed, keeping in view what would appear to be negotiation pressures in the foreign policy realm, with the north-south talks coming up and some pressures for extended credit, quite apart from the cutting back of what seems to be a large amount of loans. Mr. BLOOM. There has been a great deal of discussion in the press la'tely about the so-called LDC loan problem. I would like to point out that this lending is restricted to just the very largest banks that we have. Ninety-eight percent of our national banks of course have no foreign offices at all. About 83 percen't of the assets of the na'tional banking system are not involved with foreign lending at all. So we are talking about mammoth institutions that are really quite capable of handling these risks. I don't 'think we have ,a single bank that is on the problem list solely because of foreign loan involvement. We are somewhat concerned about some of the LDC loans, and we are watching that situation closely. It came about, as Chairman Burns went into at some length yesterday, because of the OPEC oil money that ballooned it the time of the large price increase and the private banking system became an intermediary between the OPEC countries and the non-oil-producing countries. And this is a role which I don't think should be a permanent one, especially in 'terms of longer term needs of 'these countries. Senator LUGAR. I think we are agreed that it would be undesirable for it to be a long-term role. I suppose my concern comes from the fact that we are in this sort of role, there is no way of extricating ourselves, albeit i1t is only a few of the large banks, bu't still they are there with substantial loans. I suppose what I am trying to gain is your expert testimony as to what some of the contingencies might bring. 'In other words, 1in a oolitical sense, let's say that some country simply said that we have had 'a change in government, and we don't plan to repay.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  349 Is there going to be some sort of domino effect or trigger mechanism that goes really beyond the large banks that have these liwbilities, if in fact it is impossible .to get repayment, or it is extended indefinitely, or there are pressures placed on the banking system to take on even more of a role as the price of oil might be escalated by OPEC in the foreseeable future? And just wha,t can we do as a banking system to prepare for those sorts of contingencies, the grewt safety margin required, as you begin to read some of the signs ,in terms of international contingency? Mr. BwoM. I think some of the suggestions that have been made for a greater involvement of the international banking organizations are the way to go. I would agree with that approach. ' The private banks, obviously, can't just call the loan that is not tenable. On the other hand, I see no indication of any significant increase in their involvement. They have become very aware of this problem, and I think they will work this involvement down in the coming year. Senator LuGAR. Thank you. The CHAIRMAN. Well, thank you gentlemen. I would just like to follow up a question you just asked, by pointing out you are right about the long term of service that most of the top people at the Comptroller of the Currency have had. It is interesting, however, that the subsequent employment of some of them were with Florida First National Bank of Jacksonville; American Federal National Bank; F1irst Chicago Corp., Jiin Smith, which controls the First National Bank of Chicago; Republican N a.tional Bank of Dallas; Golden Gate National Bank, San Francisco; Republic National Bank, Dallas; Chase Manhwtten, New York; Grammacy National Bank, New York; Union National Bank, Kansas City; American City Bank, Los Angeles; Fidelity American Bank Shares; Central National Bank, Chicago; First National Bank, San :Qiego; First City National Bank, Houston, Tex.; Beverly Bank, Chicago; and Northwestern National Bank. That is some of those who left. Most of those who retired did not go to work for a national bank. They went to work elsewhere, or they simply retired. But ,it is clear that there were a substantial number who ,vent to work in the industry which they had been regulating. It is also true that some, a small minority, have worked for a relatively short time. For instance, these are particularly the regional counsels. One I see worked 3 years, then went to the First City National Bank. Another worked 4 years and went to Beverly Bank of Chicago. Another worked 3 years and went to Northwestern National Bank of Minneapolis. I think in general you are right, most of the people who retired had worked for an extremely long time, ·and had not come back and forth, but a very large number did go to work in the industry which :they had been re2"Ula.ting. Mr. BLOOM. I think, as I said, the facts should speak for themselves on this question. The CHAIRMAN. All right. Thank you gentlemen very much. We appreciate your testimony.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  350 I might say, without objection, the chart you sent me indicating the names and number of years worked and the subsequent employment of the former top officials will be printed in full in the record, so we have the whole story in the r~cord. [The document follows:]   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  351  () Comptroller of the Currency Administrator of National Banks  Washington, D. C. 20219 December 21, 1976  'l'he Honorable William Proxmire Chairman, Committee on Banking, Housing and Urban Affairs United States Senate Washington, D.C. 20510 Dear Chairman Proxmire: The attached list identifies those former employees of the Office of the Comptroller of the Currency who have, since January 1, 1960, occupied the positions identified  in your letter of December 6, 1976.  In many cases, our files have not revealed  specific information on subsequent employment. However, through interviews of present and former employees and other informal inquiries, we have nonetheless attempted to provide you with information concerning such employment. The Comptroller of the Currency is the only officer requiring nomination by the President and confirmation by the Senate.  Please let me know if I can be of further service.  ~Q~\~  Robert Bloom Acting COmptroller of the Currency   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Separation Date  Years of Federal Service at Time of Se aration  Ray M, Gidney  ll-15-61  37  Retirement  c,,-/F'lorida First National Bank of Jacksonville Jacksonville, Florida  President  James S. Saxon  ll-15-66  20  'i!erm Expired  1,/'A:erican Fletcher National Bank IndiEnapolis, Indiana  Associate Chairman of the Board  William B. Camp  03-23-73  36  Disability Retirement  James E. Smith  07-31-76  18  Career Advancement  Position  ,rnptroller of ie Currency  Name  Reason for Leaving OCC  Subsequent Employment  N/A  / 4 c Chicago Corporation Chicago, Illinois  1.'\· puty Comptroller the Currency   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  05-15-60  n  Retirement  Reed Dolan  Ol-06-62  37  Retirement  w.  04-01-62  36  Retirement  Hollis S. Haggard  08-03-62  38  Retirement  c.  08-31-62  33  Retirement  Chapman  Fleming  N/A  Executive Vice President  i:.:i  N t  Q1  tv  L. A. Jennings  M. Taylor  Position  Griffith W. Garwood  12-31-62  38  Retirement  Clarence B. Redman  10-26-63  33  Retirement  V:epublic National Bank Dallas; Texas Federal Deposit Insurance Corporation Washington, n. c. N/A  ✓  N/A  Golden Gate National Bank San Francisco, California  v  ,,-  N/A  Republic National Bank Dallas, Texas  Vice President Consultant  N/A N/A  Executive Vice President N/A Unknown  /0 Position  Name  Separation Date  Years of Federal Service at Time of Se ration  Reason for Leaving DCC  Subsequent Employment  Position  Private Consulting (Principal Contract with  eputy Comptroller f the Currency  Albert J. Faulstich  10-26-74  44  Retirement  Financial General Bankshares I Inc. Washington, D. C.)  John D. Gwin  12-31-74  40  Retirement  Justin T. Watson  07-18-75  32  Retirement  Richard Blanchard  09-26-75  30  Retirement  David H. Jones  10-01-76  ~ief Counsel  Roy T. Englert  06-23-62  _egional dministrator  Frank W. Krippel  N/A  Haskins  &  Sells  N/A  N/A  Consultant  Washington, D. C.  Private Law Practice  Career Advancement  , /~ase Manhattan Bank New York, New York  Deputy Corporate Controller  14  Career Advancement  Department of the Treasury Washington I D. c.  General Counsel  01-04-63  39  Retirement  Cyril B. Upham  09-30-64  31  Mandatory Retirement  Marshal Abrahamson  07-19-66  40  Retirement  Paul L. Ross  01-12-68  · 33  Retirement  w i:,;-. Cl:!   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ✓~ramercy  National Bank New York, New York N/A  Studley and Schubert Brokerage Rouse Philadelphia, Pennsylvania \/tJnion National Bank Kansas City I Missouri  Consultant N/A  Vice President  Director   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ({_Four  · Position  ;ional Counsel  Kame  Separation  Frederick H. Hummert  11-18-66  James s. Sollina  Data  Years of :Federal Service at Time of Se aration  Subsequent Employment  Reason for Leaving 0CC  Position  Career Advancement  International Bus.iness Machines  Unknown  03-11-67  Career Advancement  Department of Housing and Urban Development Washington, D. c.  Unknown  Oscar Turner III  03-25-67  Career Advancement  'i.st City National Bank Houston, Texas  Unknown  William R.. Kastman  05-26-67  Career Advancement  Commerce Bankshares Kansas City, Missouri  Unknown  Franz F. Opper  04-19-68  Career Advancement  Securities Exchange commission  Unknown  Charles M. Shea  07-05-68  Career Advancement  Cornell L. Moore  03-23-68  3  Robert L. Schwind  08-11-72  10  1  4  /  Vti~verly Bank Chicago, Illinois  Career Advancement  L.,_..,.N;rthwestern National Bank of Minneapolis Min~eapolis, Minnesota  Resignation in Lieu of Accepting a Washington Assignment  Haas, Collin, Levinson & Gibert Atlanta, Georgia  Unknown Assistant Vice President Legal Officer Attorney  w  CJ"< ~  /ree Position  Regional Administrator   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Name  Separation Date  Years of Federal Service at Time of Se aration  Reason for Leaving OCC  Subsequent  Employment  Chalmer DeRemer  0l-10-69  30  Retirement  N/A  Norman ~nn  0l-10-69  38  Retirement  ~erican City Bank Los Angeles, California  Douglas Bushman  09-09-69  21  Disability Retirement  N/A  Elmer J. Peterman  10-21-69  36  Retirement  William A, Robaon  02-28-70  42  Retirement  Frank Ellis  05-20-72  30  Page D. Cranford  09-22-72  8  Retirement  Career Advancement  John L. Donovan  02-28-73  14  Career Advancement  Jos8ph G. Lutz  11-30-73  30  Retirement  Arnold E. Larsen  06-28-74  30  Retirement  John Thomas  02-28-76  34  Retirement  Donald B, Smith  0S-21-76  27  Disability Retirement  N/A Union Planters Mortgage Company Memphis, Tennessee N/A  v-":Fidelity-American Bankshares, Inc. Lynchburg, Virginia Casco-Northern Corp. P_ortland, Maine  Position  N/A  Consultant  N/A  N/A  Consultant  c.,,:i C)l  N/A  Vice-President & Counsel  Executive Vice  President  ,/ Central National Bank of Chicago Chicago, Illinois  Vice Chairman  / i s t Na'.tional Corp. San Diego, Cali~?rnia Westland Banks, Inc. Denver, Colorado  President  N/A  of the Board  Director N/A  01  356 The CHAIRMAN. Our next witnesses are Professor Hyman Minsky, Washington University; Professor Bernard Shull, Hunter College; and Professor Joe Sinkey, University of Georgia. Unfortunately, gentlemen, I have to go to the floor at about 12 o'clock, so we hope you can abbreviate your statements and we will have time for questioning.  STATEMENT OF PROF. HYMAN :MINSKY, WASHINGTON UNIVERSITY Mr. MINSKY. Thank you, Mr. Chairman. My name is Hytnan Minsky. I am a professor of economics at Washington University in St. Louis. I am also a director of and economic adviser to Mark Twain Bankshares. I have written on the banking and financial system, with some specia:l emphasis upon financial instability. Two papers I wrote as a consultant to the Board of Governors may be of special interest to the committee: "Financial Instability Revisited-The Economics of Disaster" was written in 1966 for the study of the discount mechanism and "Suggestions for a Cash Flow Oriented Bank Examination" was written in 1967. I have submitted these papers for the record. Financial instability· and crises have been prominent features of the American economy since the beginning of our Republic. The breakdown of the financial and banking system of 1929/33 was an extreme form of a recurrent phenomenum. The 30 years between the bottom of the Great Depression in 1933-35 and the middle 1960's constitute a unique period of financial tranquility. Three episodes of financial turbulence, 1966, 1970, and 1974-75, in which the Federal Reserve System acted as a lender of last resort to abort what was believed to be an incipient financial crisis, have occurred since the middle 1960's. Today's standard economic theory, which guides economic policy, offera no understanding of financial instability as a systemic attribute. The persistence of financial instability throughout our history and under a wide range of monetary, banking, and financial regimes is evidence that financial instability is ·a characteristic of our economy. Our economy is unstable because of the ways investment and control over capital assets are financed and how financing techniques evolve in response to profit opportunities. . In our economy good times are transformed into a speculative investment boom, which continues until either an incipient or actual financial crisis occurs. In our present day world this does not lead to a deep depression, because the Federal Reserve intervenes as a lender of last resort and massive Government deficits sustain demand and business profits. We are now trapped in a dismal cycle in which the economy oscillates between a threat of runaway inflation and the danger of a deep depression. I approach the problems that the committee is examining from the perspective that there is a deep-seated flaw in our type of economy. Business cycles, including the prospect of "bone crunching- depressions," are inherent in an economy with our capital intensive techniQues and financial institutions. ! will now comment briefly on the issues raised by Senator Proxmire's letter. First, capital adequacy. Capital-asset ratios of commercial banks have trended downward since the mid-1960's, while the changing com https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  357 position of bank assets and liabilities increased bank exposure to losses and to runs. The capital-asset ratio decreased even as changes in the ways banks do business indicated that capital-asset ratios should increase. The capital-asset ratio for smaller banks is about 8 percent, whereas some of the giant banks have capital-asset ratios close to 3 percent. I doubt if it can be maintained that the asset and liability structure of the giant banks are sufficiently superior to that of smaller banks .to warrant this discrimination. The smaller the capital-a·sset ratio, the smaller the markup on money costs the banks can afford to charge. The discriminatory capital-asset ratios lead to interest rate differentials which discriminate in favor of the giant business customers of the giant banks. I sug~est that a common asset-capital ratio be established for all banks, tightening up on the giant banks even as a higher asset-capital ratio is allowed to the smaller banks. Liquidity. Banks and other financial institutions become illiquid when there is a run on their liabilities. These days a run take the form of an inability to roll over bought money. A massive run occurred on Franklin National and the REIT's in 1974. Underlying such a run is a decrease in profitability, which almost always is due to a deterioration in. bank asset quality. The liquidity of the banking system depends upon the asset, liability and cash-flow relations of bank borrowers. Over the past decade the banks have been dealing with a domestic business sector whose liquidity has decreased. The liquidity of banks is adversely affected by covert bank liabilities such as lines and letters of credit. In particular, liquidity is adversely affected when banks extend lines of credit to borrowers on the commercial paper market. Such lines are most likely to be drawn upon when other demands for bank credit are high. · Much of the recent weakness of banks is an outgrowth of the commercial paper bank lines of credit connection. In any revision of bank supervising practices and banking control legislation one objective should be to establish better controls over covert liabilities. Asset structure of banks. Because of time limitations, I will skip this question. Bank examination practices. Three responses by the regulatory authorities to the question raised by this committee indicates that the agencies visualize bank failure as the result of individual error, bad management, or wickedness rather than as the result of systemic characteristics. In truth when bank difficulties are widespread they are part of an economywide liquidity problem. Bank examination procedures aim at discovering error, incompetence, and wickedness rather than at uncovering those systemic developments that lead to widespread financial difficulties. Bank supervising procedures should aim at the maintenance of adequate capital and the avoidance of asset and liability structures which can lead to expensive and uncertain positionmaking activity. Bank examinations should pay increased attention to the covert liabilities of banks, the use of purchased money, and the ability of the bank to properly supervise its borrowers than it now does. In any discussion of bank examinations, a distinction has to be drawn between the giant money market and international banks and  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  358 smaller banks. Examiners anJ supervisors can understand and can guide the business of smaller banks; they have little or no ability to control or guide giant banks. In the interrelations between supervising authorities and giant banks, the initiative comes from the giant banks. The Federal Reserve and the other authorities are left with little choice but to validate the decisions of giant banks. The Federal fund market, certificates of deposit, line-of-credit banking, and Eurodollar activities are examples of initiatives, mainly by the giant banks which have forced the hands of the Federal Reserve and other authoi;ities. The existence of overseas branohes makes bank examination and supervision much more difficult. The only way to control the overseas involvement of U.S. banks is to impose stiff capital requirements against overseas liabilities and assets. As things stand, control of the giant banks by examining and supervising authorities is virtually impossible. Only general balance sheet controls, such as a minimum aggregate capital-asset ratio, can be effective for the giant banks. The Federal Reserve as the lender of last resourt. In the credit crunch of 1966, the liquidity squeeze of 1970, and the Franklin National crisis of 1974, the Federal Reserve acted as a lender of last resort. Lender of last resort actions are required when a run is taki~ place. Usually the need for such action occurs when high and rising mterest rates affect cash flows and asset values. Federal Reserve refinancing prevents disorderly conditions in some market or the bankruptcy of some institution. When the Federal Reserve does this it extends Federal Reserve protection and refinancing to the threatened institution or market. Essentially this makes the institution or the instrument that is under pressure legitimate. As a result of being legitimized, the instruments or markets that w'ere under pressure are available for use in the subsequent expansion, unless the Federal Reserve or the Congress effectively bars the use of that instrument. As far as I know neither the Federal Reserve nor the Congress has followed up on recent lender of last resort interventions with measures to control or forbid the practices that were the proximate cause of the instability. A critical element in 1974 was the failure of the Franklin National Bank. At the end of 1973, Franklin National was a $5-billion bank. When Franklin National's tr9ubles 'became public in May, it immediate~y lost its ability to borrow by Federal funds and certificates of deposits, or on the Eurodollar market. Two weeks after its troubles become public, Franklin National was borrowing $900 million from the Federal Reserve Bank of New York. The Federal Reserve sustained the Franklin National until October 1974, when it was declared bankrupt. At bankruptcy Fra,nklin National had $3.6 billion in assets and was borrowing $1.7 billion from the Federal Reserve. .Aibout $3.1 billion of Franklin N ational's deposits and borrowing were pa,id off by funds that either accrued as assets matured or were supplied by the Federal Reserve. By its actions, the Federal Reserve validated the overseas deposits at Franklin National. If Franklin National is a precedent the Federal Reserve h'as extended "insurance" to all deposits at and loans to overseas branches of U:S. banks. If this is so, the deposits at overseas   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  branches of U.S. banks are more secure than deposits in domestic offices, for the authorities may choose to protect only the statutory maximum of deposits in a U.S. office of a failed bank. The 1974 action by the Federal Reserve may have been necessary and wise. However, it was unwise and unnecessary to let it stand as a precedent. After bailing Franklin National's depositors out, the Federal Reserve should have moved to establish strict controls over the operations of U.S. banks overseas. The Federal Reserve, by bailing out the overseas depositors of Franklin National and then doing nothing, made the present "touchy" situation with the overseas "deposits" of U.S. banks possible. The huge growth of deposits at the overseas branches of U.S. banks is due to the implicit guarantee of these deposits by the Federal Reserve. Depositors in these branches need not be concerned about the capital adequacy or banking prudence of the branch in which they deposit. As a result of the Federal Reserve's guarantee, deposits have flowed to branches of U.S. banks from su;11>lus countries and these banks h·ave rather carelessly financed activities around the world. As things now stand, the Federal Reserve, the FDIC, and the Comptroller of the Currency have no effective power over giant banks. Since the middle 1960's, these banks have innovated usage-certificates of deposit, covert liwbilities to "back" commercial paper, Eurodollar deposits-and the Federal Reserve validated the usage when a "crunch" came. To mix a metaphor, the banking system is an engine of inflation that is periodically bailed out by the Federal Reserve System. The combination of speculative expansive finance, the Federal Reserve lender of last resort actions, and the sustaining effects of big government, have led to an economy that oscillates between threats of a runaway inflation and a financial collapse. The policy question is "How to get off the back of the tiger." To get off the back of the tiger, we need to establish financing constraints upon business and as.set and liability constraints upon banks and other financial institutions, even as we move to minimize unemployment by encouraging labor-intensive production techniques in private industry and using Government employment programs as the major fiscal device. We should eliminate investment tax credits and accelerated depremtion, these encourage investment and speculative finance, and adopt measures t.o encourage consumption. We have ·been following the dictates of •a view that capital-intensive investment is the road to growth in gross national product, and growth in gross national product is the road to an increase in well-being. When our type of economy emphasizes capital-intensive investment, it becomes inflation prone and financially unstable. We should abandon the view that capital-intensive investment is the way to better our economy, especially as the emphasis upon such investment has brought us not only instability but chronic high unemployment. Until we achieve sustainable financial relations, financing of investment by private deficits should be constrained. In place of policy that induces investment output, policy should emphasize consumption. Instead of rushing ahead and stopping, like the hare, we can do better by steady progress, like the tortoise. [The complete presentation of Professor Minsky follows:]   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  360 Statement by  Hyman P. Minsky Professor of Economics Washington University, St. Louis  My name is Hyman P. Minsky.  I am a Professor of Economics  at Washington University in St. Louis.  I am also a Director of  and economic adviser to Mark Twain Bankshares, a Missouri bank holding company.  I appreciate this opportunity to express my  views on the condition of the banking system. Over the past twenty years I have written quite extensively on the banking and financial system with some special emphasis upon financial instability.  I wrote two papers as a consultant  to the Board of Governors that may be of special interest to the Committee - "Financial Instability Revisited - The Economics of Disaster" was written in 1966 for the study of the Discount Mechanism and "Suggestions for a Cash Flow Oriented Bank Examination" was written in 1967.  I have submitted these papers for  the record. Financial instability and crises have been leading features of the American economy since virtually the beginning of our Republic.  The great breakdown of the financial and banking  system of 1929/33 was an extreme form of a recurrent phenomena. The Second Bank of the United States, Wildcat Banking, the crises of 1857, 1873 and 1893, the campaigns of William Jennings Bryan, and the panic of 1907 which led to birth of the Federal Reserve System indicate the large role that the "money and banking question" has played in our history. The thirty years between the bottoming out of the great depression (and the simultaneous reform of the hanking system)   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  361 -2and the middle l960's constitute a unique period of financial tranquility.  Since the middle l960's we have had three episodes  (1966, 1970, and 1974/75) in which the Federal Reserve System acted as a lender of last resort to abort what was believed to be an incipient financial crisis. Today's standard econvmic theory - that which is in the textbooks and which guides economic policy - offers no understanding of financial instability as a characteristic of our economy.  The existence of financial instability throughout our  history and under a wide range of monetary, banking, and financial regimes lends preemptive credence to the proposition that financial instability is a characteristic of our economy.  For us to under-  stand how our economy works we must be able to explain  why the  financial system was stable (or robust) in 1945-65 and unstable (or fragile) in the past decade.  Our economic policy has been  unable to cope with the instability of the past decade because it has not been based upon views that understand why instability occurs. Our economy is a capital using capitalist economy with a sophisticated and complex financial system.  Our economy is  unstable because of (l) the way the mix of outstanding financial and real assets determines the prices of capital assets and financial assets,  (2) how these prices, in conjunction with the  price of current output and available financing, determines investment, and (3) how the acceptable financing techniques for both investment in new capital assets and holdings of inherited capital assets depend upon the legacies of the past, including   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  362 -3the inherited stock of debts , and views about the future.  In  particular an economy with the financial characteristics of our economy will tend to ~ransform a period of good times into a speculative investment boom.  The momentum of a specu-  lative investment boom will be broken by either an incipient or an actual financial crisis.  Whereas the path from good times  to a boom seems to be an essential attribute of an economy with a complex financial system,the path of the economy after an incipient financial crisis seems to depend upon the actions taken by the central banking authorities and the government. The processes that make for financial crises and deep depressions such as occurred in the past still operate but modern central banking and big government have changed the shape of the business cycle.  Instead of a crisis being followed  by a debt deflation and a deep depression, a crisis is now followed by a bailout by the Federal Reserve, a more or less serious recession, huge government deficits which sustain private financial positions, a burst of inflation, and a return to a crisis prone financial situation.  We seem trapped in a  dismal cycle in which the economy oscillates between an inflationary speculative boom and the threat of·a deep depression. The perspective with which I approach the problems that the committee is examining today is that there is a deep seated flaw in our type of economy in that business cycles, including the prospect of "bone crunching depressions", are inherent in an economy with our type of production techniques and financial institutions.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  This does not mean that policy is hopeless.  We  363 -4can modify and reconstruct our institutions so that we do better.  For thirty years after the Roosevelt Reconstruction  of our financial system and the introduction of "Keynesian" ideas into policy we did not have any serious threat of a financial crisis.  Furthermore we have not had a deep depression  for over forty years.  In terms of our history our economy did  better in the first thirty years after 1935 than hitherto. What hai. happened is that we have so to speak "outgrown" the Roosevelt reforms so that a new era of economic reconstruction and reform is needed. I will now address the five problems put by Senator Proxmire in his letter inviting me to this session: (a)  The capital adequacy of banks (national, state  member and insured nonmember) including capital adequacy by size category of institution. Bank capital can be viewed as equivalent to the margin that purchasers of stocks furnish their brokers.  This margin  protects the lender against loss and assures that the investor is prudent because his own money is at stake.  Bankers are  largely lending or investing other people's money.  If a bank  has an 8% capital/asset ratio then $11.50 of other people's money is used for every dollar of the "banker's money" whereas a 3.3% capital/asset ratio yields a 29/1 ratio of other people's money to banker'S money.  B6•617 0 • 77 • 24   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  364 -5-  0nce bank capital is looked upon as the margin put up by bankers to protect the lenders to the bank against losses, then the adequacy of bank capital depends upon the nature of the bank's assets and the conditions under which the bank acquires funds.  If a bank's assets consist largely of short  term loans or securities which are default free and readily marketable (such as government debt), then the capital asset ratio can be lower than if- the assets are long term with considerable default risk.  Similarly if the assets finance well  defined transactions which will yield sufficient cash to repay the banker and if the banker is capable of supervising the borrower's activities, then the capital/asset ratio can be lower than if the transactions being financed are illdefined, if the cash to repay the banker will have to come mainly from borrowing, and if the banker cannot supervise the borrower.  Furthermore if the banker's liabilities are  mainly demand deP.osits and pass-book type savings accounts then the capital/asset ratio can be less than if the bank is largely dependent upon bought money - wholesale certificates of deposit, euro-dollar loans, repurchase agreements and federal funds. The adequacy of bank capital cannot be determined by any simple formula which will flash a warning signal when some minimum level is reached.  Whether bank capit_al is  adequate or not depends upon the economic conditions that determine the cash flows to borrowers who expect to pay off   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  365 -6debt and the financial market conditions upon which refinancing is available to those who expect to borrow to repay debt.  The  bank capital/asset ratio can safely be lower in an era of financial tranquility than in an era of financial turmoil. Even though there is no magic number with respect to bank capital, the trends in the capital/asset ratio in the past decade together with the changes that have taken place in the asset and liability structures of banks indicates that bank capital is now less "adequate" than hitherto.  Further-  more the developments in the asset composition and the nature of the liability structure of the very largest banks indicates that the capital/asset ratio for the largest banks might very well need to be increased. The business of banking puts pressures on bankers to try and decrease their capital/asset ratio.  Banks are busi-  nesses that have to yield a competitive return to their stockholders.  The profit per dollar of bank capital equals the  profit per dollar of assets times the assets per dollar of capital.  One way a banker can increase the profitability  of his bank is by increasing the ratio of assets to capital. As is evident from Chart I in the attachment the ratio of financial net worth of banks to total liabilities peaked at about 8.6% in 1960 and thereafter trended downward to 5.6% in 1974.  At the same time the ratio of liabilities to  protected assets (cash plus government securities) trended upwards (Chart II) and bought funds increase   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  as a ratio to  366 -7total liabilities (Chart III).  Even as the ratio of capital  to liabilities has decreased,the asset and liability structure of banks indicates that the required capital/asset ratio has been increasing. Before we go into the adequacy of capital we must recognize that a bank's economic capital is a residual derived by subtracting the dollar value of liabilities from the dollar value of assets.  True there is a "capital-account", that  reflects the initial investment, the history of retained earnings, and sales of stocks after the initial investment, but this "book" capital is equal to the economic capital only if in fact all assets are worth what the books say they are worth.  If market conditions are turbulent, as they have been  in the past decade, then the market value of assets, and thus the true value of capital, may be much below the value as entered upon the bank's books.  In many ways it is better to  look at the bank's cash flows and the cash flows of its borrowers and depositors than at the bank's capital ratio. Smaller banks consistently have significantly larger capital/asset ratios than the giant banks.  But smaller banks  cannot finance the giant businesses of our land - they specialize in financing the smaller and modest sized businesses.  How-  ever these smaller banks must earn returns on their holder's investment that are in the same ball park as the returns earned by the giant banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Because smaller banks have a lower ratio  367 -8-  of assets per dollar of equity, they must earn a larger amount per dollar of assets than the giant banks.  This means that  the smaller businesses will be charged higher interest rates than the giant banks charge their "larger" business customers. As Congress and the regulatory agents set the rules on capital/asset ratios and perrnissable banking business they are effectively determining whether, or to what extent, financing terms are going to be favorable to one or another class or type of business.  As the capital/asset ratios are enforced  by the supervising agencies, a bias is introduced which favors the giant banks and their big business clients. The regulatory authorities have more effective power over the smaller banks than over larger and giant banks.  The  authorities seem to try and enforce a capital/asset ratio equal to or greater than 8% for the smaller banks.  Some of  the giant banks now have a capital/asset ratio in the neighborhood of 3%.  In the present situation where the giant  banks are heavily into foreign loans and foreign deposits I doubt if the authorities would defend the proposition that the asset and liability structures of the giant banks are superior to that of the smaller banks so that this discrimination in favor of the giant banks is warranted.  Recent  experience shows that well run smaller banks have better asset and liability structures than many of the giant banks. Because we want healthy economic expansion even as we want   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  368 -9a safer and more secure financial system I suggest that the regulatory authorities should move the banks toward a common asset/capital ratio by tightening up on the giant banks even as they allow the smaller banks a higher asset/ capital ratio. (bl  The liquidity of the banking system including your  analysis of loan to deposit ratios and short term borrowings. A bank, the banking system, or for that matter any organization that has debts to pay becomes illiquid when it cannot fulfill the financial commitments embodied in its debts.  Banks and other institutions become illiquid when  there is a run on their liabilities~ when deposits are withdrawn or short term debts, such as Federal Funds or certificates of deposit, cannot be rolled over.  A unit is  unable to attract deposits or roll over debt when doubt arises that the unit will be able to repay newly issued debt when it matures.  Therefore the essential cause of bank illiquidity  is a deterioration of bank asset quality and the thinness of the protection that bank equity provides to a bank's lenders and depositors. The above indicates that the liquidity of a bank, a banking system, or a set of financial markets depends upon the asset-liability and liability-cash flow structures of the borrowers, i.e., of firms.  Three charts dealing with  the Non-Financial Corporate sector are attached which give us some idea as to how the balance sheet of United States firms have evolved over the years since 1950.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  In Charts VI  369 -10and VII the liabilities relative to cash flows and to demand deposits are exhibited.  It is evident that the  ability of non-financial corporations as a whole to meet payment commitments on debts out of cash flows and out of excess holdings of demand deposits deteriorated over the 25 years.  From Chart VIII it is evident that non-financial  corporations have become increasingly dependent upon borrowing in the open market and from finance companies. Thus banks have been dealing with a decreasingly liquid business sector. In Charts II through IV, which were referred to earlier when capital adequacy was discussed, some of the changes in the financial position of commercial banks over the post war period are detailed.  Protected Assets are cash and U.S.  Government securities.  In the early post war era the ratio  of liabilities to protected assets increased slowly; since 1963 this ratio rose rapidly so it stood at 11.9 in 1974. Similar deterioration of the liquidity of the banking system is evident in Charts III and IV.  