The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
For R e l e a s e o n D e l i v e r y Approximately 12:00 noon Eastern Standard Time, Friday, March 19, 1965) LENDING STANDARDS AND THE QUALITY OF CREDIT Remarks of C, Canby Baiderston, Vice Chairman, Board of Governors of the Federal Reserve System, Before the ABA Monetary Conference, in Princeton, New Jersey, on Friday, March 19, 1965 (Governor J. Dewey Daane delivered this speech for Governor Baiderston in his absence.) LENDING STANDARDS AND THE QUALITY OF CREDIT I shall not discuss the volume of total debt except to observe: first, that private debt has been increasing much faster than public debt; and second, that, despite the nearly sixfold expansion of private debt since the end of World War II, its current ratio to GNP is still below comparable ratios reached in 1912, 1922 and 1929. Nor shall I discuss the mixture of private debt except to remark that between 1945 and 1964, consumer debt increased 13 times and residential mortgage debt nearly 11 times. In short, these types rose about twice as fast as all forms of private debt taken together. Finally, I shall not argue whether lending, to be sound, requires that the borrower possess adequate equity in the collateral. Experimentation with signature loans, credit cards, and the financing of travel without down payments makes one wary of being dogmatic about the degree of risk involved in lending even where the equity is thin or nonexistent. Rather I shall turn to the perennial concern of lenders with measurement of the overall quality of the credit they are advancing. Scattered failures of banks and other financial institutions as well as other evidence of unsound financial practices cannot help but be disquieting when viewed against the broader backdrop of continuing reports that loan standards are lower. While the ultimate indicators of doubtful credit quality--loan losses, delinquencies, and foreclosures--have remained relatively small, their rise during a period of general economic expansion suggests that the quality of credit arrangemen tôt^fcuing and careful attention. Decisions as to wh e and on what terms are, of course, the responsibility of indivi* an essentially free economy like LIBRARY ours. W i t h i n the b r o a d l o a n s t a n d a r d s e s t a b l i s h e d by s t a t u t e a n d by s u p e r visory authorities, the i n d i v i d u a l l e n d e r is in a b e t t e r p o s i t i o n to ju d g e the c r e d i t s t a n d i n g of his b o r r o w e r s t h a n g o v e r n m e n t a l a u t h o r i t i e s ; he is a l s o f r e q u e n t l y a b l e to m a k e a m o r e r e a l i s t i c a p p r a i s a l of l o a n c o l l a t e r a l . R e a s o n i n g fro m this truism, m a n y e c o n o m i s t s a r g u e that the d e t e r m i n a t i o n o f l e n d i n g s t a n d a r d s s h o u l d be left w h o l l y to the c o m p e t i t i v e i n t e r p l a y of m a r k e t forces* As they see it, u n f e t t e r e d c o m p e t i t i o n a m o n g l e n d e r s w i l l o p e r a t e to i n s u r e a n o p t i m u m a l l o c a t i o n of l o a n funds a m o n g b o r r o w e r s , a n d the r i s k of loss w i l l p r o v i d e a n e f f e c t i v e d i s c i p l i n e o n l e n d e r jud g m e n t s . T h e y a r g u e that l e n d e r s tfrho are f o o l i s h w i l l be f o r c e d o u t of b u s i n e s s , a n d the i r m i s f o r t u n e s w i l l s e r v e in t u r n to i m press o t h e r l e n d e r s w i t h the w i s d o m of p r u d e n t f i n a n c i a l m a n a g e m e n t * T h i s d o c t r i n e is a d m i t t e d l y a p p e a l i n g . A t times, h o w e v e r , the c o s t of t hese le s s o n s of e x p e r i e n c e a f f e c t s n o t o n l y the m a r g i n a l few a s s u m e d by the d o c t rine, b u t m a n y o t h e r l e n d e r s a n d b o r r o w e r s as well. They, l ike G o v e r n m e n t o f f i c i a l s , ar e s u b j e c t to w a v e s o f o p t i m i s m a n d p e ssimism. F o r t hese r e a sons, it g ives o n e pa u s e to h e a r l e n d e r s r e p o r t i n g n o w that l o a n s t a n d a r d s a r e b e i n g relaxed, p r e c i s e l y b e c a u s e o f the i n t e n s i t y of c o m p e t i t i o n a m o n