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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
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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
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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
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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 ______________________________ _
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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
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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_____________________________________________________
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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
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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 :]
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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
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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.
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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
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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
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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.
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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
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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.
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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
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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.
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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
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Federal Reserve Bank of St. Louis
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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,
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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:]
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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
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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.
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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.
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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
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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.
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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
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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.
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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
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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
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Federal Reserve Bank of St. Louis
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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
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Federal Reserve Bank of St. Louis
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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.
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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.
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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
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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
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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
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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
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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
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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.
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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.
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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
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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.
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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.
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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
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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
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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
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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
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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.
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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,
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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
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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.
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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~
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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.
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[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
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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
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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-
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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,
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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,
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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 ••• "
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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.
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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
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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
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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
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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
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■ 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
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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.
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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.
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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.
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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.
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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
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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.
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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,
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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
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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,
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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
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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.
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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
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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.
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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
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"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.
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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:
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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
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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
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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
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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
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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
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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.
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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.•
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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.
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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
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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.
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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
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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.
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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.
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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.
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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:]
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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
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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
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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
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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.
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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.
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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.
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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
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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,
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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,
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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
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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.
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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.
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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
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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
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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
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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.
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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:]
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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
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--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
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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
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--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
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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.
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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.
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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.
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--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.
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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.
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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.
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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.
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--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,
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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
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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
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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."
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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
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--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.
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Federal Reserve Bank of St. Louis
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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-.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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~).
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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.
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, 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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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'
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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,
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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.
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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).
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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.
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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.
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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.
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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.
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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.
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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.
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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.]
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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
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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
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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.
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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:]
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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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
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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
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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
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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
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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
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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.
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Federal Reserve Bank of St. Louis
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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,
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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
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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,
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However, we believe that no one
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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.
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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.
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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
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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
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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
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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
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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.
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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,
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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.
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We are developing plans to enlarge on this concept
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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.
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This effort, although not
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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.
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'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,
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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.
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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
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(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
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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
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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-
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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.
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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
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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
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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.
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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.
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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
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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
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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.
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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.
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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.
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Federal Reserve Bank of St. Louis
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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 $1 million excess bank
err.p loyee dishonesty bond.
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Federal Reserve Bank of St. Louis
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Application for De;,oait
Inf~#! °"'!{,ea-,:~-J3~?4)
'
...
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261
applicant's definition of the trade &rt>a. In some instances, the applicant may
artificially draw its trade are.i bo1..r.daries so as to excfo,de factors which would
be unfavorable to the proposal (ne.a:rby banks, depressed &reaa, etc.) and include
others which would increase the attractivene~s of the proposed location (significant residential or co11111ercial developments, highly concentrated population area.,
etc.). The Examiner should be aware of this possibility and any differences
between the Euminer 's conception of the trade area and that of the proponen·ca
should be discussed fully in the report togethe~ with a description of the trade
area as the Examiner perceives it. Once. the trade area has been defined, information regarding the following should be set forth:
1.
Economic Data
The principal industrial, trade, or agricultural activity should be
deacribed aod annual values of principal products indicated. The presence and source of large payrolls in the area may also be an important
consideration. The past and present volume of postal activity and the
number ,md value of resider.tial and coni.Jt~rcial building perm.its can often
be of considerable value in determining the vitality of the area. Figurea regarding retail~ sales from public so~rces or trade organizations
are useful; however, if they are not available, it ::aay be possible to
obtain sorae estimate$ 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.
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Federal Reserve Bank of St. Louis
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Ap;_,Ziaatwn for D•posit
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(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.
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Federal Reserve Bank of St. Louis
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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
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Federal Reserve Bank of St. Louis
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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
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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
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AppZicationa for Deposit
InaUMnee (R•,,..••<1 8-18-?4}
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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.
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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
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Federal Reserve Bank 86-817
of St. 0Louis
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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.
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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.
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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,
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Federal Reserve Bank of St. Louis
Holding company
271
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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.
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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)
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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
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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.
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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.
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(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
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Federal Reserve Bank of St. Louis
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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
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Federal Reserve Bank of St. Louis
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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
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Federal Reserve Bank of St. Louis
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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;
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Federal Reserve Bank of St. Louis
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(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
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Federal Reserve Bank of St. Louis
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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 ■•
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Federal Reserve Bank of St. Louis
While it is possible
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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.
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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.
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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;
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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.
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Regional Directors
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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.
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(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
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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
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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.?
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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.
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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.
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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.
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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
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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
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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.
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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.
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-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.
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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·,·
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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.
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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.
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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■
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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
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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.
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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).
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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.
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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.
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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.
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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.
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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
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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;
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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.
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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,
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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.
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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
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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
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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;
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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
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-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.
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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.]
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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
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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.
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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.
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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.
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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:
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(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
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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.
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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.
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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.
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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.
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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.
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Federal Reserve Bank of St. Louis
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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.
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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.
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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
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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.
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'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
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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
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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-
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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.
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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.
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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.
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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
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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?
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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
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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-
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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.
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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
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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
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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.
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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
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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.
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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.
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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:]
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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
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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
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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
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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
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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:]
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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)
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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
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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.
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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
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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
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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
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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
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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
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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.
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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.
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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
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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
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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.
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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
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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
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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
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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.
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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.
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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.
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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
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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
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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.' "
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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."
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'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,
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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
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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.
·
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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.
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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,
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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.
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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
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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).
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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.
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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
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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.•
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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)?
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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
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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.
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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.
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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.
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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
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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
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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."
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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
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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,
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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.
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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.
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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.
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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
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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.
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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."
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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
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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.
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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
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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
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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
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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
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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.
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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.
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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
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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."
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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
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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.
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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
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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
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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
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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.
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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.
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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,
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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
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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
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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
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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-
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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-
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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.
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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.
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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.
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86-817 0 - 77 - 28
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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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.
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'/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
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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.
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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 •
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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
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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.
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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,
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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.
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Federal Reserve Bank of St. Louis
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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.
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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.
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Federal Reserve Bank of St. Louis
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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
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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(--)
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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
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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
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Federal Reserve Bank of St. Louis
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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.
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Federal Reserve Bank of St. Louis
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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?
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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:
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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
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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.
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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
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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.
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Federal Reserve Bank of St. Louis
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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
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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.
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Federal Reserve Bank of St. Louis
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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.
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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."
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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.
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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:]
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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.
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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,
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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
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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,
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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.
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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
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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.
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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
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86•817 0 •
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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,"