The liabilities of banks  are increasingly non-deposit debts plus large denomination Certificates of Deposit.  The firm basis of liabilities in  bank equity and demand deposits eroded over this period. Loan deposit ratios are the result of these underlying trends in which secure deposits become a smaller proportion of liabilities even as government securities and cash become smaller proportions of total assets.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The trends that are  370 -11shown would give us little cause for concern if we were sure that the overall behavior of the economy was becoming more stable, that inflation was not a problem, cyclical troughs such as we had in 1971 and 1975 were becoming milder, and fluctuations in interest rates were diminishing. As we know exactly the opposite is true: even as bank exposure to funds flights and cash flow disappointments and interest rate variations have increased the stability of the economy has decreased. In thinking about the liquidity of banks we should also be aware of the problems due to the existence of covert liabilities.  Bank lines of credit and letter of credit are "covert  liabilities" of banks.  When banks extend a line of credit  to a commercial or a manufacturing firm, the bank has a fairly good idea as to how the line will be used, the use of the line will depend upon the seasonal and cyclical rhythm of the borrower's business. Businesses borrow from the open market by means of commercial paper.  After the Penn Central debacle it became  normal practice for borrowers on the commercial paper market to have open or unused lines of credit at banks equal to or greater than their borrowing by commercial paper.  The  lender on commercial paper therefore had the guarantee that the borrower could always repay by drawing upon bank credit. The banks extending the lines of credit were "lenders of last resort" to the borrowers on commercial paper.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Whether or not  371 -12the bank lines were going to be used depended not so much upon the rhythm of the underlying J::usiness but upon the behavior of financial markets. In 1974/75 there was a "run" on the commercial paper of the REIT's.  Commercial bank lines of credit were out-  standing to support this commercial paper and the REITs drew upon these lines to repay their commercial paper.  This  meant that banks had to "come up" with some $4 billions of funds and took on some $4 billion of additional loans to suspect institutions.  Much of the recent weakness of banks  is a direct outgrowth of the commercial paper-bank lines of credit connection.  In any revision of bank supervising  practices and banking control legislation one objective should be to establish better controls over covert liabilities. Certainly the authorities should have data on lines of credit outstanding and whether these lines represent the financing of activity or whether they represent back up financing to some financial market.  In the bank examination  procedure I drew up in 1967 I suggested that such data be collected in the examination process. (c)  The condition of the asset structure of the banking  system including an analysis of classifications in the loan and securities portfolios of banks. I really haven't much to say about this question.  We  know that corporate gross profits after taxes increased markedly in response to the government deficits of 1975 and 1976.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  372 -13This improved cash flow combined with the stable if not declining corporate fixed investment meant that the balance sheets of many corporations improved.  As corporations paid  off their debts, banks were able to acquire substantial amounts of U.S. government securities.  This meant that the  liquidity of commercial banks, as far as their United States operations balance sheets are concerned, improved enormously. Furthermore we know that the quality of bank loans to industries such as airlines and utilities have improved markedly over the past two years. "examiner"  Regardless of what the  classification system shows it is evident from  the aggregate experience that in a meaningful sense the quality of the United State assets in bank portfolios has improved over the past several years. There is a question of course in the quality of the assets and the nature of the liabilities in the overseas branches of United States domestic banks.  Fortunately the  problem of overseas assets and liabilities really affects only the very largest banks.  Because you specifically  inquire into overseas deposits in question e I will defer my comments on that score. (d)  An analysis of whether current bank examination  practices are adequate to uncover bad  management practices:  whether the agencies take timely curative action: and whether the agencies utilize sufficient objective standards on criteria to assure the safety and soundness of the banking system.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  373 -14The safety and soundness of the banking system depends upon the ability of borrowers to repay the debts owed to banks and the ability of the banks to finance and refinance their holdings of assets.  The ability of borrowers to repay  debts to banks depends upon the cash flows that their business activities generate and in particular the margin of safety built into the borrowers cash flows and liquid asset holdings.  Thus the safety and soundness of the banking  system mainly depends upon the way the economy is functioning and the extent to which economic activity is debt financed. Unfortunately there seems to be a strong tendency to increase the extent of indebtedness and the layering of financial relations over a period in which the economy has a run of good times.  Elsewhere I have described the way in  which a robust financial system is transformed into a fragile financial system over a run of good times such as we have had in the years since World War II.  I hold that bank  -examination and bank supervision should be more concerned with the conditions that make for financial fragility and the systemic changes in financing practices than it is at present.  Thus I would have bank examinations focus upon cash  flows and positions making processes rather than on asset valuation and documentation as at present. The responses by the Comptroller of the Currency and the Federal Deposit Insurance Company to questions raised by this committee (I did not receive the Federal Reserve System's response in time for these remarks.) indicates that   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  374 -15the bank supervising agencies visualize bank failures as the result of individual error, bad management, or wickedness rather than as the result of systemic characteristics.  In  truth b_ank difficulties are more due to the way in which rising interest rates and heavier reliance on debt financing makes financial difficulties some place in the system inevitable.  It is true that almost always after the event reasons  in the form of incompetency, unfortunate financial practices, or illegal activities can be found to explain why particular banks fail, but,except when the failure is of an isolated individual unit,the overriding reasons for the failures lie in the overall financial structure of the economy.  A  systemic flaw always shows up as the failure of individual units, unless the situation deteriorates to a general collapse as in 1929-33. Bank examination and  supervising procedures should aim  at the maintenance of an adequate capital asset ratio and the avoidance of asset and liability structures which can lead to expensive and uncertain position making activity. Bank examinations should pay increased attention to the covert liabilities of banks, the use of purchased money, and the ability of the bank to properly supervise its borrowers than it now does. In any discussion of bank examination and the use of bank examination to assure the safety and soundness of the banking system a distinction has to be drawn between the giant money market and international banks on the one hand   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  375 -16-  and the smaller banks.  The examiners and supervisors can  understand and can guide the business of the smaller banks; they have little or no ability to control or guide the giant banks.  In the complex ~nterrelations between the  supervising authorities and the giant banks I venture to say that the initiative comes from the giant banks and the Federal Reserve and the other authorities are left with little choice but to validate the giant bank decisions.  The devel-  opment of the Federal Funds market, Certificates of Deposit, line of credit banking, and eurodollar activities are examples of initiatives mainly by the giant banks, which so to speak force the hands of the Federal Reserve and the other authorities. It is also evident that the existence of serious overseas branches makes the bank examination and bank supervision task much more difficult.  Perhaps the only way_to really control  the overseas involvement of United States banks is to impose stiff capital requirements against overseas liabilities and assets.  As things stand detailed control of the giant banks  by examining and supervising authorities is virtually impossible and the only control and supervision of giant banks that can be effective are general balance sheet controls such as a minimum capital/asset ratio.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  376 -17(e)  The role of the Federal Reserve as a lender of last  resort to assure the ultimate solvency of individual banks or the banking system, including the effect of such on the international operations of large banks. In the credit crunch of 1966, the liquidity squeeze of 1970, and the Franklin National crisis of 1974 the Federal Reserve acted as a lender of last resort.  In the past decade  or so under the influence of monetarist doctrines increased emphasis has been placed upon the Federal Reserve as the "controller" of the economy by its actions that affect the reserve base.  However the Federal Reserve was organized more  to be a lender of last resort - to guarantee that debt deflations do not.happen - than to guide the economy.  Even  as the Federal Reserve bailed out the. financial system on three occasions in a decade, the main attention has been on the Federal Reserve as determining the money supply.  The  implications of the Federal Reserve~ lender of last resort actions for the behavior of the economy have been ignored. Lender of last resort actions are required when a run is taking place; when normal channels for financing activity are not available.  Usually the need for such action occurs  when some institution  or market is under pressure, perhaps  because high and rising interest rates have affected cash flows and asset values.  The Federal Reserve's intervention  provides financing which prevents disorderly conditions in some market or the bankruptcy of some institution.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Whenever  377 -18the Federal Reserve engages in lender of last resort action it extends Federal Reserve protection and refinancing to the threatened institution or market.  By extending this protection,  the Federal Reserve essentially legitimizes the institution or the instrument that is under pressure.  The Federal Reserve  intervenes as a lender of last resort because it believes that in the absence of such intervention a cumulative debt deflation would take place and this debt deflation would lead to a major depression. [We should note that when the Federal Reserve acts as a lender of last resort it acts in the belief that the economy is unstable, when the Federal Reserve acts to steer the economy by controlling the money supply it acts on the basis of a theory which maintains that the economy is stable.] As a result of being legitimized by Federal Reserve  actions, the instruments or markets that were under pressure when the Federal Reserve intervened as a lender of last resort are available for use in the subsequent expansion, unless the Federal Reserve or the Congress effectively bars the use of that instrument.  After the great crash of 1929-33 it was  common to blame the depression on the stock market crash of 1929 and to blame the stock market crash on the thin margins that were required.  As a result Congress gave the Federal  Reserve the authority to set margin requirements for the purchase of stock.  As far as I know neither the Federal  Reserve nor the Congress has followed up on recent lender   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  378 -19of last resort interventions by the Federal Reserve by measures to control or forbid the practices that were the proximate cause of the instability that led to the lender of last resort intervention. The credit crunch of 1966 took the form of a run on bank certificates of deposit - the Federal Reserve intervened by opening up the discount window.  The Federal Reserves action  legitimized the use of certificates of deposi~ and in the subsequent expansion  banks have become ever more dependent  upon certificates of deposit.  In broader terms the Federal  Reserve in 1966 vatidated what is called liability management banking. The liquidity squeeze of 1970 culminated in the Penn Central failure.  This triggered a run on commercial paper,  especially on that of the Chrysler Corporation.  The Federal  Reserve intervened by encouraging the formation of a syndicate to refinance Chrysler's commercial paper.  The 1970 squeeze  legitimized the use of commercial paper and established the precedent that commercial paper would be backed by open lines of credit at banks.  In 1974/75 some $4 billions of commercial  paper of REITs were run off.  The REITs borrowed the funds  to repay this commercial paper from banks. The critical element in 1974 was the failure of the Franklin National Bank. was a $5 billion bank.  At the end of 1973 Franklin National Of this $5 billion some $3 billion  was in a retail business in Long Island, about $1 billion was in its Wall Street business, and about $1 billion was   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  379 -20-  in overseas branches.  When Franklin National's troubles  became public in May of 1974, it immediately lost its ability to borrow on the Federal Funds Market and it could no longer rollover its uninsured certificates of deposits and its eurodollar borrowings.  Two weeks after its troubles  becoming publ.ic knowledge, Franklin National was borrowing $900 million from the Federal Reserve Bank of New York. The Federal Reserve sustained the Franklin National until October 1974 when it was finally adjudged bankrupt.  At the  time of its bankruptcy Franklin National had $3.6 billion in assets and was borrowing $1.7 billions from the Federal Reserve.  About $3.l billion of Franklin National's deposits  and borrowings were paid off by funds that accrued as assets matured and by borrowing from the Federal Reserve. By its actions in the Franklin National Bank the Federal Reserve validated the overseas deposits at Franklin National. If Franklin National is a precedent, and I believe it is, the Federal Reserve has extended "insurance" to all deposits and loans to overseas branches of United States banks!  In  effect the deposits at overseas branches of United States banks are more secure than deposits in domestic offices, for it is possible for the authorities to protect only the statutory maximum of a deposit in a United States office of a failed bank rather than the entire deposit. The 1974 action by the Federal Reserve may have been necessary and wise.   https://fraser.stlouisfed.org 86-817 0 - 77 - 25 Federal Reserve Bank of St. Louis  However I believe it was unwise and  380 -21unnecessary to let it stand as a precedent.  It was quite  clear in the Franklin National case that a run on an overseas branch of a United States bank can disrupt the functioning of United States financial markets.  After bailing Franklin  National's depositors out, the Federal Reserve should have either established strict controls over the operations of United States banks overseas or it should have requested authority from the Congress to establish such controls.  The  Federal Reserve, by bailing out the overseas depositors of Franklin National and then doing nothing, set the stage for the present "touchy" situation with the overseas "deposits" of United States banks. If there is no deposit insurance, then depositors, especially large depositors, investigate the liquidity and solvency situation of banks in which they deposit funds. Let us call this depositor surveillance.  As long as my  deposit falls within the insured limits then I need not be concerned about the liquidity, solvency, competence, or even honesty of the banker with whom I deposit funds.  However,  if I have more than the insured amounts on deposit then I will "look" over the banker's shoulder. The huge growth of deposits at the overseas branches of United States banks is due to the implicit endorsement of these deposits by the Federal Reserve which the Franklin National precedent implies.  Depositors in these branches  do not need to be concerned about the capital adequacy of   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  381 -22-  the branch in which they deposit and they need not be concerned about the quality of the assets of the branch. As a result deposits have flowed to the branches of United States banks from surplus countries and the banks have rather carelessly financed activities around the world. Neither the depositors in these branches nor the various banking authorities in the United States have been particularly concerned with the assets that were acquired by these banks. It seems as if the Federal Reserve, the F.D.I.C., and the Comptroller of the Currency have no power over the giant banks.  The situation we have had since the middle 1960's  has been one in which the banks innovate a usage - Certificates of Deposit, covert liabilities to "back" commercial paper, eurodollar deposits - and the Federal Reserve validates the usage when a "crunch" comes.  In order to achieve a more  stable economy we have to find some way to control the activities of the giant banks.  As things now stand the banking system  is an engine of inflation that is periodically bailed out of difficulties by the Federal Reserve System. I have skimmed the surface of each question the committee has raised.  Fundamentally the issue is the role of the  financial system in our type of economy and whether an economy with our type of financial system is characterized by instability.  It certainly seems as if the combination of speculative  expansive finance, the Federal Reserve lender of last resort   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  382 -23-  actions, and the sustaining effects of big government have led to an economy that generates a dismal cycle,oscillating between threats of a runaway inflation and a financial collapse.  If we are in such a dismal situation then the  important policy question is "How to get off the back of the tiger". Our dismal cycle is mainly due to the external financing of private investment and the elaboration of financing techniques for ownership and control of capital-assets.  However  if measures are taken to discourage such investment financing then total investment will be smaller.  In existing circumstances  this means a higher unemployment rate, i.e., a "continuing recession."  What we need to do is establish financing constraints upon business and asset and liability constraint upon banks and other financial institutions even as we move to minimize unemployment by encouraging more labor intensive production techniques in private industry and using employment programs as the major fiscal device.  We should also eliminate the  investment tax credit and acceleratedclepreciation; these encourage investment and speculative finance, and adopt measures to encourage consumption. We have been following the dictates of a view that capital intensive investment is the road to growth in Gross National Product and a growth in Gross National Product is the road t0--an increase in well being.  It is now evident  that when our type of economy emphasizes capital intensive   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  383 -24investment it becomes inflation prone and financially unstable.  We should begin to question the simplistic logic  that holds that capital intensive investment is the way to better our economy, especially as the emphasis upon investment has brought us not only instability but chronic high unemployment. The way we can get off the back of the tiger is to consciously replicate the financial relations that rule during a deep depression without having a deep depression.  Until  we achieve sustainable financial relations, financing of investment by private deficits should be constrained.  In  place of policy that induces investment output, policy should emphasize consumption.  Instead of rushing ahead and stopping,  like the.hare, we can do better by slow and steady progress, like the tortoise.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  384 -25Commercial Banking Selected Financial Ratios 1950 - 1974 Chart I Flnllncl■I  Chart II  Net Worth  +  Total Ll ■blllUes  Total Llabllltlu,  +  Prolecled A...1■,  1970  1974  Chart IV Chart III Demand Depoalla + Total UabllltlH, Bought Fund1  +  Tol■ I  Llablllllff,  .17  .15 .13 .11  .51 .47 .43 .39  .09 .07  .35 .31 1960  1965  1970  1974  ==---:-:!:::-~-±::----:-~---,-,J'--':!....  Source: Hyman P. Minsky, "Financial Resources in a Fragile Financial Environment," Challenge, July-August 1975.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  385 -26Non-Financial Corporations Selected Financial Relations 1950 - 1974  Chart V  Chart VI  Fixed lnve1tmen1t  + G,- Internal l'undl,  Total L11bHltle1 11.0  1.48  o,.____,____,___---1_ _ _. __ 1950  + G.- lnteffllll Fundl,  1955  1960  11185  1970  _._  1974  5.0 4.0. __ _...,__ _..J...._ ___.__ ___,_ __,__ 1950 1955 1960 11185 1970 1974  Chart VII  Chart VIII Open M - Poper - llorrowlnp Inn Fblonce Compenle1 + Total Uabll-.  Totel L11bllltln + Demond Depoollo,  :ze 22 18  .04  14 10  .Ill  8 2  1950  1955  1960  11185  1970  1974  0L----'----'----'---.L....l---'-  1900  1955  1980  11185  1970  Source: Hyman P. Minsky, "Financial Resources in a Fragile Financial Environment," Challenge, July-August 1975.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1974  386  Volume 3  REAPPRAISAL OF THE FEDERAL RESERVE DISCOUNT MECHANISM  Board of Governors of the Federal Reserve System   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  JUNE 1972  387  FINANCIAL INSTABILITY REVISITED: THE ECONOMICS OF DISASTER Hyman P. Minsky Washington University  Contents I.  Introduction  97  II.  The Economics of Euphoria  Ill.  cash Flows  100 1(13  IV.  Financial Instability and Income Determination  108  Appendix to Section IV: A model  V.  How Does Tight Money Work?  114  VI.  The Theory of Financial Stability  117  Attributes of stability The "banking theory" for all units Modes of system behavior Secondary markets Unit and system instability  VII. VIII.  IX.  An Aside on Bank Examination  124  Regional Aspects of Growth and Financial Instability  130 132 135  Central Banking  Biblio1raphy  The original draft of this paper was written in the fall of 1966 and it was revised in January 1970. I wish to thank Maurice I. Townsend, Lawrence it. Seltz.er, and Bernard Shull for their comments and encouragement. Needless to say, any errors of fact or fancy are my. responsibility. Hyman P. Minsky   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  95  388  FINANCIAL INSTABILITY REVISITED: THE ECONOMICS OF DISASTER  I. INTRODUCTION A striking characteristic of economic experience in the United States is the repeated occurrence of financial crises-crises that usher in deep depressions and periods of low-level economic stagnation. More than 40 years have passed since the financial shock that initiated the Great Depression of the 1930's, a much longer period of time than between the crises and deep depressions of the previous century. 1 Is the experience since the Great Depression the result of fundamental changes in the economic system and of our knowledge so that crises and deep depressions cannot happen, or are the fundamental relations unchanged and our knowledge and power still inadequate so that crises and deep depressions are still possible? This paper argues that the fundamentals are unchanged; sustained economic growth, business cycle booms, and the accompanying financial developments still generate conditions conducive to disaster for the entire economic system.  Every· disaster, financial or otherwise, is compounded out of initial displacements or shocks, structural characteristics of the system, and human error. The theory developed here argues that the structural characteristics of the financial system change during periods of prolonged expansion and economic boom and that these changes cumulate to decrease the domain of stability of the system. Thus, after an expansion has been in progress for some time, an event that is not of unusual size or duration can trigger a sharp. financial reaction.• Displacements may be the result of system behavior or human error. Once the sharp financial reaction occurs, institutional deficiencies will be evident. Thus, after a crisis it will always be possible to construct plausible arguments--by emphasizing the triggering events or institutional flaws--that accidents, mistakes, or easily . corrected shortcomings were responsible for the disaster.' In previous work, I have used an accelerator-multiplier cum constraining ceilings and floors model to represent the real economy. Within this model the periodic falling away from the ceiling, which reflects parameter values and hence is an endogenous phenomenon, is the not unusual event that  ~ chronology of mild and deep depression cycles see M. Friedman and A. J. Schwartz, "Money and Business Cycles." In that chronology all clearly deep depression cycles were associated with a financial crisis and all clearly mild depression cycles were not. Friedman and Schwartz choose to ignore this phenomenon, preferring a monolithic explanation for both 1929-33 and 1960-61. It seems better to posit that mild and deep  • I. Fisher, "The Debt-Deflation Theory of Great Depressions., .. • See M. Friedman and A. J, Schwartz, A Monetary History of th, United States 1867-1960, pp. 309 and 310, footnote 9, for a rather startling example of such reasoning.  depressions are quite different types of beasts and the  differences in length and depth are due to the absence or occurrence of a financial panic. See H. P. Minsky, "Comment on Friedman and Schwartz's 'Money and Business Cycles.' "   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  97  389 98  can trigger the "unstable" financial reaction -if a "proper" financial environment or structure exists. The financial reaction in turn lowers the effective floor to income. Once the gap between floor and ceiling incomes is large enough, 1 assumed that the accelerator coefficient falls to a value that leads to a stagnant behavior for the economy. In this way a set of parameter values that leads to an explosive income expansion is replaced by a set thit leads to a stagnant economy. I assumed that the gap between floor and ceiling income is a determinant of the accelerator coefficient and that the immediate impact of financial instability is . to lower the ftoor income, becauae financial variables--including the market value of common stocks-detennine the position of a conventional Keyncsilln C011S11mption function.• This view neglect& decision-making under uncertainty as a determinant of system behavior. A special type of uncertainty is inherent in an enterprise system with decentralized decisions and private ownenbip of productive resources due to the financial relations. The financial system of such an economy partitions and distributes uncertainty. A model that recogniz,es the problems involved in decision-making in the face of the intrinsically irrational fact of uncertainty is needed if financial instability is to be understood. A reinterpretation of Keynesian economics as just such a model, and an examination of how monetary ccinstraintwhether due to policy or to behavior of the economy-works, are needed before the stability properties of the financial system and thus of the economy can be examined. it turns out that the fundamental instability of a capitalist economy is a tendency to expiode-to enter into a boom or "euphoric" state.  This paper will not present any empirical research. There is, nevertheless, need to: ( 1) examine updated information of the type analyzed in earlier studies, ( 2) explore additional bodies of data, and ( 3) generate new data (see Section VII). Only with this infonnatlon can the problem be made precise and the propositions tested. There is a special facet to empirical work on the problems at issue. Financial crises, panics, and inatability are rare events with short durations.' We have not experienced anything more than unit or minor sectoral financial distress since the early l 930's. The institutions and usages in finance, due to both legislation and the evolution of financial practices, are much different today from what they were before tke Great Depression. For example, it is necessary to guess the power of deposit insurance in order to estimate the conditions under which a crisis can develop from a set of initial events.• The short duration of cri11es means that the smoothin& operations that go into data generation as wen as eoonometric analysis will tend to 111inimim the importance of crises. Because of such facton it might be that the most meaningful way to test propositions as to the cause and effect of financial instability will be through simulation studies, where the simulation models are designed to reflect alternative ways that financial instability can be induced.' In this paper, Section II discusses differences between a11 economy that is simply ~ n g steadily and one that is booming.  • H. P. Minsky, "FiMnClal Crisis, f'inencial Sys-  teMO. atld the Perfonllance of the Economy." pp. 326-70, where a 11uabcr of "priailive" simulations are pre,emed.  tems. and the Perfonunce of the Economy," attd "A Linear Model of c,dical Orowllo."   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  'The larp and long contraction of 1929-33 can be interpreted as a succession of crises compounding an initial disturbance. • Perhaps the financial history of 1966 can be in• ttrprete,I as a test of the power of deposit insurance to olftet the dalabilmn1 aspocts of tlnancial constraint.  'K. P. MiMky, "Finllllcial Crisis, Financial Sys,  390 FINANCIAL INSTABILITY REVISITED  The characteristics of a euphoric economy are identified. This section develops the proposition that, in a boom or euphoric economy, the willingness to invest and to emit liabilities is such that demand conditions will lead to tight money marketsdefined in terms of the level and rate of change of interest rates and other financing terms--independently of the rate of growth of the money supply. Section III focuses upon cash flows due to income production, balance sheet relations, and transactions in real and financial assets. The likelihood of financial instability occurring is dependent upon the relationship between cash payment commitments and the normal sources of cash, as well as upon the behavior of markets that will be affected if unusual sources of cash need to be tapped. Section IV develops the role of uncertainty as a determinant of the demand for investment within a framework of Keynesian economics. Section V examines alternative modes of operation of monetary constraint. In a euphoric economy, tight money, when effective, does ilot operate by inducing a smooth movement along a stable investment schedule; rather it operates by shifting the liquidity preference function. Such shifts are typically due to a liquidity crisis of some sort. Section VI explores the domains of stability both of the financial system and of the economy. These domains are shown to -be endogenous and to decrease during a prolonged boom. In addition, the financial changes that take place during a euphoric period tend also to decrease the domain of stability and the feedbacks from euphoria tend to induce sectoral financial difficulties that can escalate to a general financial panic. If such a. panic occurs, it will usher in a  deep depression; however, the central bank   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  can abort a financial crisis. Nevertheless, the tensions and tremors that pass through the financial system during such a period of near crisis may lead to a reconsideration of desired portfolio composition by both financial institutions and other economic units. A rather severe recession may follow such a reconsideration. Sections :vu and VIII deal with two special topics; bank examinations and regional impacts. In Section VII it is argued that a bank examination procedure centering around cash flows as determined by balance sheet and contractual relations would be a valuable guide for Federal Reserve policy and an important instrument for bank management. Such an examination procedure would force financial-unit managers and economic policy-makers to consider the impact upon financial units of the characteristics of both the real economy and the financial system. The discussion of the regional impact of Section VIII centers around the possibility that there is a concentration of financially vulnerable units within one region. In these circumstances the escalation of financial constraint to a financial crisis might occur though financially vulnerable units, on a national basis, are too few to cause difficulty. Section IX sets forth some policy guidelines for the Federal Reserve System. It is argued that the discount window should be open to selected money market position takers ( deaiers) and that the Federal Reserve should move toward furnishing a larger portion of the total reserves of banks by discounting operations. This policy strategy follows from the increased awareness of the possibility of a financial crisis and of· the need to have broad, deep, and resilient markets for a wide spectrum of financial instruments once a financial crisis threatens so that the effects of such a crisis can be moderated. ·  391 100  II. THE ECONOMICS OF EUPHORIA In the mid-1960's the U.S. economy experienced a change of state. Political leaders and official economists announced that the economic system had entered upon a new era that was to be characterized by the end of the business cycle as it had been known.• Starting then, cycles, if any, were to be in the positive rate of growth of income. The doctrine of "fine tuning" went further and asserted that even recessions in the rate of growth of income could be avoided. Contemporary business comments were consistent with these official views. The substance of the change of state was an investment boom: in each year from 1963 through 1966 the rate of increase of investment by corporate business rose.• By the mid-l 960's business investment was guided by a belief that the future promised perpetual expansion. An economy that is ruled by such expectations and that exhibits such investment behavior can properly be labeled euphoric. Consider. the value of a going concern. Expected gross profits after taxes reflect the expected behavior of the economy, as well as expected market and management developments. Two immediate consequences follow if the expectation of a normal business cycle is replaced by the expectation of steady growth. First, those gross profit~ in the • I. Tobin, The lntt/1,ctua/ Rtvolution in U.S. Economic Policy Making. • Investment by nonfarm, nonfinanciat corporations. 1962-66: Year  Purchaw or phy1ical anc1s  Billiom of  dollars  1962 .. ............ , ..... · 1963 .. ............ , .... . 1964 .••. .••••..•.••.....  196' .................... . 19'6 .. .................. .  ;::~ 53.!I  64.9  19.1  j Growth r,ue (per cent)  4j 14.6  21.3 21.6•  •The "crunch" o( 1966 occurred in late Au1ust/early September; it put a damper on inYCstment and the purchase of physical auets declined to S74.1 billion in 1967. SovacE.-Ec011omk R•po,t of tlw P,,sidrnt, 1969, Table  B73.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  present-value calculations that had reflected expected recessions are replaced by those that reflect continuing expansion. Simultaneously there is ·1ess uncertainty about the future behavior of the economy. As the belief in the reality of a new era emerge~. the decrease in the expected down or short time for plant and equipment raises their present values. The confident expectation of a steady stream of prosperity gross profits makes portfolio plunging more appealing to firm decision-makers. A sharp rise in expected returns from real capital makes the economy short of capital overnight. The willingness to assume liability structures that are less defensive and to take, what would have been considered in earlier times, undesirable chances in order to finance the acquisition of additional capital goods means that this shortage of capital will be transformed into demand for financial resources. Those that supply financial resources live in the same expectational climate as those that demand them. In the several financial markets, once a change in expectations occurs, demanders, with liability structures that previously would in the view of the suppliers have made them ineligible for accommodations, become quite acceptable. Thus, the supply conditions for financing the acquisitions of real capital improve simult11neously with an increase in the willingness to emit liabilities to finance such acquisitions. Such an expansionary, new era is destabilizing in three senses. One is that it quite rapidly raises the value of existing capital. The second is an increase in the willingness to finance the acquisition of real capital by emitting what, previously, would have been considered as high-cost liabilities, where the cost of liabilities includes risk or uncertainty  392 FINANCIAL INSTABILITY REVISITED  borne by the liability emitter (borrower's risk) . The third is the acceptance by lenders or" assets that earlier would have been considered low-yield-when the yield is adjusted to allow for the risks borne by the asset acquirer (lender's risk). 10 These concepts can lie made more precise. The present value of a set of capital goods collected in a firm reflects that firm's expected gross profits after taxes. For all enterprises there is a pattern of how the business cycles of history have affected their gross profits. Initially the present value reflects this past cyclical pattern. For example, with a short horizon  v~ Q, Q, Q, t+,,+o+r,>•+o+r.)1 where Q, is a prosperity, Q2 is a recession, and Q, is a recovery gross profits after taxes, (Q,<Q,<Q,). With the new era expectations Q,! and Q,', prosperity retunis replac;e the depression and recovery returns. As a result we have: V (new era) > V (traditional) . This rise in the value of extant capital assets as collected in firms increases the prices that firms are willing to pay for additions to their capital assets. Generally, the willingness to emit liabilities is constrained by the need to hedge or to protect the organization against the occurrence of unfavorable conditions. Let us call Q," and Q," the gross profits after taxes if a possible, but not really expected, deep and long recession occurs. As a risk averter the portfolio rule might be that the balance sheet structure must be such that even if Q(' and Q," do occur no serious consequences will follow: Q," and Q,"-though not likely-are significant determinants of desired balance sheet structure.11 As a result " M. Kalecki, "The Principle of lncre1sin1 Rist.