g d i f f e r e n t types o f l e n d i n g ins t i t u t i o n s . U n f o r t u n a t e l y , U n i t e d States f i n a n c i a l h i s t o r y is r e p l e t e w i t h e p i s o d e s in w h i c h a g g r e s s i v e l e n d e r c o m p e t i t i o n d u r i n g p e r i o d s o f e c o n o m i c e x p a n s i o n led to e u p h o r i c j u d g m e n t s a b o u t u n d e r l y i n g c o l l a t e r a l v a l u e s a n d a b o u t the l o n g - t e r m a b i l i t y of b o r r o w e r s to pay d e b t - s e r v i c e charges. I n e v i t a b l y these e a r l i e r p e r iods of o v e r e x u b e r a n c e c u l m i n a t e d in m o m e n t s o f t r u t h in w h i c h a s s e t v a l u e s w e r e g e n e r a l l y a d j u s t e d down w a r d * O n some - 3 of these occasions the shift in credit climate itself triggered a corollary decline in economic activity; on others, economic activity turned down first, but then initiated an adjustment in the credit climate which further aggravated the economic decline* Much of the concern expressed in financial circles about present tendencies in credit standards undoubtedly reflects the propensity to reason by analogy from this past* Of course these past episodes appear today as extremes that occurred at times when the financial system did not possess its present underlying structural strength. Nonetheless, this earlier history is a useful reminder of the perverse impact which cyclical downturns can exert on credit arrangements, not only those of a marginal character but also many credits previously thought to be of unquestioned quality. This persistent and proper concern poses two logical questions: first, how can one measure the extent to which credit quality has in fact been changing; and second, how does one ascertain the point at which any broad trend toward greater liberality in loan characteristics is becoming unsound? These questions are, of course, fundamental to lenders. are also important to the Federal Reserve, They Close attention to lending standards at individual banks is crucial to successful exercise of the Federal Reserve supervisory responsibility. Also, in the implementation of general monetary policy, domestic economic activity is more vulnerable to contraction when the underlying credit structure is weak. Unfortunately, changing trends in credit quality are difficult to measure. In theory, one might conclude that it is deteriorating if an increasing volume of loans .is being made on which there is a noticeable risk of borrower default and ultimate loss to the lender. But in practice - 4 l e n d e r r i s k has m a n y d i m e n s i o n s that are d i f f i c u l t to quantify. F or e x a m p l e , one ke y c o n s i d e r a t i o n in j u d g i n g the q u a l i t y of a l o a n p o r t f o l i o is the e c o n o m i c c l i m a t e l i k e l y to prev a i l d u r i n g the p e r i o d w h e n the loans are outstanding. Statistics on loan delinquencies, f o r e c l o s u r e s , a n d lo s s e s are u l t i m a t e m e a s u r e s of l e n d e r r i s k - ~ a f t e r the fact. a small part of the total c r e d i t iceberg* Moreover, they s h o w o n l y By t h e m s e l v e s they tell us l i t t l e a b o u t the c h a n c e s that o t h e r loans o u t s t a n d i n g m a y a l s o get into trouble. To o b t a i n a n idea of the r e l a t i v e q u a l i t y o f o t h e r cr e d i t s , a d d i t i o n a l i n f o r m a t i o n w o u l d be needed. two types of First, w o u l d be s t a t i s t i c s s h o w i n g the p r e v a i l i n g c h a r a c t e r i s t i c s of r e p r e s e n t a t i v e loans a c t u a l l y b e i n g m a d e currently; second, w o u l d be q u a l i t y b e n c h m a r k s a g a i n s t w h i c h c u r r e n t s t a t i s t i c s c o u l d be judged. to s t e m from past e x p e r i e n c e , While such bench marks would necessarily have they w o u l d also n e e d to r e f l e c t the c h a n g i n g s t r u c t u r e a n d s t a b i l i t y of the economy. Ideally, good historical bench marks w o u l d m a k e it p o s s i b l e - a s s u m i n g c o n t i n u a n c e of r e l a t i v e l y s t a b l e e c o n o m i c g r o w t h - - t o e s t i m a t e the i n c r e a s e d d e l i n