• "W. Fellner, "Aver■ae-Cost Pricing and the Theory of Uncenainty,• and "MonetarY Policies and  Hoardin& in Periods of Sta,niltion,• and S. A. Ozp," ExP«tOtio,u in Economic Tli11N1,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  101  of the euphoric change in "state," the view grows that Q," and Q," are so unlikely that there is no need to protect the organization against them. A liability structure that was expensive in terms of risk now becomes cheap when there were significant chances of Q," and Q.'' occurring. The cost of capital or of finance by way of such· liability structures decreases. Financial institutions are simultaneously demanders in one and suppliers in another set of financial markets. Once euphoria sets in, they accept liability structures-their own and those of borrowers--that, in a more sober expectational climate, they would have rejected. Money and Treasury bills become poor assets to hold with the decline in the uncertainty discount on assets whose returns depend upon the performance of the economy. The shift to euphoria increases the willingness of financial institutions to acquire assets by.engaging in Jiquidity-decreasing portfolio transformations. · A euphoric new era means that an investment boom is combined with pervasive liquidity-decreasing portfolio transformations. Money market interest rates rise because the demand for investment is increasing, and the elasticity of this demand decreases with respect to market interest rates and contractual terms. In a complex financial system, it is possible to finance investment by portfolio transformations. Thus when a euphoric transformation of expectations takes place, in the short run the amount of investment financed can be independent of monetary policy. The desire to expand and the willingness to finance expansion by portfolio changes can be so great that, unless there are serious side effects of feedbacks, an inflationary explosion becomes likely. A euphoric boom economy is affected by the financial heritage of an earlier, more insecure time. The world is not born anew each moment. Past portfolio decisions and  393 102  conditions in financial markets are embodied in the stock of financial instruments. In particular, a decrease in the market value of assets which embody protections against ~tates of nature that are now considered unlikely to occur will take place, or alternatively there is a rise in the interest rate that must be paid to induce portfolios to hold newly created assets with these characteristics. To the. extent that such assets are limg lived and held by deposit institutions with short-term or demand liabilities, pressures upon these deposit institutions will accompany the euphoric state of the economy. In addition the same change of state that led to the investment boom and to the increased willingness to emit debt affects the portfolio preferences of the holders of the liabilities of deposit institutions. These institutions must meet interest rate competition at a time when the market value of the safety they sell has decreased; that is, their interest rates must rise by more than other rates. The rising interest rate on safe assets during a euphoric boom puts strong pressures on financial institutions that offer protection and safety. The linkages between these deposit institutions, conventions as to financing arrangements, and particular real markets, are such that sectoral depressive pressures are fed back from a boom tb particular markets; these depressive pressures are part of the mechanism by which real resources are shifted. The rise in interest rates places .serious pressures upon particular financial intermediaries. In the current ( 1966) era the savings and loan associations and the mutual savings banks, together with the closely related homebuilding industry, seem to take a large part of the initial feedback pressure. It may be that additional feedback pressures are on life insurance and consumer finance companies.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  A little understood facet of how financial and real values are linked centers around the effect of stock market values." The value of real capital rises when the expectation that a recession will occur diminishes and this rise will be reflected in equity prices. The increased ratio of debt financing can also raise expected returns on equities. Inasmuch as owners of wealth live in the same expectational climate as corporate officers, portfolio preferences shift toward equities as the belief in the possibility of a recession or depression diminishes. Thus, a stock market boom feeds upon and feeds an investment boom. The financing needs of the investment boom raise interest rates. This rise lowers the market value of long-term debt and adversely affects some financial institutions. Higher interest rates also increase the cost of credit used to finance positions in equities. Initially, the competition for funds among various financial sectors facilitates the rapid expansion of the economy; then as interest rates rise it constrains the profits of investing units and makes the carrying of equities more expensive. This first tends to lessen the rate of increase of equity prices and then to lower equity prices. All in all, the euphoric period has a short lifespan. Local and sectoral depressions and the fall in equity prices initiate doubts as to whether a new era really has been achieved. A hedging of portfolios and a reconsideration of investment programs takes place. However, the portfolio commitments of the short euphoric era are fixed in liability structures. The reconsideration of investment programs, the lagged effects upon other sectors from the resource-shifting pressures, and the inelasticity of aggregative supply that leads to increases in costs ,. R. Turvey, "Does tbe Rate of Interest Rule tho Roost?" J, M. Keynes. Tht Gtn,ral Thtor,- of Emp/oym1nt, lnt,r,st and Money, Cbapter 12.  394 FINANCIAL INSTABILITY REVISITED  combine to yield a shortfall of the income of investing units below the more optimistic of the euphoric expectations. The result is a combination of cash flow commitments inherited from the burst of euphoria and of cash flow receipts based upon lciwer-than-expected income. Whether the now less-desirable financia1 positions will be unwound without generating significant shocks or whether a series of financial shocks will occur is not known. In either case, investment demand decreases from its euphoric levels. If the boom is unwound with little trouble, it becomes quite easy for the economy once again to enter a "new era"; on the other hand, if the unwinding involves financial instability, then there are prospects of deep depressions and stagnation. The pertinent aspects of a euphoric period can be characterized as follows:  103  I. The tight money of the euphoric period is due more to runaway demand than to constraint upon supply. Thus, those who weigh money supply heavily in estimating money market conditions will be misled. 2. The run-up of short- and long-term interest rates places pressure on deposit savings intermediaries and disrupts industries whose financial channels run through th~se intermediaries. There is a feedback from euphoria to a constrained real demand in some sectors. 3. An essential aspect of a euphoric economy is the construction of liability struc·tures which imply payments that are closely articulated directly, or indirectly via layerings, to cash flows due to income production. If the impact of the disruption of financing channels occurs after a significant build-up of tight financial positions, a further depressive factor becomes effective.  Ill. CASH FLOWS Financial crises take place because units need or desire more cash than is available from their usual sources and so they resort to unusual ways to raise cash. Various types of cash flows are identified in this section, and the relations among them as well as between cash flows and other characteristics of the economy are examined. The varying reliability of sources of cash is a well-known phenomenon in banking theory. For a unit, a source of cash may be reliable as long as there is no net market demand for cash upon it, and unreliable whenever there is such net demand upon the source. Under pressure various financial and nonfinancial units may withdraw, either  by necessity or because of a defensive financial policy, from some financial markets. Such withdrawals not only affect the potential variability of prices in the market but   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  also may disrupt business connections. Both the ordinary way of doing business and standby and defensive sources of cash can be affected.. , Withdrawals on the supply side of financial markets may force demanding units that were under no special strain and were not directly affected by financial stringencies to look for new financing connections. An initial disturbance can cumulate through such third-party or innocent-bystander impacts. Financial market events that disrupt well-established financing channels affect the present value and cash flows of units not directly affected. 11 For most consumers and nonfinancial (ordinary) business firms the largest source " Thus the disruption of the southern California savinp ind Joan mortaaae markets in mid-I 966 af. fected al/ preaent values and casb llow expectations in the ICOIICIIDy.  395 104  of cash is from their current income. Wages and salaries are the major source of cash to most consumers and sales of output are the major source for business firms. For financial intermediaries other than dealers, the ordinary cash flow to the unit can be derived from its financial assets. For example, short-term business debts in a commercial bank's portfolio state the reserve money that borrowers are committed to make available to the bank at the contract dates. A mortgage in a savings and loan association's portfolio states the contractual "cash flow to" for various dates, For financial market dealers cash receipts usually result from the selling out of their position, rather than from the commitments as stated in their inventory of assets. Under ordinary circumstances dealers as going concerns do not expect to sell out their positions; as they sell one set of assets they proceed to acquire a new set. The ordinary sources of cash for various classes of economic units will be called cash flow from operations. All three types of cash flow from the operations described -Income, financial contracts, and turnover of inventory~an be considered as functions of national income. The ability to meet payment commitments depends upon the normal functioning of the income production system. In addition to cash flow from the sale of assets, dealers-and other financial and nonfinancial units--can meet cash drains due to the need to make payments on liabilities by emitting new liabilities. This second source of cash is called the refinancing of · positions. Furthermore, liquidating, or running off, a position is the third possible way for some units to obtain cash. This is what retailers and wholesalers do when they sell inventories ( seasonal retailers actually do liquidate by selling out their position).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The financial assets and liabilities of an economic unit can be transformed into time series of contractual cash receipts and payments. The various items in these contractual receipts and payments depend upon national income: the fulfillment of the terms of mortgage contracts depends upon consumer disposable income and so forth." Estimates of the direct and indirect impact of variations in national income upon the ability of units in the various sectors to meet their financial commitments can be derived." Each economic unit has its reserve, or emergency, sources of cash. For many units· the emergency source consists of positions in some marketable or redeemable assets. Savings bonds and time deposits are typical standby sources of cash for consumers. A corporation may keep a reserve in Treasury bills or other money market instruments to meet either unusual needs for cash or an unexpected shortfall in cash receipts. Hoards of idle cash serve this purpose for all units. Cash has the special virtue that its availability does not depend upon the normal functioning of .any market. In principle the normal and secondary sources of cash for all units can be identified and their ratio to financial commitments can be estimated. By far the largest number of units use their income receipts to meet their financial commitments. Mortgage and consumer instalment payments for consumers and interest and sinking fund payments for businesses would be financed normally by income cash flows. The substitution of a deposit by customer B for a deposit from customer A in a bank 11' lbis becomes the rationale for a cash flow bank examination. 1be deviation of actual from contrac•  tual cash ftows depends upon the behavior of the economy. 11 The Minsky.Bonen txperiments in H. P. Minsky. "Financial Crisis. Financial Systems. and the Performance of the Economy," were primitive attempts  to do this.  396 FINANCIAL INSTABILITY REVISITED  liability structure may be viewed as the refinancing of a position. The typical financial unit acquires cash to meet its payment commitments, as stated in its liabilities, not from ariy cash flow from its assets. or by selling assets but rather by emitting substitute liabilities. (The only financial organizations that seem to use cash flows from assets to meet cash flow commitments are the closed-end investment trusts, both levered and unlevered.) When a unit that normally meets its financial commitments by drawing upon an income cash flow finds it necessary, or desirable, to refinance its position, additional pressures may be placed upon financial institutions. Some financial relations are based upon the periodic liquidation of positions-for example, the seasonal inventory in retailing. Capital market dealers or underwriters liquidate positions in one get of assets in order to acquire new assets. However, if organizations that normally finance their payments by using cash from either income or refinancing of positions should instead attempt to sell their positions, it may tum out that the market for the assets in position is thin: as a result a sharp fall in the price of the asset occurs with a small increase in supply. In the market for single-family homes a sale is usually not a forced sale, and to a large extent sellers of one house are buyers or renters of another. If homeowners as a class tried to sell out their houses, the market would not be able to handle this without significant price concessions. But significant price concessions mean a decline in net worth-not only for the selling unit but for all units holding this asset. More particularly, a fall in price may mean that the offering units may be unable to raise the required or expected cash by dealing in the affected asset. As an empirical generalization, almost all financial commitments are met from two   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  105  normal sources of cash: income flows and refinancing of positions. For most units-especially those that have real capital goods as their asset-the selling out of their position is not feasible ( no market exists for a quick sale); for others, aside from marginal adjustments by way of special money markets, it is an unusual source of cash. A further empirical generalization is that asset prices-prices of the stock-can fall much more rapidly than income prices-prices of the flow. 11 Any need or desire to acquire cash that leads to attempts to sell out positions in reproducible assets will result not only in large-scale decreases in net worth but also in market prices for reproducible assets that are far below their current cost of production. Even in the face of a widespread need or desire to acquire cash by selling assets, not all assets are allowed to fall in price. The price of some assets will be stabilized by central bank purchases or loans ( refinancing positions) ; such assets can be called protected assets. Financial instability occurs whenever a large number of units resort to extraordinary sources for cash. The conditions under which extraordinary sources of cash have to be_ tapped-which for financial units means mainly the conditions in which positions have to be liquidated ( run off or sold out)-are the conditions that can trigger financial instability. The adequacy of cash flows from income relative to debt, the adequacy of refinancing possibilities relative to position, and the ratio of unprotected to protected financial assets are determinants of the stability of the financial system. The· trend or evolution of the likelihood of financial instability depends upon the trend or evolution of the determinants of financial stability. "'Ibis is the content of the alleaed waae rigidity assumption of Keynesian theory. See H. G. Johnson, "The 'Cleneral Theory' after Twenty-five Yeiin."  397 106  IV. FINANCIAL INSTABILITY AND INCOME DETERMINATION The essential difference between Keynesian and both classical and neoclassical economics is the importance attached to uncertainty." Basic propositions in classical and neoclassical economics are derived by abstracting from uncertainty; the most that uncertainty does is to add some minor qualificatioliS to the propositions of the theory. The special Keynesian propositions with respect to money, investment, and underemployment equilibrium, .as well as the treatment of consumption, can be understood only as statements about system behavior in a world with uncertainty. One defense against some possible highly undesirable consequences of some possible states of the world is to make appropriate defensive portfolio choices." In an attempt to make precise his view of the nature of uncertainty and what his "General Theory" was all about, Keynes asserted that in a world without uncertainty, " I include the conventional interpretation of Keynes under the rubric of neoclassical economics. This standard interpretation, which •~ook off" from 1. R. Hicks' famous article--"Mr. Keynes and the 'Claalcs,' A Sussested Interpretation," and which since has been entombed in standard works like G. Ackley, Macro«onomic Th~ory-ia inconsistent with Keyne■' own succinct and clear statement of the content of the general theory in bis rebuttal to Viner's famous review ("Mr. Keyne■ on the Causes of Unemployment"). Keynes' rebuttal appeared with the title "The General Theory of Employment" and emphasized the dominance of uncertainty in the determination of portfolios, the pricina of capital, and the pace of investment. ,. 1. K. Galbraith in Th, A6/u,nt Soci,r, and K. 1. Affow in "Uncertainly and the Welfare Economics of Medical Care" take the view that various labor and product market deviation■ from competitive conditions rellect the need lo constrain the likelihood that undesirable 11states" of the world will occur. This Galbraith-Affow .view of the optilnal behavior of firms and houoehold■ seems to complement the view in Keynes' rebuttal to v;,,_.,r. See alt10 K. 1. Arrow, A1p,c11 of tht Th,ory of Ri1k B,aring, Lectun, 2: "The Theory of Risk Aversion," and Lecture 3: "Insurance, Riak and Re■our,:c Allocation.•   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  no one, outside a lunatic asylum, would use money as a store of wealth. 19 In the world as it is, money and Treasury bills are held as assets. Portfolios reflect the choices that sane men make as they attempt to behave in a rational manner in an inherently irrational (unpredictable) universe. This means that a significant proportion of wealth holders try to arrange their portfolios so that they are reasonably well protected irrespective of which one of a number of alternative possible states of the economy actually occurs. In making portfolio choices, economic units do not accept any one thing as a proven guide to the future state of the economy. Unless there are strong reasons for doing otherwise, they often are guided by extrapolation of the current situation or trend, even though they may have doubts about its reliability.'° Because of this underlying lack of confidence, expectations and hence present values of future incomes are inherently unstable; thus a not unusual event, such as a "salad oil scandal" or a modest decline in income, if it occurs in a " 1. M. Keynes, "The General Theory of Employment," pp. 209-23. The exact quotation, in full, is: HMoney, it is well known, serves two principal purposes. By acting as a money of account it facilitates exchange without it being necessary that it should ever come into the pictuR u a substantive object. In this reapect it is a convenience which is devoid of signifi• cance or real influence. In the second place it is a itore of wealth. So we are told without a smile on the face: But in the world of the classical economy. what an insane use to which to put it! For it is a recoanized cbatacteristic of money as a store of wealth that it is barren: whereas practically every other form of storing wealth yields some interest or  profit. Why should anyone outside a lunatic asylum wish lo use money as a store of wealth?" p. 215. • The doubts can take the form of uncertainty as to what "incnia" should be attached: should it be attached to the level, the rate of change ( velocity l, or the rate of change of the rate of change ( acceleration)?  398 107  FINANCIAL INSTABILllY REVISITED  favorable environment, can lead to a sharp revaluation of expectations and thus of asset values. It may lead not only to a sharp change in what some particular rational man expects but also to a marked change in the consensus as to the future of the economy. Conceptually the process of setting a value upon a particular long-term asset or a collection of such assets can be separated into two stages. In the first the subjective beliefs about the likelihood of alternative states of the economy in successive time periods are assumed to be held with confidence. A second stage assesses the degree of "belier• in the stated likelihoods attached to the various alternatives. When beliefs about the actual occurre!lce of various alternative states of the economy are held with perfect confidence, the standard probability expected value calculation makes sense. The present value of a long-term asset reflects its (subjective) expected yield at each state-date of the economy and the assumed likelihood of these state-dates occurring. Under stable conditions, the expected gross profit after taxes ( cash flow) of the i th asset at the t•• date, Q.,, will equal :S p,,Q,. where Q,, is the gross profit after taxes of the r• asset if the s"' state of nature occurs ( assumed independent of date, could be modified to sit, the s+< state of nature at the t th date) and p,, is the (subjective) probability that the a"' state will occur at the t th date. The s states are so defined that for each t, :Sp,,= 1. These Qu, discounted at a rate appropriate to the assumed perfect certainty with which the expectations are held, yield the present value of the ,... asset, V,. 11 • If it is withed, to each outcome Q,. a ·utility U(Qu) can be attached. The probability and present value computation can be undertaken with reapect to utilitiea. Tbe risk-aversion cbaracter of a dec:iaion unit is npmented by tbe curvature of lbe utility   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Assume that S is a set of mutually exclusive and exhaustive states of nature. At date t, one of the S, will occur; the :S p,1 1. However, the probabilities, p,1, which must be attached to the alternative outcomes in order to compute the expected gross profit and the cash flow for date t, can be accepted with varying degrees of rational belief. The value of the ;•• asset will vary, not only with the expected payoffs at various state-dates of nature and the probabilities attached to these payoffs, but also with the confidence placed in· the probabilities attached to the occurrence of these various state-dates of nature. That is, Q., (:S p,,Q11) where 0 ~ f ~ 1 and f reflects the confidence with which the particular weights are attached to the likelihood of various states of nature occurring. In other words, there are at least two conjectural elements in determining the expected payoffs, Q11 and hence V.,: one is that th~ Q,. are conjectures; the other that the probability distribution of possible states of nature, as reflected in the p,, is not known with certainty. Obviously, events that affect the confidence placed in any assumed probability distribution of the possible alternative states may also affect the co,nfidence placed in the assumed expected payoff if states occurs, Q,.. A computed present value of any asset V. may be accepted with a wide  s,  =  =,  function. A change in confidence can be depicted by a change in curvature, decreased confidence being indicated by an increase in curvature. If preference systems can be assumed to reflect experience, then a long period without a deep depression will decrease the curvature and the occurrence of a ~ncial crisla will increase tbe cuntature of the preference system. The psychology of uncertainty and the social psychology of waves of optimism and pessimism are two points at which economists need ,uidance from the relevant sister social sciences. Throughout any discussion of uncertainty and of economic policy in the framework . of uncertainty psychological assumptions must be made. At times tbe conclusions depend in a critical manner upon the psychological assumptions.  399 108  range of confidence-from near certainty to a most tenuous conjecture. This degree of acceptance affects the market price of the asset. The relevant portfolio decisions foi; consumers, firms, and financial concerns are not made with respect to individual assets; rather, they are made with respect to bundles of assets. The problem of choosing a portfolio is to combine assets whose payoffs will vary quite independently as the states of nature vary in order to achieve tlie unit's objective; which for a risk averter might be a minimal satisfactory state in any circumstance. This might be stated as follows: a portfolio is chosen so as to maximize V given a specified valuation procedure subject to the constraint that V, > V for every likely state of nature." the assets available are both inside and outside assets: the outside assets consist of money and Government debt.•• The nominal value of a monetary asset (money plus Government debt) is independent of the state of the economy. Government debt can exhibit variability in its nominal value due to interest rate variations, but in conditions where business cycles occur, its nominal value is not highly correlated with the expected nominal value of inside assets. We assume that two types of periods can be distinguished: one in which beliefs· are held with confidence concerning the likelihood of alternative states of nature occurring within some hori7.0ll period and the second in which such beliefs are most insecure. In the second situation bets are placed under duress. During these second periods-when what can be called higherorder uncertainty rules-markedly lower • Alternatively, the desired portfolio objective can be stated in terms of cash flows; Ibis less conventional  view is examined in Section VI. • J. 0. Ollrley and E. Shaw, Money In a Th,ory of Finance.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  relative values are attached to assets whose nominal value depends upon the economy's performance. Periods of higher-order uncertainty will see portfolios shift toward assets that offer protection against large declines in nominal values. Even though flexibility is almost always a virtue, the premium on assets that permit flexibility will be larger ih such periods of higher-order uncertainty. For many questions a rational man has· the option of saying "I don't know" and of postponing a decision. As a wealth owner he must assess the worth of various assets even when conditions are so fluid that he would rather not make a decision. Keynesian liquidity preference encompasses both confidence conditions. Expectations as to the likelihood of different states of nature may be held with varying degrees of confidence. During periods of stable expectations, portfolios are managed so that the outcome will be tolerable regardless which state of nature rules. Most units tend to weigh heavily the avoidance of disasters, such as a liquidity crisis for the unit. Assets that offer protection against a liquidity crisis or temporarily disorganized asset markets would be part of a rational portfolio under all circumstances. In addition a preferred market may exist for assets that obviate against capital losses. Thus liquidity preference is defined as a rational person's demand for money as an asset; this leads to a determinate demand function for money for any value of higher-order uncertainty!' In addition to periods when the likelihood of various states of nature appear stable, there a~ troubled periods when the subjective estimates as to the likelihood of various states of nature are held with much less confidence. The risk-averter reaction to .a decline in confidence is to attempt to in• See J. Tobin, "Liquidity Preference u Behavior  Toward Risk," pp. 65--68.  400 109  FINANCIAL INSTABILITY REVISITED  crease the weight of assets that yield flexibility in portfolio choices, in other words, to increase the· value not only of money but also of all asse~ that have broad, deep, and resilient markets. Any increase in uncertainty shifts the liquidity preference function, and this shift can be quite marked and sudden. Obviously, the reverse-a decrease in uncertainty--can occur. If risk-averters are dominant, then an increase in uncertainty is likely to be a rapid phenomenon, whereas a decrease will require a slow accretion of confidence. There is no need for a loss in confidence to proceed at the same pace as a gain in confidence. Rapid changes in desired portfolios may be confronted with short-period inelastic supplies of primary assets ( real capital and government liabilities) . As a resuit, •the relative prices of different assets change. An increase in uncertainty will see the price of inside assets-real capital and equities-fall relative to the price of outside assets-govemment debt-and money; a decrease in uncertainty will see the price of inside assets rise relative to that of outside assets. The nominal money supply in our fractional reserve banking system can be almost infinitely elastic. Any events that increase uncertainty on the part of owners of real wealth will also increase uncertainty of commercial bankers. Unless prices of inside assets are pegged by the central bank, a sharp increase in uncertainty will result in the price of inside assets falling relative to both money and the price of default-free or protected assets. In a decentralized private-enterprise economy with private commercial banks, we cannot expect the money supply to increase sufficiently to offset the effects of a sharp increase in uncertainty upon inside asset prices. Conversely, we. cannot expect the money supply to fall sufficiently to offset the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  effects of a sharp decrease in uncertainty. We should expect the private, profitmaximizing, risk-averting commercial banks to behave perversely, in that with a decrease in uncertainty they are willing and eager to increase the money supply and with an increase in uncertainty they act to contract the money supply... Portfolios must hold the existing stocks of private real assets, Treasury debt, and money. Even during an investment boom the annual increment to the stock of real capital is small relative to the total stock. However, in time the stock of reproducible capital is infinitely elastic at the price of newly produced capital goods. Thus there is a ceilin,: to the price of a unit of the . stock of real capital in the current market. This ceiling price allows for an expected decline in the price of the stock to the price of the flow of newly produced units. The current retum OB real capital collected in firms reflects the current functioning of the economy, whether prosperity or depression rules. During an investment boom current returns are high. Beca111e a ceiling on the price of units in the stock of capital is· imposed by the cost of investment, a shift in the desired composition of portfolios towards a greater proportion of real capital caMot lower very far the short-run • The stagnant state that follows a deep depreaion  has been c:barac:terized by very low yields--hi8'> pric:el-<>ll default-free usets. One interpretation of the liquidity trap is that it rellects the inability to achieve a meaningful difference between the } ields on real assets and on default-free austs by further lowering of the yield on default-free assets. An equivalent but more enlightening view of the liquidity trap is that cin:um9tances occur in which it is not possible by increasing the stock of money to raise the price of the units in the stock o{ existing capital so u to induce investment. In these conditions expansion.. ary fiscal policy, espscially government spending, will increase the cash flows that units in the otock or real capital aenerate. In otherwise stagnant conditions this realized improvement in eamings will tend to increase the relative price of inside capital, and thus help induce investment. 0  401 110  yield on real capital valued at market price; in fact because of prosperity and greater capacity utilimtion this yield may increase. As the outside assets-Treasury debt and so forth-are now less desirable than in other more uncertain circumstances, their yield must rise toward equality with the yield on inside or real assets. To paraphrase Keynes " ... in a world without uncertainty no one outside of a lunatic asylum . . ." will hold Treasury bills as a store of wealth unless their yield is the same as that on real assets. As the implicit yield on money is primarily the value of the implied insurance policy it embodies, a decrease in uncertainty lowers this implicit yield and thus lowers the amount desired in portfolios. As all money must be held, as bankers are eager to increase its supply, and as its nominal value cannot decline, the money price of other assets, in particular real assets, must increase. In a euphoric economy it is widely thought that past doubts about the future of the economy were based Upon error. The behavior of money and capital market interest rates during such a period is consistent with a rapid convergence of the yield upon. default-free and default-possible assets. This convergence takes place by a decline in the price of-the rise in the interest rate. ondefault-free assets relative• to the price ofyield on-the economy's underlying real capital. In addition to default-free-government debt plus gold-and default-possible-real capital, private debts, equities-assets, there are protected assets. Protected assets in varying degrees and from various sources carry some protection against consequences that would follow from unfavorable events. Typical examples of such assets are bonds and savings deposits. The financial intermediaries-including   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  banks as they emit money-generate assets that are at least partially protected. A rise in intermediation and particularly a rise in bank money, even if the asset acquired by the bank carries default possibilities, may unbalance portfolios in favor of default-free assets. The ability of banking, through the creation of money, to stimulate an economy rests upon the belief that banks and the monetary authorities are able to give such protection to their liabilities. The liabilities of other financial intermediaries are protected, but not so much as bank money; thus their stimulative effect, while not negligible, is smaller. In a euphoric economy the value of such protection decreases, and these instruments also fall in price relative to real assets or equities. 11 To summarize, the relative prices of assets are affected by portfolio imbalance that follows from changing views as to uncertainty concerning future states of the economy. A decrease in the uncertainty will raise the price of units in the stock of real inside assets for any given supply of money, other outside assets, and assets that are in all or in part protected against the adverse behavior of the economy; an increase in uncertainty will lower these prices. For a given state of uncertainty and stock of real capital assets, the greater the quantity of money, other outside assets, and protected assets, the greater the price of units in the stock of real capital. Investment consists of producing substitutes for items in the stock of real capital; the price of the units in the stock • Incidentally, the phenomenon by which a decrease in the value of some protection affects observable market prices also -exists in the labor market. Civil servants and teacben accept low money incomes relative to others with the same initial job opponunity  spectrum in exchange for security; civil servants value security more than others. In a euphoric, full employment economy the \'Blue of such civil servant security diminishes. Hen~e in order to attract worken, their relative measured market wage will need to rise.  402 111  FINANCIAL INSTABILITY REVISITED  is the demand price for units to .be produced. To the extent that the supply of investment responds positively to its demand price, the pace of investment flows from portfolio imbalance. The investment process can be detailed as ( I ) the portfolio balance relation that states the market price for capital assets as a function of the money supply (Diagram I ) , and ( 2) the investment supply function that states how much investment output will be produced at each market price for capital assets (Diagram 2). It is assumed that the market price for capital assets is the demand price for investment output. The supply curve of investment output is positively sloped. At some positive price the output of investment goods becomes zero. The market price of capital assets as determined by portfolio preferences is sensitive to the state of expectations or to the degree of uncertainty with respect to the future." In Diagram 1, I have chosen to keep the stock of capital constant. Thus V P.K + M, where V is wealth, P. is price· 1evel of capital, K is the fixed stock of capital, and M is outside money. As M increases, V increases because of both the rise in M and a rise in P,. If M increases as manna from heaven, it would be appropriate for the consumption function to include a W/P, variable ( P• is the price level of current output) . This would, by today's conventions, add an  11 STOCK PRICE OF CAl'IT AL  li P• =-Q/M,K)  P,  ....  MONEY  2 IFLOW PRICE OF INVESTMENT  P,o P,s  =  INVESTMENT  upward drifting consumption function to the mechanism by which a rise in M affects output." If C f(Y) and Y C I, then the above diagram determines income as a function of M.••  =  = +  • Alternative.!l', the value of wealth can be kept ., The investment argument b~ilds upon R. W.  Clower, "An Investigation Into the Dynamics of Investment," and 1. G. Witte, Jr., "The Microfoundations of ~e Social Investment Function:· Both  CJower and Witte emphasize the determination of the price per unit of the stock as a function of exogen. ousty given interest rate,: they are wedded to a  productivity basis for the demand for real capital assets. 1be argument here emphasizes the portfolio balance or speculative aspects of the demand for real capital asstts. Thus, interest rates are computed  from the relation between expected flows and market prices, that is, the price of capital as a function of the .money supply relation Is the liquidity pr,ference  function.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  constant; thus V==:.PtK+M. An increase in M is initially an "open market operation" 6,M=PaK. However, as portfolios now bold more money and less capital goods, the price per unit of capital goods rises. Capital is expropriated so that W remains fixed. This is a pure portfolio balance relation. If, starting from an initial position, Y.. =PhK"+ Mo, M is increased, then the p,,_ of the second variant  would lie above that of the first variant. If M is decreased, the p,, of the second variant will lie below that of the first. The constant wealth variant cuts the constant private capital stock variant from below. I have assumed constant capital stock K in drawing  Diagram I. • If we uaume that the future expected returns  403 112  It is impossible in this view to generate an investment function I f(r) that is independent of the portfolio adjustments of the liquidity preference doctrine; investment is a speculative activity In a capitalist economy that is only peripherally related to productivity. Two phenomena can be distinguished. If M remains fixed as capital is accumulated, a slow downward drift of the Q (M,K) function (Diagram 1) will take place. A rise in M is needed to maintain real asset prices · in the face of the rise in the stock of real capital.•• Alternatively, if portfolio preferences change, perhaps because of a change in uncertainty, then, independently of the impact of real accumulation, the Q(M,K) function will shift. It is the second type of shift that oc~pies center stage in the Keynesian view of the world. And this has been neglected in both monetary and investment analysis. At all times investment demand has to take into account the returns received during various expected states of the economy.  =  from capital are known, then the equation P,= Q (M,K) can be transformed into r=Q (M,R). With every quantity of M a different price will be paid for the same future income1stream; a larger quantity of money will be associated with a higher market price of existing capital and thus a lower rate ·of return oti the market value of capital. In a similar way, th, lnvtllm,nt nlatlon can be turned Into an l=I (r) relationship. This requires the same information on expected returns as is uaed in transformina the portfolio relation. In tum the l=l(r) and tlie r=·Q(M) can be transformed into l=Q (M). Because I{ and not Y is an argument in the equation P,=Q(M, K), the 1-S, L-M construction is not obtained. • This footnote appears in riaht-hand column.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  As the result of a shock, the weight attached to depression returns may increase. As the dust settles there is gradual easing of the views on the likelihood of unfavorable states of nature. The weight attached to liquidity is decreased and a gradual increase of investment will take place. Hopefully we know enough to supplement investment by honorary investments (Government spending) so that the expected returns from capital will not again reflect large-scale excess capacity. Nevertheless, if a shock takes place, some time elapses before its effects wear off. In these circumstances honorary investment may have to carry the burden of maintaining full employment for an extended period. The essence of the argument is that investment activity may be viewed as an offshoot of portfolio preferences, and that portfolio preferences reflect the attempt by rational men to do well in a world with uncertainty. Any shock to portfolio preferences that leads to a sharp .drop in investment results from experiences with portfolios that have gone sour. On a large scale, portfolios go sour in the aftermath of a financial crisis. • Underlying preferences need not be such that for dM dK M -K ; it may be that  P, to remain constant  dMdK  M  <K  dMdK or even M >K  . See  ,, Arrow, Aspects of  the Theory of Risk Bearins.• Friedman's well-known . dM dl',K result ts that M > PJ( . See M. Friedman, ''The Demand for Money: Some Theoretical and Empirical Results," pp. 327-51.  404 113  FINANCIAL INSTABILITY REVISITED  APPENDIX TO SECTION IV: A Model The model can be written as follows:  (S)  Y-C+I C-C(Y) I-I(P,s,W) P,c=L(M,K) P,.o-PK  (6)  P18 •P,.,,  (7)  M.-M,  (I) (2)  (3) (4)  M, (Money), K (capital stock), and W (wages are all exogenous, P•= 1. Symbols have their usual meaning: we add p,. as the supply price of a unit of investment, P« as the market price of a unit of existing real or inside capital, and P, .• is the demand price of a unit of investment. (3) (4)  ..!!!.._>O \P,. >0, dP,. >0  dP 1.,  ' ·I-0 dW dP" O dP"<O dM>' dK  Equation 4 is unstable with respect to views as to uncertainty; it shifts "down" whenever un' ertainty increases. This portfolio balance equation (the liquidity preference function) yields a market price for the units in the stock of real capital for each quantity of money. Given W, I adjusts so that P,.=P« (equations 3, S, and 6). Once I is given C and Y are then determined (equations 1 and 2). Nowhere in this model does either the interest rate or the productivity of capital appear. "Liquidity preference" ( equation 4) determines the market price of the stock of real assets. A shift in liquidity preference tneans a lhi~ in equation 4, not a movement. along the function. In the model, the tune is called by the market price of the stock of real capital. Given a cost curve for investment that a positive price for zero output, it is possible for the demand price to fall below the price at which there will be an appreciable production of capital goods. Thus, the complete collapse of investment is possible. Of course, productivity in the sense of the expected quasi-rents is almost always an element in the determination of the market price of a real asset or a collection of assets. However, this formulation minimizes the impact of productivity as it emphasizes that the liquidity attribute of assets may af times be of greater sipiflcance in determinin& their market price than their productivity.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  bas  The perspective in this formulation is that of business cycles, not of a full-employment steady state. Productivity of capital takes the form of expected future earnings ( gross profits after taxes) of a collection of capital goods within a producing unit. In any real world decision, the earnings. on specific items or collections of capital must be estimated, and the heterogeneity of the capital stock must be taken into account. Once earnings are estimated, then given the current market price, a discount rate can be computed. That is, we have (7)  P.-x-t·-· ,_,  EQ,/(l+r,>t  which states the arithmetic relation that the value of the capital stock is of necessity equal to the discounted value of some known stream of returns, Q,. If the current market determinea ·Po ··K and if a set of Q, is estimated, an intenst tale can be computed. If it is wished, equation 4 can be suppressed by using equation 7, that ia, (4')  I  •  ,.,_.  KL  Q,  .  (1 +r-)t - L(M,K)  a  transaction demand for money Is added, If the Q, are interpreted as a function cif r, if all r, are assumed equal, and if K is suppnaecl u being fixed in the short run then  If  (4')  M,-L(r,Y)  may. be derived. For the investment decision, we may IIIIUllle that the future return of the increment to capital is the-same as to the stock of capital. With the Q, known and assumed independent of the short-run pace of investment, then  ( 3')  I ~ Q P,.-K 1:f:'1 (I +rJ,  Thus given the fa~ that the supply price of. investment rises with investment ( constant W), greater investment is associated with a lower interest rate. That is,  W>  dJ  J.J(r, Y) and dr <0  Both equations 4" and 3" are arithmetic transformations of 4 and 3. Equations 4 and 3 represent market phenomena, whereas 4" and 3" are  405 114  computed transformations of market conditions. For financial contracts such as bonds the Q, are stated in the contract. Even so the yield to maturity is a computed number-the market number is the price of the bond. When the interest. rate is DOt computed, the investment decision an,! its relation to liquidity preference are viewed in a more natural way. Of course, for real capital the Q, rellects the produc-  tivity in the form of cash flows, current and expected. But the productivity of capital and investment affect present performance only after they are filtered through an evaluation of the state of the irrational, uncertain world that is the positioning variable in the liquidity preference function. Productivity and thrift exist, but in a capitalist economy their impact is always filtered by uncertainty.  V. HOW DOES TIGHT MONEY WORK? Tight money, defined as rising nominal interest rates associated with stricter other teqns on contracts, may work: to restrain demand in two ways.•• In the conventional view tight money operates through rationing demand by means of rising interest rates. Typically this has been represented by movements along a stable negatively sloped demand curve for investment ( and some forms of consumption) that is drawn as a function of the interest rate. An alternative view that follows from the argument in Section IV envisages tight money as inducing a change in expectations in the perceived uncertainty, due to an episode such as a financial crisis or a period of financial stringency. This within Diagrams 1 and 2 can be represented by a downward shift in the infinitely elastic demand curve for investment. The way in which tight money operates depends upon the state of the economy. In a non-euphoric expanding economy, where liability structures are considered satisfac• "Tlsbtness" of money refers to costs (includin1 contract terms) for ftnancin1 activity by -Y of debt. Hi1b and risina interest rates plus more restrictive other terms on contracts are evidence of tipt money.  Tfabtneu bas notblng direcdy to do with the rate of cbanp of the money supply or the money base or what you will. Only 11 tbele money supply phenomena affect contract terms do they affect tiabtness. Nonprice rationing by supplien of finance means tbat tbe other terms in ftnancin1 contracts for some demanden increase markedly. The tightness of money is not meas11red correctly when only one term in a contraci, 1hr interest rate, is considered.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  tory, monetary restraint will likely operate by way of rationing along a stable investment demand curve. In a booming euphoric economy, where high and rising prices of capital are associated with a willingness on the part of firms to "extend" their liability structures and of financial intermediaries to experiment with both their assets and their liabilities, tight money will be effective only if it brings such portfolio, or financial structure, experimentation to a halt. A reconsideration of the desirability of financial experimentation will not take place without a triggering event, and the reaction can be both quick: and disastrous. A euphoric boom is characterized by a stretching, or thinning out, of liquidity; the end of a boom occurs when desired liquidity quickly becomes significantly greater than actual liquidity. In a euphoric economy, with ever-increasing confidence, there is an increase in the weights attached to the occurrence of states of nature favorable to the owning of larger stocks of real capital. Thus, an upward drift in the price of the real capital-money supply function occurs (Diagram l, p. 111). This shift means that for all units both the expected flows of cash from operations and the confidence in these expectations are rising. Given these expectations, an enterprise assumes that with safety it can undertake ( I ) to emit liabilities whose cash needs  406 FINANCIAL INSTABILITY REVISITED  will be met by these now-confidentlyexpected cash flows and (2) to undertake projects with the expectation that the cash flows from operations will be one of the sources of finance. In a euphoric economy the weight attached to the necessity for cash reserves to ease strains due to unexpected shortfails in cash flows is ever decreasing. In a lagless world-where all investment decisions are taken with a clean slate, so to speak--current investment spending is related to current expectations and financial or money market conditions. In a world when today's investment spending reflects past decisions, the needs for financing today can often be quite inelastic with respect to today's financing conditions: and today's financing conditions may have their major effect upon investment spending in the future. Thus, there exists a pattern of lags between money and capital market conditions and investment spending conditions. This lag pattern is not independent of economic events. A dramatic financial market event, in particular a financial crisis or widespread distress, can have a quick effect. For units with outstanding debts, tight money means that cash payment commitments. rise as positions are refinanced. This is true not only because interest rates are higher but also because other terms of the units' borrowing contracts are affected. In addition, if projects are undertaken with the expectation that they would be financed in part by cash generated by ongoing operations, and if the available cash flows fall short of expectations--due perhaps to the increased cost of the refinanced inherited debt-then a larger amount will need to be financed by debt or by the sale of financial assets. This means that the resultant balance sheet can be inferior to and the cash flow commitments larger than the target envisaged when the project was undertaken.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  115  Conversely, if gross profits rise faster than costs, so that a smaller-than-expected portion of investment is financed by debt, the resultant balance sheet will be superior to that expected when projections were made. In this way, investment may be retarded or accelerated by cash flow and balance sheet considerations.12 Deposit financial institutions are especially vulnerable to tight money ·if their .assets are of significantly longer term than their debts; they are virtually refinancing their position daily by ·offering terms that are attractive to their depositors. A rapid rise in their required cash flows due to interest costs may take place, which can lead to a sharp reduction in their net income. Thus, during a euphoric expansion the effects of tight money are more than offset for units holding real capital, whereas for other units, such as savings banks, tight money means a significant deterioration in their financial position whether measured by liquidity or net worth. In a euphoric economy the willingness to hold money or near money decreases. The observed tightness of money-the rise in interest rates on near monies and other debts--is not necessarily caused by any undue constraint upon the rate of increase of the money supply; rather it reflects the rapid increase in the demand for financing. An attempt by the authorities to sate the demand for finance by creating bank credit will lead to rapidly rising prices: inflationary expectations will add to the euphoria. Euphoric expectations will not be ended by a fall in income, as the strong investment demand that is calling the tune is insensitive to the rise in financing terms. • For a more detailed analysis of how financial actualities may relate to project decisions. see H. P. Minsky. "Financial Intermediation in the Money and Capital Mukets." See also E. Greenbera, "A StockAdjustment Investment Model."  407 116  In a euphoric economy characterized by an investment boom, cash payments become ever more closely articulated to cash receipts; the speculative stock of money and near monies is depleted. Two phenomena follow from this closer articulation. The size decreases, both of the shortfall in cash receipts and of the overrun in cash payments due to normal operations, that will result in insufficient cash on hand to meet payments. The frequency with which refinancing or asset sales are necessary to meet payment commitments increases. Units become more dependent upon the normal functioning of various financial markets. Under these emerging circumstances there is a decrease in the size of the dislocation that can cause serious financial difficulties to a unit, and an increase in the likelihood that a unit in difficulty will set other units in difficulty. Also, even local or sectoral financial distress or market disruptions may induce widespread attempts to gain liquidity by running off or. selling out positions in real or financial assets ( inventory liquidation). This action in tum may depress incomes and market prices of real and financial assets. We may expect financial institutions to react to such developments by trying to clean up their balance sheets and to reverse the portfolio changes entered into during the recent euphoric period. The simultaneous attempt by financial institutions, consumers, and firms to improve their balance sheets may lead to a rupture of what had been normal as well as standby financing relations. As a result losses occur, and these, combined with the market disruptions, induce a more conservative view as to the desired liability structure. The view that, in conditions of euphoria, tight money ~rates by causing a re-evaluation of the uncertainties carried by economic units is in marked contrast to the textbook   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  analysis of tight money seen as operating by constraining expenditures along a stable investment function. If an expansion is taking place in the absence of a transformation -by way of euphoric expectations--of preferred portfolios and liability structures then the system can operate by rationing along a stable investment relation. Then tight money may lead to a decline in investment and a relaxation of monetary constraint may reverse this decline: conventional monetary policy can serve as an economic steering wheel. But once the expansion is associated with the transformation of asset and liability strucn1res that have been identified as characteristic of a euphoric economy, tight money will constrain demand only if it induces a shift either in the demand function for money or in the price function for capital goods. For this to happen the expansion must continue long enough for balance sheets to be substantially changed. Then some triggering event that induces a reconsideration of desired balance sheets must occur. A financial ctjsis or at least some significant amount of financial distress is needed to dampen the euphoria. The fear of financial failure must be credible in order to overcome expectations built on a long record of success. During an emerging euphoric boom, the improvement in expectations may overwhelm rising interest rates. As a result of the revision of portfolio standards, the supply of finance seems to be almost infinitely elastic at stepwise rising rates. Typically, this "infinitely" elastic supply is associated with the emergence of new financial instruments and institutions,•• such as the use of Federal funds to make position, the explosive growth of negotiable CD's, and the • H. P. Minsky, "'Central Banking and Money Market Cbanps."  408 FINANCIAL INSTABILITY R~ISITED  development of a second banking system. Under these circumstances, a central bank will see its restriction of the rate of growth of the money supply or the reserve base overwhelmed by the willingness of consumers, business firms, and financial institutions to decrease cash balances: increases in velocity overcome restrictions in quantity. The frustrated central bank can try to compensate for its lack of success in constraining expansion by further decreasing the rate of growth of the money supply, thus forcing a more rapid development of a tightly articulated cash position. Such a further tightening will occur within a financial environment that is increasingly vulnerable to disruption. The transition will not be from too-rapid economic expansion to stability by way of a slow deceleration, but a rapid decline will follow a sharp braking of the expansion. With some form of a financial crisis likely .to occur after a euphoric boom, it becomes difficult to prescribe the correct policy for a central bank. However, the central bank must be aware of this possibility and it must stand ready to ~ct as a lender of last resort to the financial system as a whole if and when a break takes place. With the path of the economy independent in its gross tenns of the rate of increase of the money supply and of the relative importance of bank financing, the central bank might as well resist the temptation to -further tighten  117  its constraints if the initial extenf of constraint does not work quickly. The central bank should sustain the rate of growth of the reserve base and the money supply at a rate consistent with the long-term growth of the economy. This course should be adopted in the hope, however slight, that the rise in velocity-deterioration of balance sheet phenomena described earlierwill converge, by a slow deceleration of the ~uphoric expectations, to a sustainable steady state. In particular during a euphoric expansion the central bank should resist the temptation to introduce constraining direct controls on that part of the financial system most completely under its control-the commercial banks. The central bank should recognize that a euphoric expansion will be a period of innovation and experimentation by both bank and nonbank financial institutions. From the perspective of picking up_ the pieces, restoring confidence, and sustaining the economy, the portion of the financial system that the central bank most clearly protects should be as large as possible. Instead of constraining cotnmercial banks by direct controls, the central bank should aim at sustaining the relative importance of commercial banks even during a period of euphoric expansion; in particular, the commercial banks should not be unduly constrained from engaging in rate competition for resources.  VI. THE THEORY OF FINANCIAL STABILITY In Section IV it was concluded that normal functioning requires that the price level, perhaps implicit, of the stock of real capital assets be consistent with the supply price of investment goods at the going-wage level. The euphoric boom occurs when portfolio preferences change so that the price level of   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  the stock rises relative to the wage level, causing an increase in the output of investment goods. A sharp fall in the price level of the stock of real assets will lead to a marked decline in investment and thus in income: a deep depression can occur only if such a change in relative prices takes place.  409 118  Attributes of stability  In the discussion of uncertainty, we identified one element that could lead to a sharp lowering of the price level of the existing stock of capital. A sharp change in the desired composition of assets in portfoliosdue to an evaporation of confidence in views held previously as to the likelihood of various alternative possible state-dates of the econoiny-will lower the value of real assets relative to both the price level of current output and money. Such a revaluation of the confidence with which a set of expectations is held does not just happen. !he event that marks the change in portfolio preferences is a period of financial crisis, distress, or stringency ( used as descriptive terms for different degrees of financial difficulty). However, a financial crisisused as a generic term-is not an accidental event, and not all financial structures are equally prone to financial instability. Our interest now is in these attributes of the financial system that determine its stability. We are discussing a system that is not globally stable. The economy is best analyzed by assuming that there exist more than one stable equilibrium for the system. We are interested in the determinants of the domain of stability around the various stable equilibria. Our questions are of the form: ''What is the maximum displacement that can take place and still have the system return to a particular initial equilibrium point?" and "Upon what does this 'maximum displacement' depend?" The maximum shock that the financial system may absorb and still have the economy return to its initial equilibrium depends upon the financial structure and the linkages between the financial structure and real income. Two types of shocks that can trigger large depressive movements of financial variables can be identified: one is a shortfall of cash flows due to an over-all drop in income,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  and the second is the distress of a unit due to "error" of management. But not all recessions trigger financial instability and not every financial failure, even of large financial units, triggers a financial panic or crisis. For not unusual events to trigger the unusual, the financial environment within which the potential triggering event occurs must have a sufficiently small domain of stability. The contention in this paper is that the domain of stability of the financial system is mainly an endogenous phenomenon that depends upon liability structures and institutional arrangements. The exogenous elements in determining the domain of financial stability are the government and central banking arrangements: after mid-1966 it is clear that the exogenous policy instrument of deposit insurance is a powerful offset to events with the potential for setting off a financial crisis. There are two basic attributes of the financial system that determine the domain of stability of the financial system: ( 1) the extent to which a close articulation exists between the contractual and customary cash ftows from a unit and its various cash receipts and ( 2) the weight in portfolios of those assets that in almost all circumstances can be sold or pledged at well nigh their book or face value. A third element, not quite so basic, that determines vulnerability to a financial crisis is the extent to whlch expectations of growth and of rising asset prices have affected current asset prices and the values at which such assets enter the financial systems." The domain of stability of 11Assets enter the financial system when they are used as collateral for borrowing. A newly built house ent~rs _the financial system through its mortgage. which 1s based upon its current production costs. If the expectation takes over that house prices will rise henceforth at say 10 per cent a year. the market value of existing houses will rise to reflect the expected capital gains. If mortgages are based upon purchase prices, once such a house turns over, the values in the_  410 FINANCIAL INSTABILITY REVISITED  the financial system is sinaller the closer the articulation of payments, the smaller the weight of protected assets, and the larger the extent to which asset prices reflect both growth expectations and realized past _appreciations. The evolution of these attributes of the financial structure over time will affect the sii.e of the domain of stability of the financial system. An hypothesis of this, as well as the earlier presentations of these ideas, is that when full employment is being sustained by private demand, the domain of stability of the financial system decreases. In addition to the impact of such full employment a euphoric economy with its demand-pull tight money will be accompanied by a rapid increase in the layering of financial obligations, which also tends to decrease the domain of stability. For as layering increases, the closeness with which payments are articulated to receipts increases and layering increases the ratio of inside assets to those assets whose nominal or book value will not be affected by system behavior ... A euphoric economy will typically be associated with a stock market boom and an increase in the proportion of the value of financial assets that is sensitive to a sharp revaluation of expectations. Even though a prolonged expansion, dominated by private demand, will bring about a transformation of portfolios and changes in asset structures conducive to financial crises, the transformations in portfolios that take place under euphoric conditions sharply accentuate such trends. It may be conjectured that euphoria is a necessary prelude to a financial crisis and that euphoria ponfolios of financial institutions reflect arowth ex-  pectations. This happens with takeovers, mergers. cOnglomerates, and so on. It is no accident that such corporate developments are most frequent during euphoric periods. • The relevant assets structure concept is outside assets as a ratio to the combined assels ( or liabilities) of all private units, not tbe consolidated assets.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  119  is almost an inevitable result of the successful functioning of an enterprise economy. Thus, the theory of financial stability takes into account two aspects of the behavior of a capitalist economy. The first is the evolution of the financial structure over a prolonged expansion, which affects the nature of the primary assets, the extent of financial layering, and the evolution of financial institutions and usages. The second consists of the financial impacts over a short period due to the existence of a highly optimistic, euphoric economy; the euphoric economy is a natural consequence of the economy doing well over a prolonged period. Over both the prolonged boom and the euphoric period portfolio transformations occur that decrease the domain of stability of the financial system. Financial instability as a system characteristic is compounded of two elements. How are units placed in financial distress and how does unit distress escalate into a systemwide crisis? The "banking theory" for all units  It is desirable to analyi.e all economic units as if they were a bank-or at least a financial intermediary. The essential characteristic of such a financial unit is that it finances a position by emitting liabilities. A financial institution does not expect to meet the commitments stated in its liabilities by selling out its position, or allowing its portfolio to run off. Rather, it expects to refinance its position by emitting new debt. On the other hand every unit, including banks and other financial units, has a normal functioning cash flow from operations. The relation between the normal functioning cash flow to and the refinancing opportunities on the one hand and the commitments embodied in tt:ie liabilities on the other determine the conditions under which the organization can be placed in financial distress.  411 120  It is important for our purpose to look 'at all organizations from the defensive viewpoint: "What would it take to put the organization in financial distress?" This aspect will be made clearer when we discuss bank and other examination procedures. Solvency and liquidity constraints. All economic units have a balance sheet. Given the valuation of assets and liabilities one may derive a net worth or owner's equity for the unit. The conditional maximization of owner's equity may be the proximate goal of business management-the condition reflecting the need to protect some minimum owner's equity under the most adverse contingency as to the state of the economy. A unit is solvent-given a set of valuation procedures--when its net worth is positive.•• A unit is liquid when it can meet its payment commitments. Solvency and liquidity are two conditions that all private economic organizations must always satisfy. Failure to satisfy either condition, or even coming close to failing, can lead to actions by others that affect profoundly the status of the organization. Even though textbooks may consider solvency and liquidity as independent attributes, the two are interrelated. First of all, the willingness to hold the debt of any organization depends in part upon the protection to the debt holder embodied in the unit's net worth. A decline in net worth-perhaps the result of revaluation of assets--1:an lead to a decreased willingness to hold debts of a unit and hence to difficulties when it needs to refinance a position. A lack of liquidity may result from what was initially a solvency problem. • The common valuation procedui-es take book or market value. For purposes of both monagemeht and central bank decisions it would be better if valuation procedures were conditional, that is, of the form: if the economy behaves as follows, then these assets would be worth as follows.   https://fraser.stlouisfed.org 86-817 0 • 77 • 27 Federal Reserve Bank of St. Louis  Similarly, a net drain or outflow of cash from an organization may lead to a need to do the unusual-to acquire cash by selling assets. If, because of the thinness of the market, a sharp fall in the asset price occurs when such sales are essayed, then a sharp drop in net worth takes place, especially if the organization is highly levered. We can identify, therefore, three sources of a decline in the price level of the stock (capital), relative, of course, to the flow (income and investment). One is a rise in the weight attached to those possible states of the society that make it disadvantageous to hold real assets, and financial assets whose value is closely tied to that of real assets. The second is the fall in asset values due to a rise in the discount caused by uncertainty. The third is a decline in asset values as the conditions change under which a position in these assets may be financed. In particular, whenever the need to meet the cash payment commitments stated by liabilities requires the selling out of a position, there is the . possibility of a sharp fall in the price of the positioned asset. Such a fall in asset prices triggers a serious impact of financial markets upon demand for current output. The need for cash for payments. Cash is needed for payments, which are related to financial as well as income transactions. The layering of financial interrelations affects the total payments that must be made. To the extent that layering increases at a faster rate than income, over a prolonged boom, or in response to rising interest rates, or during a euphoric period, the payments/income ratio will rise. The closer the articulation by consumers and business firms of income receipts with payments due to financial contracts, the greater the potential for financial crisis. Each money payment is a money receipt. As layering increases, the importance of the  412 FINANCIAL INSTABILITY REVISITED  uninterrupted flow of receipts increases. The inability of one unit to meet its payment commitments affects the ability of the wouldbe recipient unit to meet its payme.,t commitments. Three payment types can be distinguished: income, balance sheet, and portfolio, each of which can in turn be broken down into subclasses." These payment types reflect the fact that economic units have incomes and manage portfolios. The liabilities in a portfolio state the payment commitments. These contractual payment commitments can be separated into dated, demand, and contingent commitments. To each liability some penalty is attached for not meeting the commitment: and the payment commitments quite naturally fall into classes according to the seriousness of the default penalty. In particular, the payment commitments that involve the pledging of collateral are important-for "'Income payments are those paymenrs directly related to the production of current income. Even though some labor costs are independent of current output, the data are such that all wage rayments are in the income payments class. All of the "Leontier• payments for purchased inputs are such income payments.  Balance sheet payments during a period are those payments that reflect past financial commitments. Lease, interest, and repay'ment of principal are among balance sheet payments. For a financial intermediary  either withdrawals by depositors or loans to policyholders are balance sheet payments. Portfolio payments are due to transactions in real and financial assets. Any payment may be of a different class when viewed by the payor or the payee. To the producer of investment goods the receipts from the sale of the good is an income receipt; to the purchaser it is a portfolio payment. In addition to types, payments may be clusified by "from whom II and "to whom." U money con&isted solely of depo&itors subject to check, then total payment, would be the total debits to accounts and total receipts would be credits to accounts. Hence, it is the implication for system sta• bility of total clearings. where the financial footings are .integrated with the income footings, that is beina examined.