q u e n c y a nd loss e x p e r i e n c e l i k e l y to f low from a n y gene r a l l o w e r i n g of p r e s e n t standards. P r a c t i c a l d e v e l o p m e n t of these two types of i n f o r m a t i o n is a tall o r d e r indeed. C u r r e n t data o n c h a n g e s in a v e r a g e l o a n t e r m s - - s u c h as the c o n t r a c t rate, l o a n - v a l u e ratio, a n d m a t u r i t y - - a r e not c o m p l e t e m e a s u r e s o f the r e l a t i v e r i s k i n e s s of n e w loans b e i n g m ade. Full d o c u m e n t a t i o n of the p r e v a i l i n g q u a l i t y of n e w loans w o u l d n e e d to s h o w w h e t h e r a n y l i b e r a l i z a t i o n of terms h a d b e e n b a l a n c e d e i t h e r b y a n i m p r o v e m e n t in the q u a l i t y of b o r r o w e r s a n d c o l l a t e r a l , or by h i g h e r i n t e r e s t returns. Moreover, any j u d g m e n t o f total p o r t f o l i o q u a l i t y for i n d i v i d u a l le n d e r s w o u l d n e e d to - 5 c o n s i d e r w h e t h e r s u c h l e n ders w e r e b a l a n c i n g n e w loans of g r e a t e r r i s k w i t h new h i g h q u a l i t y assets. The p a r t i c u l a r i n f o r m a t i o n o n l o a n c h a r a c t e r i s t i c s w h i c h w o u l d n e e d to be c o l l e c t e d w o u l d , of course, v a r y a c c o r d i n g to the type of c r e d i t in question. other liabilities, Thus, i n f o r m a t i o n o n the income, e m p l o y m e n t status, and a s s e t s of b o r r o w e r s w o u l d be p a r t i c u l a r l y i m p o r t a n t in the a n a l y s i s of c o n s u m e r credit; w h e r e a s d a t a o n the l o c a t i o n a n d s t r u c t u r e , as w e l l as the pr i c e a n d in c o m e p r o s p e c t s of d i f f e r e n t types o f p r o p e r t i e s w o u l d be m o r e i m p o r t a n t in the a n a l y s i s o f m o r t g a g e credit. S t a t i s t i c a l s a m p l i n g for s u c h s e r i e s w o u l d a l s o h a v e to m a k e some a l l o w a n c e for g e o g r a p h i c d i f f e r e n c e s , s i n c e the a v e r a g i n g of r e g i o n a l l o a n s t a n d a r d s into o v e r a l l n a t i o n a l s e r i e s m i g h t tend to o b s c u r e i m p o r t a n t local divergences. A s u b s t a n t i a l a m o u n t o f c u r r e n t i n f o r m a t i o n is a l r e a d y being c o l l e c t e d , b o t h p u b l i c l y a n d privat e l y , as to the terms a n d o t h e r r i s k c h a r a c t e r i s t i c s of d i f f e r e n t types of credit. In fact, a n u m b e r of u s e f u l a n a l y t i c a l s t u d i e s hav e b e e n m a d e , or a re un d e r w a y . of E c o n o m i c Rese a r c h , The N a t i o n a l B u r e a u in p a r t i c u l a r , has t a k e n the lead. H o w ever, m o s t of the a v a i l a b l e s t a t i s t i c s o n l o a n terms a n d c h a r a c t e r i s t i c s a r e c o l l e c t e d as s e p a r a t e seri e s for e a c h c h a r a c t e r i s t i c a n d ar e p r e s e n t e d in the fo r m of n a t i o n a l or r e g i o n a l a v e rages. This does n ot p e r m i t s y s t e m a t i c a n a l y s i s of r e l a t i o n s h i p s w i t h i n the m a t r i x of l o a n c h a r a c t e r i s t i c s , n or does it p e r m i t m e a n i n g f u l c o r r e l a t i o n of t heir c h a n g e s w i t h loss e x p e r i e n c e . The s e c o n d n e e d to be met, n a m e l y the l a c k of q u a l i t y b e n c h m a r k s , is no less a challe n g e . Of c o u r s e m o s t lend e r s ha v e g e n e r a l r u l e s - o f - t h u m b w h i c h they u s e in p r a c t i c e to i d e n t i f y loans that are o f q u e s t i o n a b l e s o u n d n e s s . - 8 * But these c u s t o m a r y rules a r e n ot t y p i c a l l y b a s e d o n a n y s y s t e m a t i c q u a n t i t a t i v e a n a l y s i s of past e x p e r i e n c e . Moreover, t hose that are r o o t e d in the past o f t e n r e l a t e to c o n s i d e r a b l y e a r l i e r peri o d s of h i s t o r y , like the 1920's a n d 1930's w h e n i n s t i t u t i o n a l a r r a n g e m e n t s w e r e s u b s t a n t i a l l y d i f f e r e n t from w h a t they a re today. Much of our present uneasiness about c r e d i t q u a l i t y seems to