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  121  they provide a direct and quick link between a decline in market value of assets and the need to make cash payments. That is, they are a type of contingent payment commitment that involves the supply of additional collateral or cash whenever a market price falls below some threshhold. This margin or collateral maintenance payment commitment can be a source of considerable disorganization and can lead to sharp declines in asset prices. Another aspect of balance sheet payment commitments is the source of the cash that will be used to make the payments. Three sources can be distinguished: the flow due to the generaticn of income; the flow due to the assets held in a portfolio; and the flow due to transactions in assets, either the emission of new liabilities or the sale of assets. For each unit, or class of units, the trend in payment commitments relative to actual or potential sources of cash generates the changing structure of financial interrelations. The basic empirical hypothesis is that over a prolonged expansion-and in particular during a euphoric period-the balance sheet commitments to make payments increases faster than income receipts for private units (layering increases faster than income) and so total financial commitments rise relative to income. In addition, during euphoric periods, portfolio payments ( transactions in assets) increase relative to both income and financial transactions. The measured rise in income velocity during an expansion underestimates the increase in the payment load being carried by the money supply." • In various places, I have tried to estimate by proxies some of these relations. Empirical investiga• tion of stability could begin with a more thorough and also an up•to-date examination of i.hese payment relations. The relations mentioned in this section are discussed in detail in my paper, "Financial Crisis, Financial Systems, and the Performance of the Econ• omy."  413 122  Modes of system behavior Three modes of system behavior can be distinguished depending upon how ex post savings are in fact offset by ex post investment. The offsets to saving that we will consider are investment in real private capital and Government deficits. For convenience, we will call real private capital inside assets and the accumulated total of Government deficits, outside assets. Thus, the consolidated change in net worth in an economy over a time period equals the change in the value of inside assets plus the change in the value of outside assets. At 1111y moment in time the total private net worth of the system equals the consolidated value of outside plus inside assets. Assuming the value of outside assets is almost independent of system behavior, the ratio of the value of outside to the value of total or inside assets in the consolidated accounts is one gross measure of the financial structure. The savings of any period are offset by outside and inside assets. The ratio of outside to inside assets in the current offset to savings as compared to the initial ratio of outside to inside assets will determine the financial bias of current income. If the Government deficit is a larger portion of the current offset to savings than it is of the initial wealth structure, then the period is biased toward outside assets; if it is. smaller, · the period is biased toward inside assets; if it is the same, then the period is neutral. Over a protracted expansion the bias in financial development is toward inside assets. This bias is compounded out of three elements: (I) Current savings are allocated to private investment rather than to Government deficits; ( 2) capital gains raise the market price of the stock of inside assets; and ( 3) increases in interest rates lower the nominal value of outside, income--<:arnings   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  assets. Thus, the vulnerability of portfolios to declines in the market price of the constituent assets increases."' In the long run, portfolio balance has been maintained by cycles in the relative weights of primary assets accumulated: historically the portfolio cycle centered around business cycles of deep depressions. However, to judge what is happening over time it is necessary to evaluate the significance of changes in financial usages. The existence of effective deposit insurance makes the inside assets owned by the banking system at least a bit outside. The same is true for all other Government underwritings and endorsements of private debt. Thus, with the growth of Government and Government agency contingent liabilities even growth that is apparently biased toward the emission of private liabilities may in fact be biased toward outside assets. An attempt to enumerate-and then evaluate-the various Government endorsements and underwritings of various asset and financial markets in these terms is necessary when estimating the potential of an economy for financial instability. Secondary markets  The domain of stability of the system depends upon the ratio of the value of those assets whose market value is independent of system behavior to the value of those assets whose market value reflects expected system behavior. The value of a particular asset can be independent of system behavior either because its market is pegged or because the flow of payments that will be made does not depend upon system performance and its capital value is largely independent of financial market conditions. • This is, of course, an assertion as to the facts, and the truth of these statements can be tested. Per· hap\ with a government sector that is 10 per cent of GNP, such statements are less true than with one that is I per cent of GNP.  414 123  FINANCIAL INSTABILITY REVISITED  For secondary markets to be an effective determinant of system stability, they must transform an asset into a reliable source of cash for a unit whenever needed. This means that the secondary market must be a dealer market; in other words, there needs to be a set of position takers who will buy significant amounts for their own account and who sell out of their own stock of assets. Such position takers must be financed. Presumably under normal functioning the position taker is financed by borrowing from banks, financial intermediaries, and other private cash sources. However, a venturesome, reliable position taker must have adequate standby or emergency financing sources. The earlier argument about refinancing a position applies with special force to any money market or financial market dealer. The only source of refinancing that can be truly independent of any epidemics of confidence or lack of confidence in financial markets is the central bank. Thus if the set of protected assets is to be extended by the organization of secondary markets, the stability of the financial system will be best increased if the dealers in these secondary markets have guaranteed access to the central bank. It might be highly desirable to have the normal functioning of the system encompass dealer intermediaries who finance a portion of their position directly at the Federal Reserve discount window. If a Federal Reserve peg existed in the market for some class of private liabilities, these liabilities would become guaranteed sources of cash at guaranteed prices. Such assets are at least in part outside, and they would increase the domain of stability of the system for any structure of other liabilities. The extension of secondary markets to new classes of assets and the associated   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  opening of the discount window to new financial intermediaries may compensate at least in part--or may even more than compensate-for the changes in financial structure due to the dominance of private investment in the offsets to saving during a prolonged boom. Unit and system instability  Financial vulnerability exists when the t~lerance of the financial system to shocks has been decreased due to three phenomena that cumulate over a prolonged boom: ( I ) the growth of financial-balance sheet and portfoli1r-payments relative to income payments; (2) the decrease in the relative weight of outside and guaranteed assets in the totality of financial asset values; and ( 3) the building into the financial structure of asset prices that reflect boom or euphoric expectations. The triggering device in financial instability may be the financial distress of a particular unit. In such a case, the initiating unit, after the event, will be adjudged guilty of poor management. However, the poor management of this unit, or even of many units, may not be the cause of system instability. System instability occurs when the financial structure is such that the impact of the initiating units upon other units will lead to other units being placed in difficulty or becoming tightly pressed. One general systemwide contributing factor to the development of a crisis will be a decline in income. A high financial commitment-income ratio seems to be a necessary condition for financial instability; a decline in national income would raise this ratio and would tend to put units in difficulty. Attempts by units with shrunken income to meet their commitments by selling assets adversely affects other initially quite liquid or solvent organizations and has a destabilizing impact upon financial markets. Thus, an  415 124  explosive process that involves declining asset prices and income flows may be set in motion. The liabilities of banks and nonbank financial intermediaries are considered by other units ( 1) as their reservoirs of cash for possible delays in income and financial receipts and ( 2) as an asset that will never depreciate in nominal value. Bank and financial intermediary failure has an impact upon many units-more units hold liabilities of these institutions than hold liabilities of other private-sector organizations. In addition such failures, by calling into question the soundness of the asset structure of all units, tend to modify all desired portfolios. A key element in the escalation of financial distress to systemwide instability and crisis is the appearance of financial distress among financial institutions. Without the widespread losses and changes in desired portfolios that follow a disruption of the financial system, it is difficult for a financial crisis to occur. The development of effective central banking, which makes less likely a pass-through to other units of losses due to the failure of financial i nstitutions, should decrease the likelihood of the occurrence of sweeping financial instability that has characterized history. From this analysis of uncertainty it appears that, even if effective action by the central bank aborts a full-scale financial crisis by sustaining otherwise insolvent or illiquid organizations, the situation that made such abortive activity necessary will cause  private liability emitters, financial intermediaries, and the ultimate holders of assets now to desire more conservative balance sheet structures. The movement toward more conservative balance sheets will lead to a period of relative stagnation. The following propositions seem to follow from the preceding analysis: I. The domain of stability of the financial system is endogenous and decreases during a prolonged boom. 2. A necessary condition for a deep depression is a prior financial crisis. 3. The central bank does have the power to abort a financial crisis. 4. Even if a financial crisis is aborted by central bank action, the tremor that goes through the system during the abortion can lead to a recession that, while more severe than the mild recessions that occur with financial stability, can be expected nevertheless to be milder and significantly shorter than the great depressions that have been experienced in the past.•• • The above was written in the fall of 1966. If the crunch of I 966 is identified as an aborted financial crisis, then the events of I 966-67 can be interpreted as a particularly apt use of central bank and fiscal policy to first abort a financial crisis and then offset the subsequent decline in income. It is also evident from the experience since 1966 that if a crisis and serious recession are aborted, the euphoria, now combined with inflationary expectations. may quickly take over again. It may be that, for the boom and inflationary expectations evident in 1969 to be broken, the possibility of a serious depression taking place again must become a credible threat. Given the experience of the I 960's, it may also be true that the only way such a threat may be made credible is to have a serious depression.  VII. AN ASIDE ON BANK EXAMINATION Commercial banks and other deposit institutions are periodically examined. I do not intend to offer a critique of current bank examination objectives and techniques or to inquire into whether such examination   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  is useful or necessary. I assume that bank examination will continue and that the only negotiable issue is its nature. As now carried out, bank examinations enable the examining authority to determine  416 FINANCIAL INSTABILITY REVISITED  the creditworthiness of the institution and fraud are not obvious. The determination of creditworthiness is an extension of the )ender-borrower relationship, and the examination for fraud and mismanagement is a consumer protection function. It is argued here that a bank examination procedure that focuses on cash flow relationships can be a useful source of information for Federal Reserve policy-making. TypicalJy, the end result of a bank examination is a balance sheet, which places prices on assets. Many assets of financial institutions-such as bank loans--do not have an active market. 1Such assets are priced at their face value, especially if they are current, even though they would sell at a discount if a market existed." Items that are not current-what some call scheduled items-are valued at some arbitrary ratio to face value in arriving at the balance sheet. An excess proportion of scheduled items is taken as indicating a need for corrective action by the institution. It is obvious that the examiners' balance sheet reflects many arbitrary rules, especially to the extent that valuation is divorced from current market prices. An arbitrary element enters into every placing of a price on assets for which no broad, deep, and resilient market exists. In addition, measures of the adequacy of capital and liquidity are derived. These measures reflect examiners' experience. It may be that an examination procedure that focuses on cash flows will lead to a more precise evaluation of capital adequacy and liquidity. -Even though the value placed upon a financial asset may be the result of an arbitrary valuation procedure,. the commit".Of course. with a decline in market interest rates. the assets would sell at a premium. The bias in writing this report has been to examine the effect of monetary constraint and rising intere-st rates. This essay is a creature of its time-midyear to fall t 966.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  125  ments of the emitter of the instrument are precise. The commitments are to make payments-either at specified dates, on demand, or upon the occurrence of some stated contingency. Both assets and liabilities of a financial institution are such contracts. The examiner, by reading the outstanding contracts, can make a time profile of contractually dated cash flows to and cash flows from the unit. Each profile of dated payments and receipts needs to be supplemented b~ behavioral relations detailing the conditions under which demand and contingent clauses of contracts will be exercised. Thus, a time series of the needs and sources of cash, under alternative contingencies, can be estimated." Cash flow analysis enables the authorities to receive information about the expected impact of various economic policy operations upon the cash flow to and the cash flow from various units and classes of units. Whereas balance sheet analysis is essentially static, a cash flow analysis of any financial organization that forecasts cash flows at some future date must be based of necessity upon clearly stated assumptions as to ( 1) the values that certain systemwide variables will take, and (2) the functional relationships between these variables and the elements of the unit's cash flows. The conditional nature of any single statement makes it necessary to vary the assumptions-to map out how changes in parameters of the assumed functions and in systemwide variables affect cash flows. An evaluation of the expected cash status of any institution, or class of institutions, will depend upon assumptions as to how 41 Computer technology makes more feasible such a transformation of the examination procedure from an analysis of values to an analysis of cash flows. The emphasis upon capital values in bank and similar examination procedure. as well as in economic analysis. may well reflect what were at one time insurmountable computational difficulties.  417 126  the different market-determined variables will behave. Thus, the examination procedure will have to embody the results of serious economic analysis. Bank and other examination procedures should be forward looking. That is, instead of asking questions about the present status and the past history of an organization, the questions should be of the following form: "Given the present status as an initial condition, what would be the dated impacts upon the organization of various economic system, financial market, and management developments?" The vulnerability of say the New York mutual savings banks to rapidly rising interest rates on time deposits and the sensitivity of the income and liquidity of West Coast savings institutions to a decrease in the rate of growth of the local economy would have been obvious with such an analysis. The proposed examination procedure becomes an analysis of the unit that is conditional upon the behavior of the economy. Economic policy decisions cannot be made on an adequate factual basis without some knowledge of their impact upon various classes of financial institutions.. Much of what happens seems- to surprise the authorities: an adequate examination procedure would minimize such surprise. Cash flow analysis transforms every asset into a generator of a cash flow to the organization. Financial assets may be subdivided into three classes depending on how they generate cash: cash itself, loans, and investments. There is no need to discuss cash itself. Loans are those assets that generate a contractual cash flow. The ability of the owning organization to accelerate this cash flow by sale is very restricted. We may as well assume that it does not exist. However, such assets may serve as collateral for loans, for example at the discount window. Investments, while they do embody contractual cash flows, may also be salable   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  in a market. Their current market price more or less states the cash flow that the managers can generate if they choose to sell out their position. True investments would have broad, deep, and resilient markets. Those of many banks and other financial institutions have thin markets, and the relevant cash flow to the organization from such investments follows from the contractual, rather than the marketable, properties of the asset. Whereas current assets yield a cash flow to an organization, the process of asset acquisition results in a cash flow from the organization. As a continuing organization at each point in time a bank will have dated, demand, and contingent commitments to acquire assets. The commitments will be both explicit-lines of credit or letters--or implicit-the result of a long-term financial relation between the bank and the potential borrower. Banks may simUarly have an implicit commitment to bid for local municipal issues." The cash flow to an organization due to financial asset holdings reflects both the flow of income and the repayment of principal. However, this division is not really relevant-what is relevant is the amount that is available from any cash flow for the acquisition of new assets. That is, the cash • For all economic units, such continuing financial contacts and relations are valuable assets. True. implicit agreements may be not honored if a liquidity squeeze occurs, but this imposes capital losses upon  the surprised and disappointed potential borrower. One way in which widespread bank failures affected the economy was by rupturing normal financial chan-  nels. When the Bank of the United States in !iew York failed in 1930, not only were there losses by depositors but a fairly larg• portion of .the New York Agarment trade was cast adrift without a continuing bank relationship. Thus in principle we can be cavalier with respect to financial constraint resulting in loan contraction, but in fact we must tecognize that extreme constraint may ~ause losses to innocent by-  standers. See footnote 9, pp. 309 and 3 I 0, in M. Friedman and A. J. Schwartz, ..Money and Business Cycles."  418 127  FINANCIAL INSTABILITY REVISITED  flow to must be related to the cash flow from. The debt liabilities of deposit and other financial intermediaries are commitments to pay cash-at some specified date, on demand, or upon the occurrence of some contingency. These commitments include both the repayment of principal and interest payments; although for many deposit institutions interest payments are credited to the depositors' account and do not generate an automatic cash drain. The debt liabilities of deposit institutions can be separated into service and purchased liabilities. Local demand deposits and passbook savings are almost all service deposits. The volume of such deposits will depend upon the state of the local economy and the action of local competitors. Purchased liabilities include · Federal funds and large certificates of deposit for commercial banks as well as out-of-state deposits for savings and loan associations. Market demand may be volatile with respect to system performance for purchased liabilities, but be stable for service liabilities. A bank's potential ability to finance a position in assets without recourse to extraordinary techniques in times of monetary constraint may depend upon the extent to which its resources are derived from service rather than from purchased liabilities. The potential for recourse either to the discount window or to the sale of assets in some secondary market is related directly to the extent to which purchased liabilities are a source of funds. Thus the cash flow examination will have to consider the likelihood that the behavior of the market for such bank liabilities will lead to large cash flows out of the bank and thus force it to resort to discounting or asset sales.  Any cash flow analysis would need to relate each earning asset-both loans and investments-to the market in which it   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  may be sold or pledged. For each asset the terms upon which financing is available to the position takers or lenders in its market need to be examined. In particular, the breadth, depth, and resiliency of a market can be guaranteed only if the central bank or perhaps its chosen instruments stand ready to finance position takers. Thus, if new asset classes become important, the examinations procedure might feed back to the central bank the need for the development of new or strengthened secondary markets or additional discount facilities. For the demand and contingent liabilities of deposit institutions the interesting economic question is the conditions under which the demand or contingent claims will be exercised. The cash flow to and fr.om an organization because of demand liabilities is a function of at least the terms offered by the institution, the terms available elsewhere, and for certain institutions, national income. Many special variables that reflect the specific contractual terms enter into determining the impact upon cash flows of market-determined and policy variables." The content of cash flow analysis of a financial intermediary can be made more precise by illustrating how the technique would be applied to a specific institution. Let us take, for the sake of simplicity, and also perhaps because of its recent relevance, a savings and Joan association. The assets of such an institution will consist almost "In the Minsky-Bonem simulatiOn ~xpcrimentsreportcd in my paper "Financial Crisis, Financial  Systems, and the Performance of the Economy," pp. 36S and 366-least-square regression lines were fitted for new deposits and withdrawals at savings and loan organizations as functions of disposable income. For particular savings and foan organiz1tions similar functions would need to be estimated and such functions would include local economic conditions as well as interest rate variables, rather than just aggregate income data as was true in oUr rather primitive anal-  ysis.  419 128  entirely of long-term fully amortized mortgages. Because of the rapid growth of these institutions the representative portfolio is rather young. This means that the cash flow to the organization on account of its assets is a relatively small percentage of the total liabilities. In addition to such mortgages there will be some cash and Treasury bills-but at most these will be a small percentage of total assets. Thus even allowing for the cash flow that the management can generate by selling assets, the cash flow to the organization during one short period ( say 90 days) cannot be more than 5 to 10 per cent of total liabilities. Ignoring stand-by and lender-of-last-resort refinancing as a potential supplier of cash, these organizations must at all times offer interest rates attractive enough so that no appreciable flight of deposits will occur. However, as they cannot discriminate readily among depositors, they must pay all depositors whatever is needed to keep the marginal depositor. In the summer of 1966, the need arose to raise interest rates on all deposits to prevent large-scale withdrawals of some deposits. This resulted in a sharp rise in the total cost of deposit funds. At the same time savings banks were locked into young portfolios whose contracts reflected the lower interest rates of the past. The cost of money in many cases may be penal, but ·unlike the classical penal rate case, .the penal rate will rule not for · a short time but may stretch over many years. The penal rate of classical banking theory was an expensive way of refinancing a position that ran off in a relatively short span of time: 90 to 180 days. As a result of the short original dating of the contracts-within 6 months almost all of the initial assets of a commercial bank will be repaid-the turnover time for assets is short. New assets will be acquired as old ones are repaid, but only   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  at interest rates that are consistent with the higher cost of money. Thus, when the cost of money rises, the relevant question is not just "How long will the interest rates be at this higher level?" but also "How long will it take for almost all assets in the portfolio to carry rates consistent with the new rate on liabilities?" If portfolios are heavily weighted with young, fully amortized, longterm contracts, this turnaround time can be many years. A cash flow examination procedure would state how long it would take for say 25 per cent, 50 per cent, and 75 per cent of assets to adjust to new higher --or lower--costs of money. If interest on liabilities is a cash flow from the organization, a period in which a net cash flow out is financed by selling assets can occur when interest rates rise. If interest on liabilities is credited to the accounts of the depositors, deposit liabilities will rise relative to assets, and net worth will decrease. In both cases demand commitments to pay will increase relative to both the contractual cash flow to the unit due to assets and the ability of management to generate a cash flow by selling marketable assets. There is no necessity to enlarge upon the relevant conditional relations. For example, one possible reaction by a deposit institution to prospective pressures for cash payments is to increase the ratio of cash and marketable securities to other assets. This means that instead of feeding cash flows generated by its mortgage portfolios to the now high-yielding mortgages, a hardpressed savings and loan association will withdraw from the mortgage market and use cash flows to acquire low-yielding but marketable assets: it prepares its cash and near-cash position to withstand a deposit drain. For each of various assumptions as to how units react to a cumulative cash flow  420 FINANCIAL INSTABILITY REVISITED  to or cash flow from, a time series of asset and liability positions can be derived. Presumably in the example given, the cash flow from, because of withdrawals, can actually be greater than the cash flow to for some periods. Even if such withdrawals do not occur, and even if we do not value assets at the current-estimated-market price, the growth of demand liabilities that results from the crediting of the high interest rate income to deposit accounts will lead to an increase in the ratio of deposit liabilities to cash flow to the organization. Thus, it may become an ever more difficult problem to retain deposits. A conditional cash flow examination of individual and of classes of financial institutions would determine the impact upon the institution or class of institution of various policy-determined conditions. One proposition favored by nonacademics is that the high cost of funds forces financial intermediaries into making risky loans that carry a high contractual interest rate. From the preceding cash flow example the cost of funds can rise so rapidly, relative to the fixed returns on the assets, that the organization will foresee that a liquidity crisis at some stated date is certain if it follows a conservative policy in the placement of accruing cash. If it sells its low-yield, fixedmarket-price investments, reduces its cash position, and uses the cash flow on principal, income, and new deposit accounts to purchase high-yield, high-risk assets, then, if all turns out well, it avoids a liquidity crisis. That is, whereas the conservative portfolio policy yields a financial crisis with a probability of almost one, the more radical portfolio policy yields a finite probability greater than zero of avoiding the liquidity crisis. In   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  129  these conditions the chancy portfolio policy is safer than the risk-free policy. A conditional cash flow analysis of individual, and classes of, financial institutions will estimate the impact of various alternative policy and market-determined conditions upon the individual institutions and the set of institutions. For example, there may be a limit to tight money-due to the running losses, as illustrated earlier-that a nonbank financial intermediary, such as the savings and loan associations, can stand. The Federal Reserve must look beyond the commercial banking system to determine whether, or in what circumstances, its actions are destabilizing. A unified procedure for · examining all financial institutions that focuses on their cash flows will be of help not only to unit managements but also to regulatory authorities. One advantage of this approach is that through the information obtained the distribution of impacts can be estimated. Such an examination procedure should enable us to determine how many units are pushed over· or pushed too close to some threshold by some constraining event that, for example, lowers the average return to a financial intermediary. The development of an examination procedure for cash-flow-oriented banks and other financial institutions would involve a great deal of experimentation not only with observations of individual banks-the data gathered in examinations-but also with the system attributes that are relevant to determining individual bank behavior. Fortunately, the recent interest in banking and bank markets has generated a body of studies that can be used as a starting point for the analysis of the behavior of financial institutions under alternative qonditions.  421 130  VIII. REGIONAL ASPECTS OF GROWTH AND FINANCIAL INSTABILITY The reserve base of the banks in a region must be earned, and to keep such reserves, the return offered must be competitive. The global reserve base is the result of Federal Reserve policies.•• Every change in reserves appears initially as a change in reserves in some particular set of banks. However, even if the Federal Reserve has a policy or program that directs the initial change in reserves toward some region, the ultimate regional distribution depends upon market forces. Any change in the reserve base of the banks within any region will be the result of either an income or an asset transaction with the rest of the country. The monetary system of every region is equivalent to a very strict gold standard, where Teserves for a region are the equivalent of gold for a country. National economic growth is the result of the growth of the various regions. Some regions grow more rapidly-and some less rapidly-than the economy. The available evidence indicates that the reserve base of the various regions grows at a pace that is consistent with the growth of the region. That is, even if there is a trend in velocity in both the country and the regions, the relative velocity will change but slightly. If there is a rapidly growing region embedded in a slowly growing country-as was true of California during the l 950'sthe money supply and the reserve base of the rapidly growing region will also grow rapidly. Thus, in the 1950's while demand deposits in the United States were growing slowly, demand deposits in California were growing rapidly." • Even if there are clwtps In the reserve bue that are not due to Federal Reoerve policy, the total n• ,erve clwtp la the result of Federal R...rve actionor inaclian. • SN Minlky (ed.), Collfornia Banking In a Grow(,., E_,_. 1'46-1'7:S.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  In the case of California, two identifiable, large, and rapidly growing sources of bank reserves were (1 ) the excess of Federal Government payments over receipts in the State and ( 2) the flow of funds to the State to finance home construction. Other sources of reserves undoubtedly exist, but they were not identifiable at the time of the research underlying this section. During the decade of the I 950's, the financing of housing generated a large flow of funds toward California. It has been estimated that as much as 40 per cent of the total financing for house-building in California came from out of the State. This flow of funds into California reflected both the export of mortgages and a rise in out-ofstate deposits in California savings and loan associations. About 20 per cent of the deposits in California savings and loan associations were from out-of-state depositors. A build-up in the stock of mortgages and deposits owned by out-of-state investors means that an increasing reserve drain takes place to meet the commitments as stated in this growing stock of liabilities. That is, without an appropriate offsetting growth in the cash flow from new mortgages, deposits, or other items, the growing stock of out~ standing liabilities will tend to generate payments that lower the region's reserve base. Any slowdown in the influx of funds to the region on account of the housing market can lower the growth prospects for commercial banks and for the State's money supply. Mortgages, especially the standard fully amortized contract, generate a known, dated series of payments; the only variation in the cash drain from the region due to the stock of mortgages will be due to an inability to make payments, prepayments, or the sale of mortgages. Given that there is some experience on prepayments and sales,  422 FINANCIAL INSTABILITY REVISITED  it seems clear that the outstanding foreignowned (out-of-state) mortgages yield a known cash drain from the region's banks. The cash flow due to all depositors but especially those from out of state, at California savings and loan associations will depend upon safety and profitability. Deposit insurance eliminates concern or doubt_ about the safety; thus, the cash flow to California because savings and loan deposits depend upon relative interest rates. A variety of rate-sensitive "hot monies" exist as deposits in these institutions; some of these would be sensitive to small differentials in interest rates. We would expect these potentially hot-money deposits to be the large out-of-state accounts. Even though all deposits-local and out of state:......should be equally sensitive to rate differentials, the convenience factor may dominate in the case of local, mostly passbook deposits. A rapidly growing region must maintain a rate structure that attracts funds. and that retains previously acquired out-of-state deposit funds. Thus, California savings and loan associations must keep a favorable interest rate premium, even if the demand for financing of housing is slack. Defensive rate competition is based upon the unit's liability structure. Note that if the national cost of money is high, the supply price of finance from these institutions will remain consistent with this cost of money, even though local demands for financing may be slack. One impact of monetary constraint in a euphoric economy is that a rise has taken place in other market interest rates relative to the rate on savings and loan shares (deposits) in California. The observation that the California mortgage market exhibited signs of disorderly conditions in mid1966 needs no documentation. Due to rate competition, these deposits have stopped  increasing Even if there is a net increase   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  131  in deposits ( at a slower rate) the net increase may be compounded of a decrease in foreign (out-of-state) deposits and an offsetting rise in domestic (in-state) deposits. During recent periods of monetary constraint, the housing-related financial markets have tended to generate a decrease in California's reserve base. If all else remains the same, this means that either monetary velocity in California must increase relative to that of other geographical sectors, or the rate of growth of income must decrease. There is nothing sacred about the favored growth experience of California, nor is there any reason why the national authorities should operate to keep California growing more rapidly than the country as a whole. Howeyer, tight money will be particularly hard on California homebuilding, mortgage financing institutions, and commercial banks. This will be compounded if a rate ceiling is adopted to prevent competition for deposits. Nonconstrained market instruments are substitutes for savings and loan liabilities, and a potential expansion of the retailing of such market instruments is a threat to deposit institutions. A decline, or a slowdown, in the growth of commercial bank reserves in a rapidly growing region will lead to a decline in locally available credit through commercial banks. California banks are traditionally light on secondary reserve assets. The opportunity to sustain loan growth by decreasing investments is tninimal. Monetary constraint, after a period of rapid growth-especially if it is a reaction to a spread of euphoria from a previously rapidly growing region to the country as a whole-will put serious pressures upon the banks and other financial institutions of the previously rapidly growing region. The regional concentration of financial duress may trigger a more general spread of distress than if the same total financial  423 132  tightness were more evenly distribut.·d geographically. The practitioner of monetary policy must be aware that there are different regional  pressures due to monetary constraint and that contagion phenomena within a region may be one way in which financial instability may be initiated.  IX. CENTRAL BANKING The modern central bank has at least t\\ o facets: a part of the stabilization a1 d growth-inducing apparatus of Governme:1t and the lender of last resort to ail or pa rt of the financial system. These two functions can conflict. For the United States, central bank fun,:tions are decentralized among the Fedenl Reserve System, the various deposit insu ·. ance and savings intermediary regulato, y bodies, and the Treasury. The decentralization of central banking functions and responsibilities makes it possible for "buck passing" to occur. One result of this decentralization, along with the fact of usa!·c and market evolution, is that there exists a perennial problem of defining the scope and functions of the various arms of the centw 1 bank. The behavior of the various agenck s in mid-1966 indicates that ad hoc arrang,·ments among the various agencies can sene as the de facto central bank. However, even though central banking functions are distributed among a number of organization,. the fact that the Federal Reserve Systen appears first among them should not bi obscured. The Federal Reserve may have t,i make markets in the assets or liabilities t'f the other institutions if they are to be abl: to carry out their assigned subroutines. The Federal Reserve System undertook. when the peg was removed from the Gm ernment .bond market, to maintain order!: conditions in this market. l\ laintainin:• orderly conditions in a key asset market i, an extension of the lendcr-ot-last-resor1 functinns in that it is a prewn1 ,ve lende   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  of last resort. "If we allow the now disorderly conditions to persist, we will in fact have to be a lender of last resort" is the underlying rationalization behind such action. Maintaining orderly conditions in some markets serves to protect position takers in the instrument traded in these markets. This protection of position takers may be a necessary ingredient for the development of efficient financial markets. The stabilizer and lender-of-last-resort functions are most directly in conflict as a result of such efforts to maintain orderly conditions. If constraining action, undertaken to stabilize income, threatens the solvency of_ financial institutions, the central bank will be forced to back away from the policy of constraint. If a financial crisis occurs, the central bank must abandon any policy of constraint. Presumably the central bank should intervene before a collapse of market asset values that will lead to a serious depression. However, if it acts too soon and is too effective, there will be no appreciable pause in the expansion that made the policy of constraint necessary. 1 have already discussed one way in which tight money can cause financial instability; that is, asset holders that arc locked into assets bearing terms born in times of greater ease are forced into risky portfolio decisions. In addition the very rise in interest rates, which measures tight money, induces substitutions in portfolios that makes financial instability more likely. Thus. interwntion on grounds of lender of last resort and re-  424 FINANCIAL INSTABILITY REVISITED  sponsibilities for maintenance of orderly conditions become more likely during such periods. In exuberant economic conditions central banking has to determine, once distress appears, just how disorderly markets can become before the lender-of-last-resort functions take over and dominate its actions. Perhaps the optimal way to handle a euphoric economy is to allow a crisis to develop-so that the portfolios acceptable under euphoric conditions are found to be dangerous--but to act before any severe losses in market values, such as are associated with an actual crisis, take place. If monetary conditions are eased too soon, then no substantial unlayering of balance sheets will be induced, and the totai effect of monetary actions might very well be to reinforce the euphoric expansion. If conditions are eased after a crisis actually occurs -so that desired portfolios have been revised to allow for more protection-but the effective exercise of the lender-of-last-resort function prevents too great a fall in asset prices, then the euphoria will be terminated and a more sustainable relation, in terms of investment demand, between the capital stock and desired capital will be established. If the lender-of-last-resort functions are exercised too .late and too little, then the decline in asset prices will lead to a stagnation of investment and a deeper and more protracted recession. Given that the error of easing too soon only delays the problem of constraining a euphoric situation, it may be that the best choice for monetary policy really involves preventing those more severe losses in asset prices that lead to deep depressions, rather than preventing any disorderly or near-crisis conditions. If capitalism reacts to past success by trying to explode, it may be that the only effective way to stabilii.e the system, short of direct in-   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  133  vestment controls, is to allow minor financial crises to occur from time to time. Note that the preceding is independent of the policies mix. If, as seems evident, the tight money of 1965-66 was due more to a rapid rise in the demand .for money than to a decline in the rate of growth of the supply of money, a greater monetary ease combined with fiscal constraint would not have done the job. If we accept that a major expansionary element over this period was the investment boom and that the expenditures attributable to Vietnam only affected the degree, not the kind, of development, then an increased availability of finance would have resulted in increased investment and nominal income. A changed policy mix would have constituted further evidence of a new era. Of course, the fiscal constraint could have been severe enough to cause such a large decline in private incomes that existing commitments to make payments could 1;1ot be met. A financial crisis or a close equivalent may be induced by too severe an application of fiscal constraint as well as by undue monetary constraint. Within the Federal Reserve System, from the perspective of the maintenance of financial stability or at least the minimization of the impact upon income and employment of instability, a reversal may be in order of the trend that has led to the attenuation of the discount window. If secondary markets are to grow as a way of generating both liquidity while the system is functioning normally and protection while the system is in difficulty, then the dealers in these markets will need access to guaranteed refinancing. The only truly believable guaranty is that of the_ central bank. However, a central bank's promise to intervene to maintain orderly conditions in some market will be credible only if the central bank is already operating in that market. If the central bank is not operating  425 134  in the market, then it will not have working relations with market participants and it will not be receiving first-hand and continuous information as to conditions in the market; no regular channels that. feed information about market conditions will exist as now exist for the Government bond market. Thus, the Federal Reserve will need to be a normal functioning supplier of funds to the secondary markets it desires to promote. At present, only a small portion of the total reserve base of banks is due to discounting at the Federal Reserve System. Discounting can serve three functions-a temporary offset to money market pressures, a steady source of reserves, and the route for emergency stabilization of prices. In order to set the ground for the Federal Reserve System to function effectively in the event of a crisis that requires a lender of last resort, the Federal Reserve normally should be "dealing" or "discounting'' in a wide variety of asset markets. One way to do this is to encourage the emergence of dealer secondary markets in various assets and to have the Federal Reserve supply some of the regular financing of the dealers. It might be that a much higher percentage of the bank's cash assets than at present should result from discounting, but the discounting should be by market organizations rather than by banks.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Monetary and fiscal constraint may not be enough once the Keynesian lessons have been learned. The monetary-fiscal steering wheel had assumed a mechanistic determination of decisions that center around uncertainty; the system's doing well may so affect uncertainty that an arsenal of stabilization weapons including larger rationing elements may be necessary. Let us assume the present arsenal of policy weapons and objectives. The policy objectives will be taken to mean that the high-level stagnation of the 1952-60 period does not constitute an acceptable performance. Under these conditions, the lender-oflast-resort obligations of the Federal Reserve, redefined as allowing local or minor financial crises to occur while sustaining over-all asset prices against large declines, become the most important dimension of Federal Reserve policy. The lender-of-lastresort responsibilities become also the arena where human error may play a significant role in determining the actual outcome of economic situations. It is only in a taut, euphoric, and potentially explosive economy that there is much scope for error by the central bank. The importance attached to human error under these circumstances is due to a system characteristic-the tendency to explode-rather than to the failings of the Board of Governors. Fall 1966 (revised January ]970)  426 FINANCIAL INSTABILITY REVISITED  BIBLIOGRAPHY Ackley, G. Macroeconomic Theory. New York: Macmillan, 1961. Arrow, K. J. "Aspects of the Theory of Risk Bearing." Yrjo iahnsson lectures. Helsinki: Yrjo Jahnssonin Siiii.tio, 1965. - . "Uncertainty and the Welfare Economics of Medical Care," American Economic Review, December 1963. Clower, R. W. "An Investigation into the Dynamics of Investment," American Economic Review, March 19S4. Economic Report of the President. Washington, D.C.: U.S. Government Printing Office, 1969. Fellner, W. "Average-Cost Pricing and the Theory of Uncertainty," Journal of Political Economy, June 1948. - - - . ''Monetary Policies and Hoarding in Periods of Stagnation," Journal of Political Economy, June 1943. Fisher, I. ''The Debt-Deflation Theory of Great Depressions," Econometrica, October 1933. Friedman, M. "The Demand for Money: Some Theoretical and Empirical Results," Journal of Political Eco11omy, August 1959. Friedman, M., and Schwartz, A. J. A Monetary History of the United States, 1867-1960. Study by the National Bureau of Economic Research, N.Y. New Jersey: Princeton University Press, 1963. - - - . "Money and Business Cycles," Review of Economics and Statistics, Supplement, February 1963. Galbraith, J. K. The Affluent Society. Boston: Houghton Mifflin, 19S8. Greenberg, E. "A Stock-Adjustment Investment Model," Econometrica, July 1964. Gurley, J. G., and Shaw, E. Money in a Theory of Finance. Washington, D.C.: Brookings Institution, 1960. Hicks, J. R. "Mr. Keynes and the 'Classics,' A Suggested Interpretation," Econometrica, April 1937. Johnson, H. G. "The 'General Theory' after Twenty-five Years," American Economic Review, papers and proceedings, May 1961. Kalecki, M. "The Principle of Increasing Risk,'' Economica, November 1937. Keynes, J.M. "The General Theory of Employment," Quarterly Journal of Economics, February 1937. - - - . The General Theory of Employment, Interest and Money. New York: Harcourt, Brace, and Company, 1936.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  135  427 136  Minsky, H.P. "A Linear Model of Cyclical Growth," Review of Economics and Statistics, May 1959; also in Gordon, R. A., and Klein, L. R., A.E.A. Readings in Business Cycles, vol. 10. Homewood, Ill.: Richard D. Irwin, Inc., 1965. - - - (ed.). California Banking in a Growing Economy: 1946-1975. Berkeley, California: University of California, Institute of Business and Economic Research, 1965. - - - . "Central Banking and Money Market Changes," Quarterly Journal of Economics, May 1957. - - - . "Comment on Friedman and Schwartz's Money and Business Cycles," Review of Economics and Statistics. Supplement, February 1963. - - - . "Financial Crisis, Financial Systems, and the Performance of the Economy," in Private Capital Markets. Prepared for the Commission on Money and Credit, N.Y. Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1964. - - - . "Financial Intermediation in the Money and Capital Markets," in Pontecorvo, G., Shay, R. P., and Hart, A. G. Issues in Banking and Monetary Analysis. New York: Holt, Rinehart and Winston, Inc., 1967. Ozga, S. A. Expectations in Economic Theory. Chicago: Aldine Publishing Co., 1965. Tobin, J. The Intellectual Revolution in U.S. Economic Policy Making. Noel Buxton lecture. Essex, England: Tiie University of Essex, 1966. - - - . "Liquidity Preference as Behavior Towards Risk," Review of Economic Studies, February 1958. Turvey, R. "Does the Rate of Interest Rule the Roost?" in Hahn, F. H., and Brechling, F. P. R. (eds.). The Theory of Interest Rates. New York: St. Martin's Press, 1965. Viner, J. "Mr. Keynes on the Causes of Unemployment," Quarterly Journal of Economics, November 1936. Witte, J. G., Jr. "The Microfoundations of the Social Investment Function," Journal of Political Economy, October 1963.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  86-817 0 - 77 - 28   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  428  proc.eedings of a c.onference on  Bani<  Struc-turct. and  Compct.tition federal reserve bank of chkago  may 1 and 2 1975 ftelUl'Cho.,artment Faderal IINerM Sank of  P. 0. ■••134 ChlC-.O, ffllnols IOIIO  Chfcato  429 50  BANK STRUCTURE AND COMPETITION  Suggestions for a Cash Flow-Oriented Bank Examination Hyman P. Minsky Washington University  I.  Introduction  In the summer of 1967, as an offshoot of a paper for the Board of Go\'ernor's "Reappraisal of the Discount Mechanism," 1 some suggestions were put forth for a cash flow-oriented bank examination procedure. In the light of developments since then, in particular the growth of liability cnanagemen t banking and the r-ecurre ntthreats ( 1966, 1970, 1974) of financial instability. the 1967 suggestions for reforming bank examinations seem es.pecially relevant. The aim of the suggested examination was to use the examination process to generate information on both the liquidity and solvency of particular institutions but also on threats, if any, to the stability of financial markets; this information was to be forward looking and to be .such that the implications of alternative economic and policy scenarios could be investigated. In particular, the examination procedure was designed to focus upon the actual (past) and potential (near-term future) position-making operations of a bank,. so that the Federal Reserve quthorities would be aware of actual or threatened financial fragility. The perspective underlying the suggestions was of a dynamic, evolving set of financial institutions and relations. All too often, it seems as if the Federal Reserve authorities have been surprised by changes in financial practices. One aim in the design of the examination system was to establish a regular ,eporting procedure which would force the authorities to be aware of inStitutional changes that were ongoing, and which furthermore forced the authorities to inquire into how the ongoing developments can be expected to affect the stability of the financial system. Questions about the need for bank examinations were not addressed in the report.~ The assumption underlying the report was that bank examinations were to continue and the objective was to make them more ijSeful. An open question, in my mind, is whether the objective of the suggested reform of bank .examinations can be served by an integrated system of reports that focuses upon bank cash flows, so that the expensive examination procedure is not necessary. The 1967 comments upon the proposed examination forms are t.!produced in Appendix A, and Appendix 8 contains the forms that were  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  430 MINSKY  151  set up in 1967. A clear picture of what was intended can be obtained by reading the comments on each form as the form is perused. Some additional 1975 comments on the examination procedure.are in Appendix C. In the body of th.e paper an argument as of 1975 for the proposed procedure is presented. This paper draws upon but considerably modifies the argument submitted in 1967. II.  Economic Theory Underpinning  The economic theoretic underpinning of the proposed examination procedure is the financial instability hypothesis which in turn is an unorthodox interpretation of The General Theory of Keynes. 3 This view holds that endogenous destabilizing forces, centered in the sophisticated financial system of a modern capitalist economy, make business cycles of the kind that involve threats and realizations of financial crises an inherent characteristic of these economies. Recent experience-the crunch of 1966, the liquidity squeeze of 1969-70, and the current ( 1974-75) difficulties-furnishes conclusive evidence that such crises and threats of crises are very much with us; the open issues center around the explanation of these events and whether they can-or even should-be avoided by either policy measures or institutional reform. Perhap& the fundamental question in economic theory is whether the development of such crisis-prone situations reflects a fundamental characteristic of the economy we are dealing with, whether they are the result of correctable institutional flaws; or whether they are due to policy errors. A quite common interpretation, implicit in both the monetarist and the conventional Keynesian views, is that events like our current crisis are due to errors of economic policy management rather than inherent characteristics of the economy. A view that was quite common during the aftermath of the Great Depression was that financial crises could be avoided if rather substantial reforms (100 peccent money, for example} were made in the banking system. The view underlying this paper is that while improvements in policy management and institutional reforms may alleviate and attenuate some of the forces that make for financial instability, the fundamental endogenous speculative elements in the demand for, and the financing of positions in, capital assets under capitalist financial arrangements make for the development, over time, of crisis-prone financial interrelations. As has been demonstrated in 1966, 1970, and 1974, such crisis-prone financial situations need not lead to a full-blown crisis; on the other hand, the repercussions of aborting a threatened financial crisis by Federal Reserve action can lead to subsequent inflationary pressures. Thus, the Federal Reserve, cognizant of its ultimate responsibilities. as a lender of last resort (i.e., an aborter of financial crises), needs to develop in https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  431 ·52  BANK STRUCTURE AND COMPETITION  orma1ion on financial market developments that point towards the :mergcncc of a crisis-prone-i.e .. fragile-financial structure. The informaion that is needed includes knowledge oftheevolvingposition-makingaci, ities of banks and the changing nature of the interrelations among banks md between banks and nonbank financial institutions. Such information :an only be achieved by systematic direct observations on bank >eha,ior-i.c .• by an examination procedure. A basic proposition in the alternative interpretation of Keynes is that ·capital assets are valuable because they yield profits (i.e., cash flows), not ,ccause they are productive" (a paraphrase of a remark by Keynes). Both :a pita I assets and financial instruments have to be viewed as !lnnuities-i.e., terns that are expected to yield cash flows. Thus, real assets and financial tssets are similar in that they yield expected cash flows. The balance sheet or all units can be interpreted as a set of instruments which results in dated, lemand, and contingent commitments to receive and to pay cash. One ,perational constraint upon the behavior of all units is the need to have ash on hand to meet payment commitments as they arise-i.e., all conomic units can be viewed as banks (New York City in the Spring of 975). The nature of liabilities, in particular their time dimension, is of as. ouch ·importance as the cash flow due to assets of a unit in determining the 1roduct and factor market conditions that may· affect its ability to meet ommitments. By considering all of economic activity and all financial intruments as yielding cash flows, the "real" and the "financial" aspects of a apitatist economy can be integrated. In addition to -receiving cash from the fulfillment of owned contracts nd. from ..normal" deposits. a bank, or for that matter any economic unit, cquires cash by dealing in assets or selling liabilities. But dealing in assets ,r selling liabilities implies that a bank's viability, as well as its future ,rofitability, depends upon the normal or proper functioning of some inancial markets. For example, the ability of a bank to sell commercial ,aper or certificates of deposit depends upon both the unit's own •rofitability and the normal functioning of the commercial paper and cerificate of deposit markets. Thus, a dual vulnerability emerges whenever ash flows from operations are insufficient to meet financial commitments: . unit can be in a cash flow bind due to a shortfall of cash from operations r because it cannot sell assets or issue .debts to raise cash. Of particular importance in a cash flow perspective of the functioning f the economy is the distinction between hedge, speculative, and "Ponzi,. .nance. 4 In hedge finance the cash flows from operations are expected to e sufficient to fulfill contractual commitments. In speculative finance the resent value of expected cash receipts exceeds that ofcash payments, but abilities are more current than assets so that regular refinancing of ositions .is needed (this is the typical position of a bank). In Ponzi financ https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  432 MINSKY  153  ing the present value of cash flows from as.sets is less than the present value of cash flows due to liabilities, but payments, including dividend and interest disbursements, are met by increasing liabilities. (Those real estate investment trusts which paid cash dividc:nds on the basis of interest accruals were engaged in Ponzi finance.) Units that engage in hedge financing cannot be adversely affected by purely financial market developments, in the sense that they do not depend upon raising funds in financial markets to meet their obligations. Units that engage in speculative finance can be adversely affected by purely financial market considerations. Inasmuch as the cash flow on liabilities is of nearer term than the cash flow on assets for units that engage in speculative finance, a rise in interest rates can transform a speculative finance unit into a Ponzi finance unit. It is evident that the nature of Federal Reserve responsibility, as well as the effects upon 'system performance of Federal Reserve policy actions, depends upon the relative weight of hedge, speculative, and Ponzi finance in the economy. In particular, in a world of hedge finance rising and falling interest rates do not affect the viability of institutions, whereas in a world with a large admixture of speculative finance high and rising interest rates can transform speculative units into Ponzi units. Ponzi units can be sustained either because of Micawber sentiments-something will turn up-or because no one is willing to announce that "the Emperor has no clothes." The emergence of a significant number of units engaged in Ponzi finance makes the economy vulnerable to a debt-deflation process. Thui, the ability of the Federal Reserve to use its monetary weapons to control the economy is dependent upon constraining the growth of speculative and, thus, potential Ponzi-type finance. lt also means that the tolerance of an econoiny for rising interest rates depends upon the extent of speculative finance in the economy, for it is the tipping of units that -are engaged "in speculative finance into units which are engaged in Ponzi finance that is critical in the emergence of a debt-deflation prone situation.  III.  Banking Theoretic Underpinning  A cash flow-oriented examination and analysis of the operations of a commercial bank, or other depository institution, is based upon the view that liquidity is not an innate attribute of an asset, but rather that liquidity is a time-related characteristic of an ongoing, continuing economic institution imbedded in an evolving financial system. Whether a particular institution is, or is not, liquid over some time horizon depends not only upon its initial .balance sheet but also upon what happens in its business· operations and in the various financial markets in which the instruments it owns or "sells" are traded. The liquidity of an institution cannot be  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  433 154  BANK STRUCTURE AND COMPETITION  measured by assigning invariant predetermined liquidity quotients to assets and similar liquidity requirement factors to liabilities: the liquidity quotients and requirements are system-determined variables. · The normal operations of a unit over a time period generate cash and a need for cash. In addition to 1he cash flow from ordinary operations, a unit can adjust its cash position by opera1ing in asset and liability markets. In what follows, the financial transactions that are used to adjust a unit's cash position are called "position-making" activities. How, in fact, a unit goes about making position depends upon the nature of the markets that exist. A unit is liquid if, when it has a need for cash, it can obtain cash by operating in markets that quickly, easily, and cheaply yield cash. Ultimately, the liquidity of an institution depends upon the way it would obtain cash if some need to do so should arise; thus, any scenario of a -unit's positionmaking activities depends in a critical way upon the expected developments in various financial markets. The view of a bank's operations that underlies the proposed examination procedure emphasizes the central importance of position-making. A bank is not a money lender that first acquires and then places funds. Any particular day's asset acquisitions, particularly loans made, are the result of ongoing and continuing business relations; a bank first lends or invests and then 'finds' the cash to cover what~ver cash "drains arise. In some circumstances this cash can be found in excess cash on hand, in others it is found by selling or pledging owned assets for cash, and in still other circumstances the cash is acquired by issuing new liabilities. Whether excess reserves, asset management, or liability management is the source of the cash that is obtained to make a position depends upon the composition of the balance sheets and the financial markets that exist. In particula1, the efforts to generate a secondary market for acceptances and the Federal Reserve's discount window can be interpreted as the development of devices to facilitate position-making-i.e., the acquisition of cash to fulfill contractual or legal requirements. In the suggested bank examination procedure the essential operation of a bank is taken to be position-making. The key role of position-making in .banking follo~s from tile view that banks are active profit-maximizing institutions rather than passive reactors to funds placed in their custody. The instruments and financial markets used in position-making change over time, and at any one time not all banks will make position in the same way. In aadition to the narrowly defined commercial banks, all other financial institutions, and in particular those financial institutions that can be characterized as fringe banks-real estate investment trusts, finance companies, government bond dealers, commercial paper houses, etc.-actively engage in position-making. Any overview of the banking system in the Uni https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  434 MINSKY  155  ted States must consider the relations between commercial banks narrowly defined and- such fringe banks. One implication of the position-making perspective is that the Federal Reserve needs to be concerned with those markets in which fringe banks finance their activities and the extent to which the commercial banks provide both the ..normal" finance and the ..fall back" financing for fringe banking institutions. Thus, line-of-credit arrangements with financial institutions of various kinds by commercial banks become a major concern of the Federal Reserve. Any bank examination procedure that is concerned with the dynamic adjustments of banking will need to be set up so as to reveal such connections. In light of developments over the past several years it seems that a cash flow.:.oriented bank examination of the type suggested should enable the authorities to get a better handle_ on the operations of the giant multibillion dollar banks than is now available. It is now clear, as it was not in 1967, that the giant banks are the effective lenders of last resort to both non bank financial institutions and various short-term financial markets, in which both financial institutions and nonfinancial corporations raise funds. In a· revision and updating of bank examinations, one focal point should be the commitments by banks, especially the giant banks, to fringe banking institutions and markets. For example, the back up. lines of credit by commercial banks to financial and nonfinancial corporations that borrow in the commercial paper market are really commitments by the banks to the continued viability of the commercial paper market. One byproduct of a cash flow examination procedure will be more precise knowledge of the relations between the examined institutions and fringe banks. Such a clarification will enable the Federal Reserve to know ·better .what is emerging in financial relations and to be prepared better for contingencies that might dominate as the determinants of its behavior if financial disruption is imminent. The extent of the explicit and implicit exposure by banks to these fringe banks is obviously a parameter that has to be fed into monetary policy operations. It seems evident that monetary constraint, in the face of a booming economy, is for a time offset by an accelerated growth of nondeposit liabilities of banks and of fringe banking. It is also clear that during such boom periods emphasis upon bank -liabilities and in particular those liabilities which are normally called money-Mi, M2, or whatever-misses what is going on in the economy and, thus, tends to mislead the authorities. In particular, the ability of money market developments to offset monetary constraint, at least for a while, means that monetary constraint will be ineffective until it leads to such interest rates and exotic financing that a "break" in financial variables or channels can occur. (Such a break transforms normally speculative finance into Ponzi finance.) When this happens the need for the authorities to act as a "lender of last resort" can  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  435 156  BANK STRUCTURE AND COMPETITION  lead to a substantial infusion of monetary reserves. Recent experience indicates that the availability of traditional monetary constraint as a tool of economic control is very much in question.  IV.  Bank Examination  In the suggested examination procedure two items are emphasized: the desirnbility of generating a flow of information from bank examinations into the data which affect monetary policy decisions, and the need to emphasize how, at any time, banks make position-Le., which money market instruments can be expected to be mainly affected over the examination horizon by emerging developments, as seen by an analysis of current and forecast bank behavior. It is important to note that while the standard examination is essentially timeless, the cash flow procedure emphasizes the future implications of today's legacy of the past as embodied in financial relations-i.e., time and the uncertainties inherent in time are integral to the cash flow perspective. The standard bank examination procedure focuses on .two phenomena: the discovery of fraud and the oversight of the loan portfolio. A major concern is·the proper documentation of loans and some evaluation of whether loans are substandard. Su1>standard loans in turn are classified according to the estimated likelihood of repayment. Traditionally, bank examiners pay little or no attention to the liability structure-perhaps because the current fancy liability structures are.a relatively new phenomenon. The present emphasis upon fraud and loan quality is adequate for the examination and analysis of the operations of smaller banks-which in the present context might well be all banks of less than $500 million in assets. (The 200th bank in the April 21, 1975 Business Week list of the 200 largest banks has $625 million in assets.) The need is· for an ·examination procedure that can lead to a better control and •Understanding of what happens in financial markets. There is a fundamental difference in the perspective of the standard and the suggested bank examination. The standard examination procedure focuses on the individual bank and views the emergence of problem banks as the result of individual error if not fraud. It quite clearly reflects an "insurer'" or a ..consumer union" perspective. The examination procedure embodied in "Suggestions ..." focuses upon the emergence of taut financial markets, taking a tendency to speculate and to innovate in financial usages as an inherent characteristic of banks and business institutions in general. The emergence of taut or fragile financial circumstances is viewed as a characteristic of financial markets over an extended period of good times and the emergence of particular banks or fringe banks as the focus of a problem situation is viewed as in good part the luck of a draw. That is, there  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  436 157  MINSKY  always will be a breaking point in a fragile financial situation, and the particular banks and near banks that emerge as the problem institutions do so mainly because of the way market developments impinge upon their particular circumstances. In the current situation problem banks can emerge because of their exposure to real estate investment trusts, to New York City bonds, or to the financing of giant corporations-but these problems in turn reflect prior economic and financial market developments. Thus, the perspective of the suggested examination procedure is clearly that of the monetary authorities. The questions the suggested examinations ask are, "Can we see -the emergence of financial situations that will lead to our need to act as a lender of last resortr' and "How, if at all, is the emergence of such a situation the result of policy actions we taker' It is also worth noting that a cash flow-oriented examination procedure is analogous to an internal control system for a complex financial organization that focuses upon liability exposure and the need of the un-it to make position. In fact, we can view the suggested procedure as an attempt by the authorities to develop a unified perspective on bank operations, and this unified perspective is that of the manager of the cash position of the organization. It is evident that experimentation with procedures and content is called for if such an alternative is to become operative. In particular, the underlying perspective in the suggested examination procedure is that banking is a dynamic, evolving, and innovative industry and the examination procedures need to evolve to keep up with changes in banking. Since the procedure was suggested, the emergence of the complex multinational bank holding companies has changed banking. There is not sufficient allowance in the suggestions as written for foreign banking operations. In the light of one dimension of the Franklin National debacle, there is need for a study of how to-examine foreign banking operations and how to integrate foreign exchange exposure into the examination procedure. V.  Comments on the Suggested Procedure  One objective of the suggested bank examination is to generate information that can aid Federal Reserve policy-making. At present the information generated by bank examinations is not available for making monetary policy decisions. In order to make data generated by bank examinations available for policy-making decisions, it will be necessary to combine information obtained from individual banks into market aggregates. The examination procedure is so designed that information on prospective position-making programs for individual banks can be combined at the Board of Governors into aggregate data on prospective   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  437 158  BANK STRUCTURE AND COMPETITION  position-making activity. In this way the authorities can infer which particular financial markets will be "under pressure" if ~ight" matket situations develop. One purpose of the suggested examination procedure is to serve as a possible early warning system for financial difficulties, to signalthe Federal Reserve that its responsibilities to "maintain orderly conditions" or to·be "a lender of last resort" may be coming to the fore. For this aspect of Federal Reserve responsibilities, it may be that the situation, and the contemplated actions, of the "extreme" rather than the "average" -bank are what is·most relevant. Thus, the processing of the individual reports into market aggregates will not provide all the relevant information available from the suggested procedure. It will be necessary to use the examination information to identify those banks that can be expected to be most severely affected by the prospective market situation and examine their likely behavior under alternative scenarios as to market and economic developments. The emphasis in the examination is upon bank and market usages as they exist, rather than upon some theoretical notion of how banks and markets should operate. Thus, the classification of activities in the examination will evolve with market and usage changes; under no circumstances are the examination's concerns to be frozen. This examination procedure is designed to yield useful inputs into Federal Reserve policy-making. One input will be an improved knowledge of how banks are going about making their position and how the financial markets -affected by position-making activity change over time. As the Federal Reserve can affect the cost (includi:.1g the risks) of the various position-making· techniques, know.ledge of how positions are being made at the various classes of banks (including the fringe banks) is of vital importance. In order to evaluate the liquidity of a bank, an analysis that is consistent with banking procedures is essential. It is necessary to identify the constraints implied by a bank's continuing business operations and to estimate how its resultant needs for cash can be met under different business and financial market conditions. Those items that management can control in the very short run are critical if a need for cash arises. These can be listed as position-making items. Basically, position-making revolves around· the needs for cash to make payments, including thos~ payments involved in debt repayment. However, for banks, legal and traditional requirements for cash exist. As a result, bank position-making activity takes place not only to obtain cash but also to make a reserve position or a desired cash items ratio. A reporting or examination scheme that first estimates cash flows to and from a unit under a specified expected set of economic conditions will  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  438 MINSKY·  159  yield a meaningful perspective on possible developments in banking and financial markets. Ways of estimating expected cash flows of a bank under specified overall economic conditions are needed. The view of a bank that is essential to such an examination is that a bank is an ongoing, continuing business that is affected by economic and financial conditions. On each day a bank is acquiring loan assets as the result of a continuing customer. relation with the emitter of the asset. To engage in a meaningful cash flow-oriented examination, estimates of such continuing relationships for each class of assets and liabilities are needed. Thus, the analysis of loan behavior (Form lll, Appendix B) calls for data on loan commitments, both explicit ·and implicit. As a "customer's" behavior depends upon economic and money market conditions, some idea is needed as to how each class of assets and liabilities depends upon economic and money market conditions. This "idea" or conditional forecast will be the product of the examiner's view, gained from his own observations and his discussions with officials of the bank, of how the various accounts are expected to develop. Note that the meaning for the barik's locality of the hypothesized national economic conditions will need to be spelled out. Often the examined banker can be the source of this local implication. It is clear that the. proposed examination procedure will require continuing cooperation between conventional bank examiners. and staff economists. On each day the inherited continuing assets and the newly acquired assets, which reflect the ongoing operations of the bank, yield a position that must be financed by liabilities. The view that banks are passive, tap emitters of liabilities is inconsistent with banking practices. Banks set terms upon their liabilities so that they acquire sufficient resources to finance-the position that is the result of their normal operations. Thus, to a bank the manner in which its liabilities will respond to explicit and implicit rate differentials is of major importance. The cash flow to and the .cash flow from a bank due to various deposit accounts, as well as the responsiveness, in the short run, of such deposits to the terms offered by the-banker are major ingredients in the position-making strategy of the bank. It is clear that much ofthe conditional cash flows we need to estimate for a bank can be thought of as elasticities in an empirical model of the institution. The "examiner"· and the ..examination process" by direct observations upon the ongoing institution are substitutes for the nonexistent empirically relevant model of the institution. The suggested set of report~ leads to identifying a position-making set of operations for the bank. These operations have boundaries determined· by initial stocks, operating results over time intervals, commitments of assets to specified collateral, and standards of asset and liability structure which may be conventional or legal. Schematically, we. have balance sheet dates, Bo, B1, B2 ... and cash   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  439 ·1&0  BANK STRUCTUR_E AND COMPETITION  flow intervals, 0C1, 1C2, 2C1, .... Balance sheets are conventional. Cash flows are divided into cash flows to the unit, C+, and cash f.lows from the unit. C-. For each balance sheet item the cash flows to and from the unit over an interval can be separated in-to those that are the result of prior commitments by the bank and those that are due to the "managerial decisions" of the period. Both "commitment" and ''current" cash flows for any period will depend upon economic and financial market conditions. At the examination date the balance sheet is observed. For each balance sheet class, the examination requires estimates of cash flow to (C+), cash flow from (C-). and the terminal balance sheet item (B,). One possible way to estimate these is to estimate first the terminal balance sheet item ( B1) and then derive the net cash flows due to this item. This procedure ignores the information about cash flows over the period, as stated in various contracts and other commitments. For each category of loans, the contractual commitments to make payments as stated by the loan agreement plus the roll over (renewal commitments) yield a cash flow to the bank. The procedure is designed to exploit the available data in the existing contractual and other commitments. Thus, the flow estimates will not be simply the results of estimating terminal balance sheets and then deriving flows by differencing. . Actually, for the loan and investment accounts the initial balance sheet entry plus and minus .the cash flows are not equal to the terminal balance sheet entry. This is so because the cash flow -includes both principal· and interest. Consider a bond worth S 1,000 at the beginning and worth the same at the end of a period. It could generate a cash flow-the semiannual interest payment during the period. (We might adopt the convention of entering all "current" mortgages at 100.) Thus, there would be no change in the value of the mortgages that survive the period of analysis even though they generate a cash flow. Thus, once you look at cash flow analysis closely, the alternative of obtaining net cash flows by differencing terminal and initial balance sheets is not available. The report forms have been set up so that, for the deposit accounts, the initial balance sheet entry plus the cash flow to and minus the cash flow from equals the terminal.balance sheet entry. (Interest on passbook savings is handled as it is in order to achieve this consistency.) There is little, if any, constraint from commitments on cash flows due to deposits. It might be that for the deposit accounts, estimates of the terminal date deposits can act as a "control" in estimating cash flows. Notions of deposit turnover rates can generate the cash flow from. This, together with estimates of the terminal balance sheet values can yield estimates of the expected cash flows to on account of the various deposit accounts. A consistency check of this kind for deposits, where little in the way of commitments exists, may be useful.