s t e m f r o m the fact that today's l e n d e r s - - m a n y of w h o m h a v e b e e n a c t i v e o n l y s i n c e W o r l d W a r I I - - b e l i e v e th e y c a n j u s t i f i a b l y a l l o w c u r r e n t s t a n d a r d s to fall b e l o w the o l d r u l e s - o f - t h u m b * But as y e t they h a v e no new, s u f f i c i e n t l y t e s t e d b e n c h m a r k s to i n d i c a t e w h e n the r i s k o f loss o n t o d ay's m o r e li b e r a l l o a n c h a r a c t e r i s t i c s o v e r b a l a n c e s the n e e d to v e n t u re. To me, o ne o f the m o s t i n t r i g u i n g e x p e r i m e n t s in this f i e l d is a p i l o t s u r v e y r e c e n t l y i n i t i a t e d b y the s t a f f o f the F e d e r a l R e s e r v e B o a r d in c o o p e r a t i o n w i t h those w h o e x t e n d c o n s u m e r credit. gets dat a f r o m a s e l e c t e d g r o u p of banks, This p i l o t p r o j e c t l i s t i n g the k e y terms a n d b o r r o w e r c h a r a c t e r i s t i c s of i n d i v i d u a l c o n s u m e r loans. Data are being collected for a s a m p l e of ne w c o n s u m e r loans m a d e o n a g i v e n day or days e a c h m o n t h , as w e l l as for o l d loans c l o s e d out, loans w r i t t e n off, a n d a p p l i c a t i o n s r e j e c t e d o n the same days. Loan characteristics surveyed include contract t e r m s - - s u c h as rate, m a t u r i t y , a n d d o w n p a y m e n t ; s e c u r i t y p l e d g e d ; a n d data b e a r i n g o n the c r e d i t w o r t h i n e s s of the b o r r o w e r . The l a t t e r i n c l u d e b o r r o w e r income, e m p l o y m e n t , o t h e r debt o b l i g a t i o n s , b a n k depo s i t s , a nd y e a r s o f r e s i d e n c e at the p r e s e n t a nd p r e v i o u s address. W h e n the c h a r a c t e r i s t i c s of n ew loans are c o m p a r e d w i t h those for o l d loans b e i n g c l o s e d out, one c a n see w h e t h e r o r n o t l e n d i n g s t a n d a r d s a r e b e i n g lib e r a l i z e d . Moreover, data o n loans w r i t t e n o f f s h o u l d in time - 7 permit some correlation of such characteristics with loss experiences* Ultimately the Board hopes to expand this survey to a representa tive national sample, but so far the project is being used only to test methodology* The sample is as yet too small to produce statistically significant results* The data already collected do suggest, however, that a shift in a single loan and borrower characteristic, such as an increase in the number of loans with maturities over 36 months, gives a very incom plete picture of changing credit quality because of offsetting changes in other quality elements* Absent more public or private surveys of this type in other credit sectors, our general measures of credit quality will remain frag mentary, and will force continued reliance on the impressionistic judgments of lenders and bank examiners* It has been said that, barring collusion, no lender ever knowingly makes a bad loan; it just becomes bad afterward* The chief culprit responsible for turning good loans to bad in the past has, of course, been general economic deflation* To a considerable extent recent relaxation of lending standards clearly reflects the view that our economy has become less vulnerable to deflation* Success in achieving an active rate of future economic growth without serious depression will obviously be of prime importance in determining the ultimate quality of the credit now being extended* In conclusion, many lenders seem to me to be taking a more prudent look at the risks attaching to the credit extensions they are being pressed to make because of the current growth in savings. All the while continued good business has been aiding those who so desired to improve their portfolio quality. In closing with a note of optimism, I am not assuming that all - 8 - the real estate, accounts receivable, and consumer loans now being made will in fact be paid off, I am merely expressing gratification that I sense a lively awareness of the need for balance and proper proportion between risk and the desire for yield. But only the future holds the answer as to whether this balance is, in fact, being maintained.
@FedFRASER