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  440 MINSKY  181  The arithmetic of the deposit accounts is not con~istent with that of the loan accounts. There is no reason in the logic of the suggested examination for such consistency. Experimentation in estimating cash flows due to deposits will be necessary to determine whether linking the terminal balance sheet to the initial balance sheet by cash flows is useful. As a result of the "normal" expected operations of the bank over a period, a terminal cash position is attained. The usual position-,makingactivities of a bank are identified by designating some set of assets and liabilities as position-making accounts. Feasible or likely programs of position-making, given the assumption about money market conditions, will need to be sketched; usually more than one feasible solution will e]!:ist. At present we can ignore the problem of choice among feasible solutions. For money market banks, at any one time, the choice from among a set of conventional position-making operations will depend upon sharp pencil cost computations. This set of conventional position-making oper.ations can be considered as an entity. The Federal Reserve's problem will be to estimate whether position-making by the deficit banks will be possible by operations within this set of conventional activities or whether some "exotic" markets will have to be tapped. In order to do this, they will need to estimate the contribution of surplus banks ai,d other financial units to the supply of funds in the conventional markets. The positionmaking programs will need to be evaluated in terms of their impact upon the bank as a continuing institution. The broad structure of the suggested procedure divides bank activities into classes that are consistent with standard balance sheet items; that is, forms are included for the analysis of cash flows due to deposit, loan, in.vestment, and operation activity. Adjustments for compensating balances and collateralized deposits are needed to clean up cash flows and allow an estimate of the assets available for position-making. The crux of the report is the form on which the position-making accounts are identified. From the cash needs as derived from the liability structure and business operations and the cash position as derived from activity in the various accounts, a need to acquire or- place cash by position-making activity emerges. The final steps in the examination procedure are to develop feasible positionmaking operations and to evaluate the liquidity of the bank under the hypothesized economic and financial conditions. Footnotes 'Hyman P. Minsky: "Financial Instability Revisited: The Economics of Disaster," in Board of Governors. of the Federal Reserve System: Reappr.aisal oftht Federal Reserve Discount Mechanism, 3 vols. (Washington, 1971-1972), vol. 3, pp. 95-137. 'George J. Benston, "Bank Examination," New York Univenity, Graduate School of Business Administration, Institute of Finance, Bulletin, Nos. 89-90, May 1973.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  441 162  BANK STRUCTURE AND COMPETITION  '/1. statement of this interpretation is scheduled for fall publication: Hyman P. Minsky, John Marnard #,:t..,.nes, Columbia Essays on Great Et:onomists,.(New York: Columbia Un-  i\cr,ity Press, 1975, forthcoming). Insights into this interpretation can be gathered from H)man I'. Minsky, "Money and the Real World: A Review Article," Quarterly Review of Lcvnomic.1· and 8uJiness, XIV (Summer 1974), 7-17. 'Hyman P. Minsky, "The Modelling of Financial Instability: An Introduction," in ln,1rum.:n1·Society of America, Modelling and Simulation Volume 5: Proceedings ofthe Fifth A1111uul Pi11.1burg Cof!/'erenu (Pittsburg, 1974), pt. I, pp. 267-73. Reprinted in U.S., Congre,s. Senate. Committee on Banking, Housing and Urban Affairs, Compendium of Major /.,.HI<'' in Bunk Regulation, Committee Print'(Washington: Government Printing Office, 1975}. pp . .154-64.  Appendix A  Detailed Comments For the present, we are interested mainly in the overall structure of the report. The details are very much subject to revision. The initial problems are whether the stock-flow-stock format that emphasizes the independent determination of the flows is meaningful and whether the gathering of the required numbers is feasible. Most of the details will need to be determined experimentally, and .many questions cannq~ be answered until some effort is made at learning by doing. Form I: Hypothesis and Critique. The time horizon and the .economic and money market conditions hypothesized are to be specified on this form. It also is to include a short summary ofany difficulties that the examiner perceives the bank as facing; particular emphasis should be placed upon position-making. A complete examination might consist of a number of reports, each one differing in the hypotheses specified. Form I really states: "If we assume H 1, H2, Hl, then P,, P2, Pl follows," where the H's are .economic and financial conditions and the P's are position-making activities. In these notes we will assume that the implications of one hypothesis over a single time horizon are being determined. · It will be necessary to feed hypotheses about the expected behavi_or of economic and financial variables into the examination process. For example, an hypothesis forwarded from Washington to the examiners in the field might state that over the relevant period the economy is expected to be "strong." This·may be made precise by stating that nationally the demand for business loans is expected to increase at an annual rate of, say, 8 percent per year and that this is expected .to be accompanied by a l / 2 percent increase in the Treasury bill rate. In addition, t-he·prime rate is expected to increase by either I / 4 or I / 2 percent. These money market and economic conditions should have implications for the willingness of the bank to switch among categories of loans, and from loans to investments and vice  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  442 MINSKY  163  versa. The examiner may determine how the bank can be expected to react either by discussing the expected developments with the bank managers or by analyzing previous behavior of the bank. It usually will be necessary to add some special details dealing with the local or regional economy to the national hypotheses as forwarded from Washington before the bank's reaction can be gauged. Thus, for California an expected national increase at the rate of 8 percent per year in bank credit might be translated into a IO percent per year rate of increase in the demand for bank credit in California. The same national forecast might imply no change in loan demand for a bank in upstate New York. Thus, the expected growth or decline of each locality or region as a function of the behavior of the national economy will have to be estimated. In order to obtain local implications of each specification of national economic conditions, each Reserve Bank's economic research department will be required to translate the national hypothesis into a local or district hypothesis. Note that if a complete set of examinations with varying hypotheses are to be undertaken, each Reserve Bank's research department-will have to spell out the local meaning of, for example, three phrases applied to the national economy: normal seasonal, strong, and weak. It might be that the hypotheses sketching for the purposes of guiding examiners should be one end result of the review of economic conditions that is part of the preparation for the open market committee meeting. Thus, a joint product of open market committee preparation in the form of hypotheses for bank examinations will come into being. A cash flow-oriented bank examination can be meaningful only if it is based upon a forecast of economic and financial market conditions. Such an examination will require close working coordination between economists and examiners. The details of how this coordination is to be brought about will need to be developed. However, it is clear that a significant economic analysis input will be part of every such examination. Form II: Deposit Analysis. The standard form for ordinary balance sheet items consists of four columns: (l) an initial balance sheet, (2) cash flows to (over the interval), (3)cash flows from (over the interval), and (4) a final balance sheet. The initial balance sheet column is labelled ..Bo"; the final balance sheet column is labeled "B1." There are two cash flow columns: the cash flow to is labeled C+, and the cash flow from is labeled C.-, For example, a balance sheet item will be entered for demand deposits, IPC, small. Additions to deposits will be entered in the plus cash flow column. Withdrawals will be an entry in the minus cash flow column. Presumably, if there were no other changes, the initial position, the cash flow plus, and the cash flow minus can be summed to get the final balance sheet position.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  443 BANK STRUCTURE AND COMPETITK>N  164  Six categories of demand deposits are identified in the preliminary form. Always, for all forms the final set of classes can be determined only by a combination of consultation -among those concerned and experimentation. Before the report is implemented, some aspects of correspondent relations among banks may have to be clarified. A useful by-product of this examination may be a clearer underst,anding of correspondent relations and whether the nature and extent of such relations have any significance for system performance. Various categories of time and savings deposits are to be analyzed. I have allowed for five classes. The special treatment of negotiable CDs is worth noting. Here, an initial position, a cash flow from the organization on the basis of CDs, and a final position, which are the CDs whose time to maturity is longer than the horizon ofthe report, are considered. No provision is made for the emission of negotiable CDs; CDs do not yield a cash flow to the organization. The reason for this is that CD sales are assumed to be a position-making activity. Note that the interest cost over the period is treated as if it were a deposit at the initial date. Only the withdrawals of interest are allowed for (column C-). The explanation for this js given on the form. Form III: Loan and Lending Analysis. Loans are broken down into three broad classes: loans to nonfinancial businesses and households, loans to financial organizations. and loans to states and municipalities. All in all, some 14 classes of loans to businesses and households, four classes ofloans to financial organizations, and a single class of loans· to states and municipalities are identified, a total of 19 classes. For each class, the initial position is divided between clean (some other word will be better) and scheduled (classified) loans. Scheduled loans are questionable at the initial date, Bo. For each class, information is needed about the initial value, the cash flows to the bank generated by the initial position in the loan class, the cash flows from the bank due to the various "ways" in which loans of this class can be acquired, and the terminal value. In principle, obtaining information about cash flows to a bank that a loan class is expected to generate is not difficult. For clean or current loans. all that has to be done is to read and sum the contracts and make some allowance for the nonfulfillment of the contracts. For Sl-heduled or classified loans, after reading and summing the contracts, an estimate of the proportion of the contractual commitments that will be forthcoming needs to be made. Note that in the forms no separation of the cash flows into interest and principal is made. Jn the case of a fully amortized mortgage loan, the gross monthly payments over the period being analysed are the cash flow to the  86-817 0 • 77 • https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  29  444 MINSKY  115  bank. For discounted notes due during the period, the cash flow to the bank is the face value of the note. For loans or investments that yield only an interest flow, the cash flow is the interest receipts. A problem arises because many loans are rolled over when due. An accounting convention of treating such loans as if the contractual terms were fulfilled, thus generating a cash flow to the organization, and treating the roll over as a new loan which is the result of an explicit or implicit loan commitment, thus generating a cash flow from the bank, yields a consistent way of looking at roll overs. The weakness of this convention is that it exaggerates the cash flows to and from the bank. The loan acquisition process is broken down into the acquisition of loans from explicit commitments, from implicit commitments, and from managerial decisions taken during the period. In the analysis of the loan portfolios, the examiner will note, as a_ parenthetical comment, the total of explicit commitments and, by procedures that have to be determined, will estimate and note the implicit loan commitments. Managerial decisions will always be some forecast of new loans to be made during the period on the basis of day-to~y decision-making during the period. The first step in a possible technique for estimating implicit lines of credit is to note the maximWJt previous credit for all of the relevant customers, even those out of debt at the examination date. The loan officer will be asked whether the customer is as, more, or less creditworthy than at the time of the previous maximum loan. The maximum previous amount plus or minus an allowance for change in creditworthiness will be the implicit line of credit. One way to estimate drawings from Jines of credit is to estimate normal drawings by examining previous experience. This normal estimate can then -be modified to allow for the specific business condition hypothesis being used. A factor in estimating managerial decision loans will be the aggressiveness of the bank in seeking new business. A combination of a forecast of good times plus an active pursuit of new business will imply that a large cash drain will take place due to managerial decision loan acquisition. For most loan classes, there is an additional line labeled ..shifts from clean to scheduled." This shift from clean to scheduled loans is a forecast of how ·many of the loans now considered ..clean" will become scheduled items over the tiine horizon. It will reflect not only the examiners' view of the loans the bank has and might take on, but also the economic and money market condition hypotheses underlying the report. Not all items follow the standard format. For example, instalment loans (direct) will have just one acquisition item; no allowance is made for commitments. For mortgage-loans, regardless of origin, allowances are  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  445 166  BANK STRUCTURE AND COMPETITION  made for sales out of portfolio. In addition, in the mortgage loans (other origins). allowance is made for the purchase of seasoned mortgages. It is assumed that no explicit commitments exist for loans to house.holds for the carrying of securities. An item that may be questionable is the treatment of bankers' acceptances and open market paper as loan items which may involve commitments. On the loans to financial organizations, the only item of special importance is loans to dealers and brokers, except U.S. Government security dealers. A question is whether all loans to dealers and brokers should be considered as a position-making activity or whether there are some loans to dealers and brokers that are part of the normal ongoing business of the bank. Note that the current innovative frontier in bank credit cards and other overdraft-type arrangements will make the estimation of drawings by customers over time horizons an important concern of bank management and the regulating authorities. Form IV: Compensating Balances. The problem arises because the cash flow to and the cash flow frO'm due to loans were.estimated ignoring compensating balances. If a loan with a compensating balance is .repaid, the cash flow to the bank is smaller than the amount of the loan by the amount .of the compensating balance. If a loap is made which requires a compensating balance, then the loss of cash as this loan is used is smaller, by the size of.the compensating balance, than the size of the loan. The cash flow to and from needs to be adjusted to allowfor changes in compensating balances. This is taken care of in Form IV, and the net cash flow due toac-: tivity in loan accounts is determined in Form IV. This, instead of the sum from Form 111, becomes an entry into the cash position analysis of Form Vlll. Form V: Analysis of Investment Accounts. Cash flow to due to an investment class includes cash received as interest and as investments mature. The cash flow from due to an investment class is always the result of purchases of the investment. For state and municipal securities provision is made for purchase commitments. In many areas banks have undertaken implicit commitments to bid on all local government -new issues. This means that additions to the state and municipal account may be outside that period's control. This is quite different from the other securities, especially federal government securities. Fonn VI: Cash Flows Due to Operations. Basically this form is straightforward. No provision need be made for balance sheet items, and .accr.uals can be ignored. Payroll, dividends, and other operating expenses cause a cash flow from; rent revenues and sales of services cause a cash flow to. There is a question as to whether trust department activities might.be entered here; I have no notion of how-and even of whether-trust activities need be considered.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  446 MINSKY  187  Form VII: Position-Making Accounts and the Activity Therein. Some nine position-making activities or accounts are identified. These accounts are: (I) Treasury bill operations, (2) other governments less than two years, (3) federal funds, (4) loans to government dealers, (5) correspondent balances, (6) Eurodollar market operations,- (7) negotiable CDs, (8) discounting, and then (9) an all-other class. The position-making accounts, in contrast to the others, have seven columns. A division is made between "normal" activity in the account and special activity occasioned by the need to make a position. For Treasury bills, an initial position, the amount that is due in the time period under consideration, and new acquisitions under normal circumstances are combined to get B1*, which is the estimated terminal date ..normal" or ..operating" Treasury bill situation. The same setup is not possible in all other categories. For example, discounting only takes place as a position-making move. In analyzing discounting an initial amount would all be repaid over the period. The. B1 * column would always be 0. A position-making activity, borrowing from the Federal Reserve Bank, exists; the final position in discounting will equal the amount of position-making by this channel. To the usual four columns three more are added in Form VII. These are two more flow columns, labeled· P+ and P-, which detail the special cash flow operations attributable to the need to make a position, and a final balance sheet column B1. The first four columns in this form could be completed- in the usual manner. After this is done, Form VIII should be completed. Form VIII: Cash Position Prior to Position-Making. Here the initial cash, due from banks, reserves with the Federal Reserve Bank.and items in the pr<K;CSs of collection are summed into an-initial total cash position. It is assumed that shifting among the various cash items to get needed reserves is a trivial operation. The net change ·in cash due to each of the deposit, loan, investment, and operating activities as well as from normal operations in the positionmaking assets, positive if it's an addition and negative if it's a loss, is added to the initial cash position. This gives an estimate of ihe total cash position at the terminal date prior to position-making activities. A computation of the expected reserve needs at the terminal date follows. To this, other cash needs due to correspondent relations, business needs,and banking convention are ·added to get total cash needed. Given the estimates of total cash prior to position-making and total cash needs, an estimate of the cash deficit or surplus is derived. Form IX: Collateralized Deposits. Here the expected availability of various classes of securities for position-making is determined. Form X: Feasible Position-Making Program. In Form X the deficit or excess in cash is entered. Also indicated is a program of position-making operations in Treasury bills, other government securities, federal funds,  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  447 BANK STRUCTURE AND COMPETITION  t68  etc., which will make up the cash deficit or place the surplus. A number of different position-making programs may be feasible, and will be evident to the analysts examining the report. The examiner should enter his view as to the most likely program based either upon how the bank made its position in the past or upon knowledge of the bank management's thinking. These position-making activities are entered into Form VII to form a basis for estimating the final balance sheet items for each of the position-making .accounts. form X is the crux of the analysis. The organization is liquid or illi4uid over the period examined depending on whether the position-making operations are easy or difficult to .carry out. If, foy a ·significant number of ·banks, position-making entails unusual dependence upon some particular ·set of mar.kets or dependence upon unusual markets, or the examiner's reports, when analysed, show that the expected sum of the borrowings in, say, the federal funds market exceeds the expected supply, then the examination procedure will indicate that position"-making difficulties are likely. Thus, the beginnings of liquidity-problems in the banking system could be forecast.  Appendix B  Examination forms I. 11. 111. IV. V. VI. Vil. Vlll. IX. X.  Hypotheses and Critique Deposits Lo.-ns and Loan Ac4uisition Compensating Balances Investments Operations Position-Making Cash Positions Prior to Position-Making Collateralized Deposits Feasible Position-Making Program  Note: In all the forms, X in a cell means no entry; - means entry.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  448 MINSKY  161  I. Hypotheses and Crhique A.  Hypotheses I. Time hori1.0n: 2. Economic conditions: 3. Money market conditions:  B.  Critique (a short statement of any foreseen difficulties with particular emphasis placed on unusual position-making activities).  II. Deposits Initial Cash flows balance  Bo A. Demand deposits 1. IPC (small) ·Deposits Withdrawals  X X X  _2. IPC (large) Deposits Withdrawals  X  3. State and municipal Deposits Withdrawals  X X  4. U.S. Government Deposits Withdrawals  X X  5. Correspondent' Deposits Withdrawals 6. Other Deposits Withdrawals TotaP  .  -  X X  X X  X  X X  X  X X  X X  X X  X X  X  I-  I-  X X  X X  X  X  X  X X  X X  X  X  X  X  C  Terminal balance B1  X X  I-  X X  X X  X X  ~-  Service charges>  S-  Corrected final deposits  S-  'Ouest,ons as to whether-correspondent balances are result of normal business or of pos1t10n-making acllv1ty ··For each class and for the total 1e0 1 + IC +I :.. {C -I • e 1 •Service charges are debits to deposit accounts tor whlCh the bank does not lose cash.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  449 BANK STRUCTURE AND COMPETITION  170  II. Deposits (continued) ln"itial Cash flows balance + C Bo B. Time and savings deposits 1. Passbook Deposits Withdrawals Interest' 2 Certificates of deposit Sales Redemptions Interest'  3. Other time deposits Deposits Withdrawals Interest'  X X X  X X  X X X  5. CDs (negotiable)' Redemptions Interest' Totals  X X  X X X  X X  X  X X X  X X  X X X X  X  L  X X X  X X X  X X X  X  X X  X };_  X X X  x  X X  4. State and municipal  Deposits Withdrawals Interest'  X X  Terminal balance B1  };_  };_  'Enler total expected m1eras1.payment aa an initial ·depoait. Cash payments plua expected w1lhd<awals are 11nlered as C-. To determine B1 sum the two Bo's and +C, subtract the two Clnlerest is treated in this manner for it is an addition to accounts which does not have as ila counter,art a cash flow to the organization. •'Negotiable CO.sales area position-making activity and, hence, are not included.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  450 MINSKY  171  Ill.  Loans and Loan Acquisition Initial balance Bo  A. Loans to nonfinancial businesses and households 1.. Uncollateralized business loans Clean Scheduled Commitments: explicit (-1 implicit(-) Managerial decision Shifts from clean to scheduled  <--)  2. Collateralized business loans Clean Scheduled Commitments: explicit (-1 implicit(-) Managerial decision Shifts from clean to scheduled ( - l 3. All other short-term nonfinancial business loans Clean Scheduled Commitments: explicit (-1 implicit (-1 Man~gerial decision Shifts from clean to scheduled (-1 4. Loans to finance foreign trade Clean Scheduled Commitments: explicit (-1 implicit(-) Managerial ·decision Shifts from clean to scheduled (-1 5. Term loans Clean Scheduled Commitments: explicit (-1 implicit(-) Managerial decision Shifts from clean to scheduled (-1   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Cash flows + C -  Terminal balance B1  X X X X X X  X X X X  X  X X X X  X X X X X X  X X X X  X  X X X X  X X X X X X  X X X X  X  X X X X  X X X X X X  X X X X  X  X X X X  X X X X X X  X X X X  (continued on following page)  X  X X X X  451 BANK STRUCTURE AND COMPETITION  172  Ill.  Loans and Loan Acquisition (continued) Initial balance Cash flows + C -  Bo  6. Instalment loans (dealer) Clean Scheduled Commitments: explicit (----1 implicit (--) Managerial decision Shifts from clean to scheduled  Terminal balance B1  X X  X X  (----1  7. Instalment loans (direct)' Clean Scheduled Managerial decision Shifts from clean to scheduled (----1  8. Dealer floor loans Clean Scheduled Commitments: explicit (----1 implicit(--) Managerial dec1s1on Shifts from clean to scheduled(~  9. Mortgage loans (builder-originated) Clean Scheduled Commitments: explicit (----1 implicit<-Sales of mortgages• New mortgages Shilts from clean to scheduled (----1  X X  X X  X X X X  X  X X  X X X  X  X X  X  X X  X  X X X X X  X X X X  X X X  X X  X X X X X  X X  X  X X  X  X X X  X  X X  X  10. Mortgage loans (Other origins)> Clean Scheduled Sales of mortgages' Purchase of seasoned mortgages New mortgages acquired Shifts from clean to scheduled (----1  X X X X  X X X  X X X  X  X X X X  11. Construction loans Clean Scheduled Commitments: explicit (----1 implicit(--) Managerial decision Shilts from clean to scheduled(--)   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  X X X X X X  X X X  X X  x. X  (continued on following page)  X  X  452 173  MJNSKY  Ill. Loans and Loan Acquisition (continued) Initial balance Cash flows C Bo ♦  12. Loans to households to carry securities Clean Scheduled Acquisition Shifts from clean to scheduled ( - l 13. All other household loans Clean Scheduled Acquisition Shifts from clean lo scheduled ( - l 14. Bankers' acceptances and open market paper Clean Scheduled Commitments: explicit ( - l implicit ( - l Managerial decision Shifts from clean to scheduled ( - l B. Loans to financial organizations 1. Loans to sales and consumer finance companies Clean Scheduled Commitments: explicit ( - l implicit ( - l Managerial decision Shilts from clean to scheduled ( - l  X X X X   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  X X  X  X X  X  X X X  X  X  X  X X  X X X  X X X  X X X X  X X X  X  X  X  X X  X X X  2. Loans to savings and loan-associations, mutual savings banks, etc. Clean Scheduled Commitments: explicit ( - l X implicit ( - l X Managerial decision X Shifts from clean to scheduled ( - l X 3. Loans lo life insurance companies Clean Scheduled Commitments: explicit ( - l implicit ( - l Managerial decision Shifts from cl_ean lo scheduled ( - l  Terminal balance B1  X X  X X  X X X  X  X  X X X X X  X  X  X X X X  X  X X X  X  X X  X X  X  (continued on following page)  X  X X X X  453 BANK STRUCTURE AND COMPETITION  174  Ill.  Loans and Loan Acquisition (continued) Initial balance Cash flows Bo + C -  4. Loans to dealers and brokers, except U.S. Government security dealers Clean Scheduled Commitments: explicit implicit (--) Managerial decision Shifts from clean to scheduled(--)  <--)  c.  Loans to states and municipalities 1. Clean Scheduled Commitments: explicit (--) implicit (--) Managerial decision Shifts from clean to scheduled(--)  X X  ...... X X X X  Terminal balance B1  X X X X  X X X  X X  X X X X X X  X X X X  X X X  X X  'Assumption is that there are no significant commitments for direct irnitalment loans 'Aside from mortgage originations and·mortgagq repayments, there ls apparent• ly a lair amount of saleS ·of mortgages by banks to insurance companies, .etc. Such sales are a +C 1or the selling bank and should be so entered.  'It may be that ilems 9 and 10 should be combined. 1'he to1BI mortgage position could be divided into clean ·and scheduled and the distinction between builder• o<ig,nated and other sources be ca~riect only in the acquisition process. Thie would result in the follow;ng·headings for mortgages: Mortgages Clean Schedaled Commitments: e11phc1t ( - ) implicit (--I Other .new mortgages.acquired Purchases ol seasoned mortgages Sales of mortgages Shifts from clean to scheduled (--I   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  454 175  MINSKY  IV.  Compensating Balances  Estimated terminal compensating balance  (T>------,,--  lnitial compensating balance  (1)-·_ _ _ __  Difference(+ if T  > I, -  if I  > T)  Cash flow to due to loans [E(+C)] _ _ _ _ _ __ Cash fiow from due to loans [E(C-)] _ _ _ _ _ __ Net cash flow Adjustment due to compensating balances _ _ _ __ (+ if T > I, - if I> T)* Total (net reserve flow due to activity in loan accounts)=+_ __ 'Explanation of adjustment: if the terminal compensating balance exceeds the initial balance, then 1he net cash flow from due to loan activity over the period wassmaller than·the amount entered as cash flow from due to loans by a net amount equal to the increase in compensating balances. Symmetrically, if the initial balance exceeds the terminal balance, the net cash flow to due to loan activity was smaller by.the amount of compensating balances written off in the loan repayment process. That is, if 20 percent of a loan is in the form of a compensating balance, th.e borrower need only repay 80 percent of the loan in cash. The other 20 percent can be repaid by debiting the compensating balance. As the compe11sating balance was not available for making payments, it is assumed the desired cash is reduced by the amount of the reduction in the required balance. when loans are repaid.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  455 BANK STRUCTURE AND COMPETITION  176  V.  Investments  Initial balance Cash flows + C Bo  Terminal balance 81  A Government securities  X  (2-5 years) Planned purchases Planned sales Shifts to< 2 year category Shifts from > 5 year category  B. Government securities (>5 years) Planned purchases Planned sales Shifts to< 5 year category  X X X X  X  X  X  X X  X  X X  ·X  X  X  X  X X  X  C. State and municipals* Purchases: commitments(-) other Sales: commitments(-) other  X X X X  X X  D. Other investments Purchases: commitments(--) other commitments(-) Sales: other  X X X X  X X  X X  X X X X  X  ~  ·should a distinction be made by time to maturity?   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  X X X X  ~+C  X X  X X X X  ~C-  ~  456 MINSKY  177  VI. Operations Initial balance Cash flows + C Bo  Terminal balance B1  A. Payroll  X  X  X  B. Dividends, cash  X  X  X  C. Other operating expenses  X  X  X  D. Revenues from rent  X  X  X  E. Sale of services  X  X  X  :£  X  Total:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  X  :£  457 178  BANK STRUCTURE AND COMPETITION  VII.  Position-Making  Initial balance Bo  -  A Treasury b,11s New acqu1s1tions Pos,tion-mak1ng- activity  X X  B. Other Government securities (<2 years) New acquisitions Shifts from > 2 years Position-making activity  -  X X X  +-  C. Federal funds Sales commitments ( ) Purchases commitments ( ) Normal activity position Pos,llon-making activity  -x X X X  D Loars to Government bond aealers Commitments ( ) Managerial decision Pos,t,on-making acti.vity  -  X X X  Cash flows + C -  -  X X  -  X X X  X X X  -  X X X  X  -  X  X  --  X  -X X X  X  -  X  Terminal balance B1  -  X X  -X  Cash flows + p X X  X X  -  -  X X X  X X X  X X  -  -  0 X  X X X X  X X  x X  -  X X X  Terminal balance B1  -  X  -  X X X  -  X X X X  x· X  -  -  X X X  X X X  -  -  X X X  X  X X  -X  ~  E Correspondent balances' F £urodcllafs•  G fllegol<able wholesale CDs Normal plac~ents  X X  Position-making activity  -  H Discounting Pos,tion-making actjyjly  X  -X  X X  X  X  I+C  -  X  -  -X  0 X  ·-  X  X X  IC-  I  I+P  IP-  X  -  I. Other position-making .activities (detail111 I  1 oon 1 know now 10 handle coneapondent balances Th,1 probfemw1lllake-mvest.gatl0fl' Abantr.willbothoweandowncorrespondent balances  •T-he 1,eatment ot  Eurodollar balances w1tl alao requtre in-  vestaga!,on   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  I  458  179  MINSKY  VIII.  Cash Positions Prior to Position-Making  Initial cash and due from banks Initial reserve with Federal Reserve and items in process of collection Total cash 1 Net change in cash due to: Deposits Loans2 Investments Operations Normal operations in position-making accounts Total cash change due to normal activity Forecast cash at B 1 Terminal Date Reserve Needs Type of deposit  Reserve ratio  Required reserve  Demand Passbook savings  CDs Other time Total required reserve Other cash needs Total cash needs 1 Deficit(-) or surplus(+) cash 1 It ,s assumed that.d1v1s1on of cash between reserves and other accounts is trivial. 2After ad1ustmg for compensating balances.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  459 180  BAHK STRUCTURE AND COMPETITION  IX. CollateraUzed Deposits Deposits requmng collateral (terminal date) Government State and municipal Other Total Collateral  Owned at terminal date  Type of security Government {2-5 years) Government (  > 5 years)  Treasury bills Other Government { < 2 years) State and municipal Total  86-817 0 - 77 - 30   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Pledged  Available for positionmaking  460 181  MINSKY  X.  Feasible Position-Making Program + C  -  Deficit or excess cash Position-making activity in: Treasury bills Other Government securities ( < 2 years) Federnl funds Loans to Government dealers Correspondent balances Eurodollar operations Negotiable CDs Discounting Other  NOTE: A number of feasible position-making programs may be designed. Each such program will result in a different final balance sheet for items in Form VII. The critique in Form I will refer to the programs of Form X. If a number of different hypotheses and horizons are being considered, a +C- column for each hypothesis will be needed in this form. Form X will be a many-columned form, one for each hypothesis. The cash position and positionmaking of the various hypotheses will be most clearly seen here.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  461 182  BANK STRUCTURE AND COMPETITION  Appendix C Additional 1975 comments I. A view that underlies this report is that the viability of an institution-be it a bank or an ordinary business firm-depends upon economic conditions. In light of experience since 1967 it is evident that any conditional analysis will have to consider how the organization will be affected by wide swings in interest rates. 2. Since the 1967 report there has been a sharp increase in formal lines of credit which specify the commitments of banks. An examination procedure of the type suggested would reinforce this trend and, as a result, the data on commitments would be more readily available. 3. As the focus of this examination procedure shifts towards the giant banks, national economic conditions become the dominant determinant of the expected cash positions and the need to break national forecasts down to local forecasts decreases. 4. The view that banks aggressively sell their liabilities, while rather novel in 196 7, is part of today's conventional wisdom. The set of liabilities that banks "sell" is much greater in 1975 than in 1967, and the focus upon deposits rather than liabilities in the 1967 report is a bit old-fashioned. 5. It needs to be emphasized, perhaps moi:e strongly than in the 1967 report, that the flow estimates are not to be derived by first estimating an end-of-period balance sheet and then determining the cash flow that will achieve this result; the cash flows both to and from a unit on assets and liabilities are to be estimated and the resultant terminal balance sheet position is to be determined. 6. With the growth of bought funds, the deposit argument has to be reconsidered. One way in which banking changed between 1967 and 1975 was that demand and passbook savings accounts declined as a proportion of total liabilities. Even in the face of expanded deposit insurance, more sophisticated liability structures have made the ratio of potentially volatile deposits signific;antly higher than in the early postwar era. 7. Position-making now encompasses dealing in many more markets than hitherto. One problem in bringing this suggestion up to date is to separate volatile liabilities and position-making activity. It is also clear-as was implicit in the 1967 report-that position-making activity and, thus, the key financial markets for Federal Reserve control can change radically over short periods of time. Without the depth of information that the suggested procedure develops, the Federal Reserve often finds itself way behind the developments in money markets. 8'. (Form II) It might be desirable to break business deposits into compensating balances and other. 9. (Form II) The deposits of financial institutions should be separated  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  462 MINSKY  183  out, particularly if the- focus of the examination is the large banks. IO. (Form 11) In light of the recent difficulties of some large regional banks, it might be desirable to break CDs down between those sold in the bank's own market and those which are sold through brokers and dealers. 11. (Form 11) It is now known that the simple setup of liabilities which identified only demand and time deposits was a gross oversimplification. Repurchase agreements certainly need to be included. Both demand and time deposits should be separated into domestic and foreign. The treatment of holding company commercial paper is of interest and some way should be found to treat transactions between holding companies and commercial banks. 12. (Forms II, III) One glaring oversight in the reports is the absence of any capital accounts, although the change in the capital account due to retained earnings is implicit in the treatment of operating expenses and the way in which cash flows due to interest receipts and costs are entered. However, in the accounts as written, there is no way of treating an infusion of cash through new issues of debt or equity capital. Incidently, if the period under consideration is one in which there is a considerable infusion of bank capital through newly chartered banks, the examination procedure would miss these developments. Perhaps we can view new issues of debt or equity capital as a positionmaking activity. 13. (Form Ill) The term "scheduled items" is used for substandard loans of various kinds. 14. (Form Ill) The important item to note is that the loan acquisitions are broken down into the results of explicit and implicit commitments and managerial decisions. The cash flow-oriented bank examination might well have another summary sheet which draws together the commitments by class of loan and the expected drawings on these commitments. 15. (Form Ill) Because of the proliferation of offshore branches in the period since 1967, a separate analysis of the offshore loan activity of the large banks would be in order. 16. (Form V) In light of the recent behavior of interest rates and the quality ratings of municipal securities, some attention should be paid to the market value of the investment portfolio. A marked shortfall of market value below book value will make investments unavailable for positionmaking. 17. Form X could serve as an input into Federal Reserve policy-making. If such information were channeled to the Board of Governors regularly and aggregated, the emergence of overall cash deficits or surpluses for banks could be tracked. This, in turn, could be fed back by the Board of Governors into imp!ications for market interest rates, and into the Federal Reserve's own program for feeding reserves into the banking system.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  463 184  BANK STRUCTURE AND COMPETITION  Although the objective of the ·procedure is to develop a system which warns of emerging market difficulties, the way in which overall market pressures would affect particular banks should enable one to determine which banks and which markets will be most particularly affected.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  464 The CHAIRMAN. Thank you very much f<;>r a very fasc~n~ting analysis. And thank you for doing such a fine JOb of abbrev1atmg it. Our next witness is Prof. Bernard Shull of Hunter College.  STATEMENT OF PROF. BERNARD SHULL, HUNTER COLLEGE The CHAIRMAN. Professor, I hope you will do your best to finish in 10 minutes, if possible. Mr. SHULL. Yes, sir. My name is Bernard Shull. I am a professor in the department of economics at Hunter College of the City University of New York. I formerly held the position of associate advisor in the research division, Board of Governors of the Federal Reserve System, and before that, senior economist in the Office of the Comptroller of the Currency. ,vhile with the Federal Reserve Board, I served as Director of Research Projects for the reappraisal of the discount mechanism in the mid-1960's. I appreciate the opportunity to appear before this committee. I would like to summarize my views briefly and submit my statement for the record. The CHAIRMAN. Very good. The entire statement will be printed in the record in full. Mr. SHULL. In general, the banking agencies found that the specific causes of recent bank failures can be traced to inept or imprudent management and/or fraud in the form of self-dealing, sometimes through lending relationships with holding company affiliates. The Comptroller General's report found that most bank failures were caused by bad management practices, and 'places a heavy emphasis on the need for bank supervisors to persuade or force banks to quickly rectify their errors when uncovered. ThPse findings call to mind another analysis of bank failure from which I will briefly quote. Competitive liberalization of laws has led us to permit the creation of unsound banks and the indulgence of unsound banking practices. [Changing lQan portfolios have contributed] to the lack of liquidity in the resources of commercial banks. Directly associated are the increased number of noncommercial banking affiliates which have been attached to commercial banks in recent years. That these affiliates have been contributing factors to the number of bank failures seems beyond question. Another defect is found in poor management. Finally, we may mention the fact that the problem of inadequate bank supervision is still with us.  These statements are from a study by Walter Spahr in March 1932. I cite them simply to point out that either we have known the causes of bank failure for many years and have failed to do what was required to eliminate them, or there is something lacking in the analysis. My view is that the analysis is useful, but it does not go far enough. RPcause it disregards the changing environment in which banks operate! i~ is likely to suggest solutions that ultimately will be disappomtmg. Rv way of illustration, Walter Spahr also felt in 1932 it was not nossiblP to distinguish banks that failed because of bad management -f,,,..rri those that failed because of local financial denression, because and I quote: "It is t]H, purnose and test of good bank management to avoid tlw PffPcts of local financial dP_prpssion."   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  465 I think it reasonable to believe that economic instability played a role in the failures of the last few years. Even a cursory examination of the number of bank failures indicates that they rise during a period of economic recession and financial stress. I think it is important to separate the effects of depression from bad management as a cause of failure, least we concentrate all of our efforts in counterproductive ways. . . There is another environmental factor that also reqmres consideration. It is generally understood that competition has intensified in hanking over the past 15 years. In general, this new competition has been welcome and beneficial to bank customers. It is also generally nnderstood that, other things being equal, banks that are competitive tend to operate at lower levels of profitability. Thinner profit margins leave less room to succeed in the face of ineptness, imprudence, . dishonesty, and unanticipated external shocks. It is also possible that bankers will resist moves to thinner profit margins by pursuing more rapid growth, higher return, and riskier investments and by letting capital ratio slip. A few years ago the president of a large well-known banking organization attributed the movement of commercial banks through their holding companies into new financial lines to the fact that in the 1960's the banks found themselves with a lot of new money, which had to earn more because it cost more. More recently, this bank has turnea up on the problem list of one of the Federal agencies. I think the data we are now looking at is consistent with these views. In first a quiet way, and more recently in a less quiet way we have experienced a rising volume of bank failures over the past two decades. We had more bank failures in the 1960's than we had in the 1950's, and we have had about as many failures over the first 7 years of the 1970's as we did over the entire 10-year period of the 1960s. In each of the three decades the total volume of deposits in failed banks increased substantially. It appears that current and prospective developments ·will further intensify competition in banking, particularly in local banking markets. We have already seen more intense interindustry competition between thrift institutions which have obtained third party payment powers, and commercial banks. We have also seen the spread of large banking organizations nationwide through holding company affiliates. Interstate branching, and interest payments on checking deposits now seem in prospect. By and lar~e these changes should be beneficial, but they also carry with them the threat of higher-failure rates than we have experienced in the past. There is some indication in the available materials that small banks in particular will be placed under increasing pressure. It is of interest that the data the agencies provided this year are also consistent with this expectation. The number of bank :failures was unusually high in 1976, and most were failures of small banks. Twelve of the sixteen failures had less than $50 million in deposits. Only one had over $170 million in deposits. The apparently large number of banks merged or acquired to avert failure in 1976 are with one possible exception all relatively small institutions. Within this framework there are several issues I would like to address briefly.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  First, regarding bank capital; clearly there has been some improvement in capital ratios, particularly for the larger banks, since 1974. This is no doubt helpful. But I think too heavy reliance on capital ratios, particularly for smaller institutions, is likely to impede their ability to compete effectively, which can also undermine their viability. With regard to bank examinations, granted there have been inadequacies, as the General Accounting Office report stressed. Heavy emphasis on the evaluation of management policies and procedures, of the sort recently adopted by the Comptroller of the Currency seems tom~ to place a heavy burden on the managerial capacities of bank exammers. I would think extensive testing is desirable. I would add that in the consideration of foreign loans, environmental factors are considered under the term "country risk." It would seem that some similar environmental factors might ·be appropriately considered domestically. That is, capital ratio benchmarks might well depend on local economic conditions and competitive developments. Finally, with regard to the Federal Reserve as a lender of last resort, it seems unfortunate there may be two standards for lending in the last resort to banks in exigent circumstances, depending on whether they are members of the Federal Reserve System or not. It is debatable as to whether the Federal Reserve should be a lender of last resort to individual banks, in contrast to the System as a whole. But whatever the judgment, it should apply equally to all banks; lender of last resort function is too serious to be a promotional device for membership. Thank you. [The complete statement of Prqfessor Shull follows:]   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  467 STATEMENT BERNARD SHULL Professor, Hunter College of the City University of New York My name is Bernard Shull. I am a Professor in the Department of Economics at Hunter College of the City University of New York. I formerly held the position of Associate Advisor in the Research Division, Board of Governmors of the Federal Reserve System; and before that, Senior Economist in the Office of the Comptroller of the Currency. I appreciate the opportunity to appear before this Collllllittee in the course of its consideration of the health of the banking system, and its evaluation of bank regularory agencies in carrying out their statutory responsibility to assure a safe and sound banking system. We have seen in the past several years, the failure of major banks. These failures were largely unanticipated. In general, it was correctly understood that sound, well-managed banks would not fail because unsound and badly managed banks might undermine public confidence in the security of bank deposits; we have not had a recurrence of bank runs and panics. But it was incorrectly believed that major banks were so carefully managed, and had access to so many sources of funds, that they were incapable of failure. The specific causes of failure indicated by the Federal bank regulatory agencies in the material supplied to this Committee indicates that, in general, the large failures as well as the small ones have been caused by asset losses resulting from inept or imprudent management and/or fraud in the form of self-dealing, sometimes through lending relationships with holding company affiliates. In an industry as extensively regulated and as intensively supervised as counnercial banking, these findings inevitably reflect on the adequacy of regulation and supervis:lon. This line of reasoning recalls a similar analysis of bank failure by a well-known authority: "... competitive liberalization of laws has led us to permit the creation of unsound banks and the indulgence of unsound banking practices." Changing loan portfolios have contributed "... to the lack of liquidity in the resources of cODDDercial banks... Directly associated ••. are the increased number of • • • non-cODDDercial banking affiliates which have been attached to cODDDercial banks ••• in recent years . . . That these affiliates have been contributing factors to the number of bank failures seems beyond question. • . Another defect is found in . • . poor management. • • Finally, we may mention the fact that the problem of inadequate bank supervision is still with us." These statements are from a study by Walter Spahr, in March 1932 • 1  1wa1ter Spahr, Algerican pp. 216-21.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ~  Review, Supplement, March 1932,  I cite  468  them simply to point out that either we have known the causes of bank failure for many years and have failed to sustain the reforms needed to  prevent failure, or there is something lacking in the analysis, In a sense, it may be argued that we have failed to sustain Commercial banks have undertaken the needed 11 reforms. 11 the development of a wide range of new services, have expanded into new product markets and into new geographic areas. The extension of branch  banking, holding company affiliation, loan production offices have served these ends,Changing loan portfolios and relations with holdin,,: company affiliates have·weakened· a number of banks, Traditional measures of liquidity and solvency have trended downward, particularly for large banks. In a number of cases these changes have been spurred by a "competitive liberalization" of regulations, indeed, at times, one or another of the banking agencies has gone along only  under pressure from a counterpart, The sense in which this analysis of bank failure is correct is, however, less useful, in and of itself, than might be expected. Inept, imprudent and/or dishonest bank management can, in retrospect, always be  found in case of bank failure -- or else, clearly, the bank would not have failed. Since ineptitude, imprudence and dishonesty have their deleterious effects while banks are, supposedly, under close supervision, the inadequacy  of supervision, either in identifying the problems or remedying them, can always be inferred, With the exception of clear-cut cases of fraud, the cause (bad management) is not clearly separable from the effect (bank failure); and the remedy (improved management and improved supervision) may, therefore, be more difficult to achieve than it appears to be. I do not mean to argue that bank failures cannot be traced to bad  management, or that supervisors should not be held to the highest of standards. Rather, I want to suggest that there are independent causes for bank failure that may convert adequate management to inadequate and may be beyond the powers of even good supervision to correct.  One independent environmental  has been a height;ened degree of economic instability factor of importance in the past several years. In retrospect, excessive portfolio risk developed where acceptable risk was initially perceived. It is possible that the next few years will not be as troublesome and that bankers will.adjust their behavior to the new perception of possible events. This past year, however, was a reasonably good one, characterized by  expanding economic activity and relative stability, Yet the data submitted up from 12 the by the banking agencies indicate 16 bank failures in 1976 previous year; and 15 additional banks merged or 2 acquired to avert fail-  It is, of course, possible ure -- probably also up substantially from 1975, that the failures this year are a lagged reaction to problems that developed earlier. But there is another independent cause of bank failure that should be considered; that is competition.  110 data for earlier years was provided by the FDIC,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  469 3  The past 15 years have been characterized by increasingly intense competition among commercial banks, The development of new banking "products" and entry into new financial "lines" has been in response to competition for existing customers as well as an attempt to secure new ones. The expansion of commercial banks into new geographic areas by means of branching, holding company affilitations, loan production offices, etc., has similarly been both cause and effect of increased competition. The changes that have come about have been facilitated by changes in law and regulation. By and large the new competition has been beneficial and welcomed. The perception of a new aggressiveness on the part of bankers and a 'penchant for growth' which supervisors have sometimes associated with bank failure, I believe is more a reflection of the increasingly competitive environment in which bankers find themselves than a source of it, It has been generally understood that a higher rate of bank failure was likely to accompany an intensification of competition in banking, More intense competition means that individual banks will operate at lower levels of profitability -- that, other things being equal, interest rates on loans will be lower and explicit or implicit interest rates on deposits will be higher. Bankers may attempt to resist movement toward lower levels of profitability by searching for higher return investments, and letting capital ratios slip, The thinner profit margins associated with competition leave less room for ineptness, imprudence, dishonesty, and unanticipated external shock, In connection with large bank failure it is, perhaps, not accidental, that the national and international markets in which large banks operate have long been recognized as highly competitive. On the other hand, many local banking markets are still characterized by relatively few banks and high levels of concentration. But a number of changes are in process that have and will tend to increase local market competition, These include: the development of deposit and loan powers for thrifts, more extensive intrastate branching spurred by the ability of thrifts to branch, even in many unit banking states, expansion of interstate branching and holding company operations, either through Federal legislation or reciprocal agreements among states or both, and technological devices associated with electronic fund transfers that will also tend to expand the scope of geographic markets. These changes should tend to increase numbers of banks within local geographic markets, reduce concentration and lower barriers to entry. They promise better banking services at lower costs to local customers. They also threaten serious pressure on smaller banking organizations that have, up to recently, been more or less protected from the full brunt of competition. It will require careful study to determine how many small banks will encounter difficulty as a result of further intensification of competition of the sort that seems to be developing. However, the recent Federal Reserve study submitted to this Committee on "The Impact of the Payment of Interest on Demand Deposits" takes an interesting step in this direction. It indicates that small banks would be particularly vulnerable to the elimination of the interest payment prohibition. Elimination of the interest payment prohibition is, however, a proposal that would not, in itself, so much increase competition at this stage -- it is more a reflection of already increased competition resulting from the existence and spread of close substitutes   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  470 4  for demand deposits, This increased competition has or will create difficulties for the small banks identified by the Federal Reserve even without the elimination of the interest payment prohibition. It is of particular interest that the data the agencies have supplied this year are consistent with this expectation. The number of small bank failures were unusually high in 1976 -- 12 of 16 failures had deposits under $50 million; 13 of 15 banks merged or acquired to avert failure had deposits under $50 million. It remains to be seen whether this year was an aberration or the beginning of a trend, In summary, I would like to point out that the delicate regulatory balance that was established in the early 1930 1 s involved both a reduction in the intensity of competition (through the restriction of new entry and the regulation or prohibition of interest payments on deposits) and a reduction in the asset risk commercial banks could accept (through the separation of investment from commercial banking, the imposition of investment a.nd other restrictions ) , While both types of restrictions tended to reduce bank failure, a balance was involved in that the restrictions on competition tended to increase bank earnings while the restrictions on asset risk tended to lower them. This regulatory balance has disintegrated in the past 15 years, As competition emerged and threatened earnings, bankers began to invest in higher yielding (and riskier) investments, The old arrangement is clearly beyond recall, should anyone feel nostalgic about it, What is clearly needed is a new arrangement that will minimize the disruptions of bank failure in the new competitive environment. What does not seem to be clearly perceived is that it is a banking agency responsibility to develop and, at least, propose such a new arrangement. I believe that one important reason this has not yet been done is that divided authority among the agencies more or less precludes an effective response by any one,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  471 The CHAIRMAN. Thank you very much, Mr. Shull. Professor Sinkey.  STATEMENT OF PROF. JOE SINKEY, UNIVERSITY OF GEORGIA  Mr. SINKEY. Mr. Chairman, if I had some supporting staff members with me today, I would introduce them to you. However, I don't enjoy such a luxury. I would like to acknowledge, however, Joanne Sinkey, my wife, who gave me moral and proofreading support over the short time period that I had to prepare my detailed statement. I worked very hard in preparing it, and I appreciate this opportunity to participate in your committee's hearings on the condition of the U.S. banking system. The CHAIRMAN. May I say your full statement will be printed in the record, if you would like to abbreviate it. Mr. SINKEY. Yes; I plan to summarize it. My conclusions are that the banking system is relatively healthy, and that banking agencies have done an adequate job of carrying out their statutory responsibility to assure a safe and sound banking system. To support my conclusions, I will emphasize in my oral statement five of the seven points contained in my written statement. First, the bank failure record. This record speaks for itself. From 1943 to 1976, a period of 34 years, only 150 insured banks have failed. Less than 5 banks per year. With a population base of approximately 14,000 banks, in any of these years, this translates into an average annual failure rate of approximately .03 percent. That is, three failures for every 10,000 banks. On balance, the deposit insurance bank failures record is an excellent one both in absolute and relative terms. Regarding the causes of bank failures, internal factors have been the major cause of bank closings. Moreover, the major internal cause has been some form of managerial dishonesty or corruption. For example, of the 84 banks that failed between 1960 and April 30, 1976, 45 of the failures were due to improper loans to officers, directors, or owners or loans to out-of-territory borrowers. There was misuse of brokered funds in 22 of these cases. Twentyfive of the cases could be traced to embezzlement or manipulation, and, finally, 14 of the failures were due to managerial weaknesses in loan portfolio administration. Since our three largest bank failures, U.S. National Bank, Franklin, and Hamilton, have occurred within the past 4 years, and have generated considerable adverse publicity for the banking system, let us consider what appeared to have caused these failures. Franklin was a regional bank that attempted to become a New York City money market bank, but didn't make it. Alleged mismanagement and alleged poor judgments regarding the basic risk return tradeoffs of banking appeared to cause Franklin's downfall. The much publicized unauthorized foreign exchange transactions were only the last nail in Franklin's coffin. C. Arnold Smith's alleged and proven manipulations in the U.S.N.B. case resulted in the second largest bank failure, while Hamilton National, the third largest failure, had an overextended real estate loan portfolio that got caught in a severe real estate recession.  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  472 Moreover, it is my understanding that the sale of loans from Hamilton's mortgage banking subsidiary back to Hamilton National were in violation of section 23 (a) of the Federal Reserve Act. Do the causes of these three failures indicate that something is fundamentally wrong with the banking system? . I don't think so. The lessons to be learned are, one, mismanagement and/or dishonesty can occur in a large bank as well as in a small one. Two, watch out for the one-man show, that is, power tends to corrupt, and absolute power tends to corrupt absolutely. And, three, the aggressive liability management used by some of the larger banks makes them more sensitive to financial market fluctuations and thus more vulnerable during periods of tight money and credit. To summarize, nothing essentially is new in the cause of bank failures. On balance, strong interested informed and honest managers and directors do not permit or establish unsafe and/or unsound banking practices and policies. Thus, it is managers who can't or won't manage and directors who can't or won't direct that cause problems in failed banks. The second point that I want to emphasize has to do with the concept of a problem bank. The banking agencies have interpreted their safety and soundness mandate as one of limited failure prevention. By identifying banks with the highest failure risks as problem banks, the banking agencies hope to achieve this goal. Based upon my analysis, I have concluded that a problem bank is one with a large volume of substandard loans relative to its capital and reserve. Unless there is a clear understanding of what a substandard loan is, and the subjective process by which a loan is determined to be substandard, knowledge that a financial institution is considered to be a problem can be subject to serious misinterpretation. Thus in most cases the fact that a bank is flagged as a problem does not mean it is about to fail. Basically it means the bank has a large volume of substandard loans, which are examiners' least risky loanclassification category, in a loan-evaluation process which is described by the banking agencies as an art, and not a science. That is, an examiner's judgment is the primary determining factor. Now if the quality of these substandard loans continues to deteriorate, then the bank could be in greater danger of failing. Otherwise, it is simpl~ a bank that should be watched closely, and given remedial attention. Furthermore, I have estimated that there is about a five-quarter lag and an inverse relationship between the state of the economy and the number of problem banks. Thus, the fact that a bank is on one of the agencies problem bank lists does not necessarily mean that it is still a problem today. Moreover, to a certain extent there is a self-correcting mechanism associated with so-called problem banks. That is, as the economy starts to improve, the ratio of substandard loans to capital will decrease. The third point I want to emphasize is the CD rate risk premium. The spread between the interest rate for 90-day large negotiable certificates of deposit and the 91-day Treasury bill rate, which is regarded as the risk-free rate of return, can be viewed as the risk premium that   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  lenders require for holding risky CD's. There are some important qualifications regarding an observed spread. First, because of the pra:ctice of liability management, an observed spread could be due in part to an aggressive liability management or the lack of it. Thus, considering both blades of the supply and demand scissors, the spread can be determined by lenders' perception of the risks involved and by borrowers' needs for funds. Second, to the extent that upswings in the Treasury bill rate are indirectly constrained by regulation Q, the spread during credit crunches is overstated. The important point is that the spread at that time is relatively small, indicating that uninsured depositors regard the system as being relatively risk-free. When the spread is large, lenders regard the system as being more risky than normal, and banks are engaging in aggressive liability management. Whatever the true cause is, there is an indication that the system is not as safe and sound as it could be if there is a large spread. The fourth point that I want to emphasize is the five C's of credit management, which are character, capacity, capital, collateral, and conditions. These factors are the cannons of sound credit management. With the benefit of hindsight it is easy to say the banking difficulties associated with the REIT crisis were exacerbated by poor credit management on the part of the banking system, mainly by the larger banks. Granted that the worst recession since the Great Depression was a factor in this crisis; however, evaluation of a borrower's downside risk exposure still must be considered. Since bankers, like other business persons, have goals such as profit maximization, maximization of shareholder wealth, it is not unreasonable to expect them to learn from their past mistakes, especially when such errors are as. costly as the REIT crisis has been. There are two lessons to be learned from the REIT difficulties of the 1970's. First, for the bankers there is no substitute for sound credit management. And second, for the banking agencies, while identifying symptoms of poor credit management is important, it is more important to focus upon the policies and controls that produce such loans. I am encouraged by the factthat the banking agencies appear to be moving in this direction. Although REIT workouts will affect the loan losses and earnings of some banks for several year5 yet, for the most part the REIT crisis is a thing of the past for the banking system. However, one area of potential concern in the banking system is with respect to sound credit management in regard to U.S. bank loans abroad. To insure that the bankers involved in foreign lending do not get REIT fever and develop delerium about the risk return tradeoffs, the banking agencies should scrutinize carefully the banks involved in these foreign lending activities. The fifth, and final point focuses upon the effectiveness of bank supervision. Federal supervision of existing commercial banks basically focuses upon the identification and correction of banking problems. Based upon recent experience, the banking agencies have been doing a fairly good job of identifying future bank failures.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  474 For example, the recent GAO report on Federal Supervision of State and National Banks, indicated that 21 of the 30 bank failures reviewed were identified as problem banks at least 2 years before they closed. Regarding the banking agencies inability to prevent problem banks from failing, the GAO report concluded that the agencies did not use their cease and desist powers as effectively as they might have. While this is a relatively obvious conclusion to draw, is it the appropriate one i That is, since these banke1 s had demonstrated their dishonesty and/or incompetency, didn't Lheir banks deserve to fail, as long as the closings were not disruptive to the system i The goal of bank supervision should not be to prevent all bank failures, especially where gross mismanagement has been involved. Moreover, contrary to what the GAO report seems to be suggesting, the banking agencies should not be expected to act as management consultants to financially troubled banks. The role of bank supervision and regulation is to set guidelines for conduct and behavior, not to run the banks. Focusing upon problem banks that fail as a measure of effectiveness of bank supervision is unfair to the banking agencies, because it is only a small part of the total picture. The other important part is the number of problem h'anks that do not fail and become healthy banks again. Looking at this side of the story, the evidence suggests that the bank examination procedures have been adequate to uncover bad management practices and that the agencies have taken timely remedial action. To summarize, on balance I believe that the U.S. banking system is in a relatively healthy condition, and that the bank regulatory agencies have done an adequate job. 'As far as the future is concerned, I am encouraged by the direction in which the banking agencies are moving; their proposed reforms and innovations should improve bank supervision. Moreover, as the economy begins to improve, t'he few weaknesses I see in the banking system will tend to be reduced. Finally, let me conclude on a light-hearted note with respect to a subject that has been a very controversial one in banking, capital adequacy. What capital adequacy is and how to measure it has never been adequately defined. The controversy and homage that such an unknown oracle has generated deserves recognition. Accordingly in the Ogden Nash tradition, I offer you an ode to bank capital. Oh bank capital, oh bank capital, our regulators' stricken hero. Please don't, please don't, please don't go to zero. [The complete presentation of Professor Sinkey follows:] 1   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   86•817 0 • https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  475 Statement by Dr. Joseph F. Sinkey, Jr. Associate Professor Department of Banking and Finance College of Business Administration University of Georgia before the Committee on Banking, Housing and Urban Affairs United States Senate  March 11, 1977  77 • 31  476 Mr. Chairman, I appreciate this opportunity to participate in your committee's hearings on the condition of the U.S. banking system.  Over the past four years I have spent a great deal of time  and energy analyzing problem and failed banks, the bank-examination process, and early-warning systems for identifying potential problem banks.  I am pleased to have this chance to present the findings of  my research as they relate to the present condition or health of the banking system. I am submitting for the record two documents which provide detailed analyses of my research efforts.*  In my testimony, I will  emphasize seven points: 1. 2. 3. 4. 5. 6. 7.  the failure record and the causes of bank failures; the controversial subjects of problem banks and problem-bank lists; the CD rate risk premium; REIT and foreign loans; nongovernment surveillance of the banking system; the effectiveness of bank supervision; and ratio analysis.  Post-Deposit Insurance Bank Failures From January 1, 1934 through December 31, 1976, 677 banks failed (see Table 1).  However, 490 of these banks (72.5 percent) were  closed over the nine-year period 1934-1942, approximately 54 banks per year.  Thus, over the 34 years from 1943 to 1976, only 187 banks  have failed, about 5.5 per year.  With a population base of approxi-  mately 14,000 banks in any of these years, this translates into an *Joseph F. Sinkey, Jr., "Problem and Failed Banks, Bank Examinations, and Early-Warning Systems: A Summary," forthcoming in Financial Crises (edited by Altman and Sametz), New York: Wiley-Interscience, I9"i'7'and Joseph F. Sinkey, Jr;, "The Bank-Examination Process and Major Issues in Banking: A Survey," The Bankers Magazine (forthcoming Summer, 1977).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  477 2  average annual failure ra