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Address before Third International Banking and Financial Colloquium Sponsored by University of Lausanne September 6-7, 1991 £ 7 The US Financial Situation and Banking System - Implications for Regulation and Monetary Policy David W. Mullins Jr ; i The US banking industry has had mixed reactions from legislators, regulators and the public in the last few years. What seems upper* most inmost people’ s minds isthe industry's exposure to developing countries, highly leveraged transactions, the realestatecrisisand the collapse of the savings and loans institutions, with the attendant implications for deposit insurance. These events make the financial sector's headlines, though there are many other aspects to banking that provide a more welcome picture but are not reported. This chapter willlook at the shape ofthe US banking industry and the bad press the industry has been receiving. In 1990 the earnings of the industry were $17 billion,an improve* ment onjthe average of about $15 billion in previous yean. In other words growth was slow, but therewas some growth. Eighty-eightper centofthe banks inthe US earned a profit,only 12 percent reported a lossand 40 percentofinstitutionsearned a returnon assetsthatwas greaterthan 1 per cent. Fully three-quartersof the institutionsinthe US had a return on assets greater than 50 basis points. However asset quality has deteriorated - the US has nonperforming assets of about $80 billion compared with $65 billion in the late 1980s and $40 billion in the early 1980s. That $80 billionin nonperforming assets needs to be measured against capital of $210 billion and $50 billion in reserves. Equity as a percentage of total assets in 1990 was about 6.5 per cent following a gradual rise throughout the 1980s. The market value - thatisthestock market valueofUS banks - in 1991 averaged about 10 per cent over the book value. How does this compare internationally in terms of profitability? 50 Financial Strategies and Public Policies — Banking. Insurance and Industry. Edited by zuhayr Mikdashi. Great Britain: The Macmilllan Press Ltd, 1993, and United States: St. Martin's Press, Inc, 1993, pp. 50-55. D avid W. Mullins Jr 51 Cross-country comparisons, with differences in accounting methods and so on, are not altogether useful but it is apparent that a large section of the US industry compares quite favourably internationally in terms of profitability and capital, and itcontinues to be an inno vative industry. So what is the problem? If three-quarters of this industry is earning O.S per cent or more, which looks pretty good internationally, why are US newspapers filledday afterday with bad news? Whilst a third of the industryisdoing quitewell, another third is doing very well and that leads me to the subject matter of the newspaper headlines. The most notable problem isthat banks are failing. From 1940 to 1980,200 institutions failed in the US - an average of fiveper year and in the firstfiveyears of the 1980s a further 200 failed. From 1985 an additional200 institutionsper year failed- totalling 1300 in 1991 generating lossesthathave reduced the bank insurance fundfrom $18 billion in 1987 to a level which willdemand some recapitalisation in the near future. Why isthishappening? What iscausingbanks tofail?Some sayitis because ofunsettledeconomic conditions. But theeconomicenviron ment in the 1980s was relatively benign compared with the volatile conditions in the 1970s. There was a recession inthe early 1980s, but that was followed by the longest peacetime expansion in the history of the US. These were good times but stillover a thousand banks failed. Economic conditions alone cannot offer an explanation —so other forces must be recognised. One such forceisthatthe 1980swere characterisedby unparalleled innovation in finance and by growth in financial markets and or ganisations. These developments were facilitated by technological ad vances thatbroke down old barriersbetween banking and otherareas of finance. There was growth in the number of companies going directlyto capitalmarkets, bypassingbanking institutions.Securitisa tion in a wide variety of credit types also bypassed banking institu tions. And non-bank competition - finance companies, insurance companies and so on - also found ways to compete profitably with banks. Thiswas not restrictedto the assetsideofthe balance sheetmoney market mutual binds and other mutual funds competed with banks on the right hand side of the balance sheet. Why were banks not able to meet this competitive challenge? Unlike theircompetitors US banks are highly constrained by restric tive regulations framed half a century ago to address the problems of that time. Banks were prohibited from competing across both 52 US Financial Situation and Banking System financialproduct linesand geographical lines- interstatebranching is prohibited. The EC istalkingabout allowing banks to go rightacross Europe- US banks arestillprevented from crossinga singlestateline and so are not able to compete in the same way as many non-bank entities. For example they are not able to retaincustomers who move interstate. With theevolution oftechnology, which brought sweeping changes to the market, many banks were able to cope by focusing on those market areas in which they still had an advantage. However these changes eroded competitiveness, reduced competitive opportunities and eroded the profitability of the industry. While much of the industry has been able tocope, the restfailed.This can’ tbe quite the whole story though because many industries face competitive chal lenges and don’ t end up with thousands of institutions foiling. The other part of the story must be the failure of normal mechanisms which should have forced banks to deal with diminished competitive opportunity. Relevant here is the effect of the Federal Deposit In surance Corporation - federal safety net. The federal safetynet inthe US has grown dramatically. Forty per cent of deposits were insured in 1940, a little over half of total deposits were insured in the 1960s and In 1991 80 per cent of total deposits were insured. With an implicit ‘ too big to fail policy’ ,the figure may rise to 100 per cent. The federal safety net shields banks from normal market forces which dtfftyfunds to banks that are not doing well. Market disdpline is7emoved by depositinsurance,which allowsfirmslackingattractive investment opportunities to nonetheless attractdeposits and to com pete with better institutions- to'the detriment of the industry. The safety net also provides an incentive to take risks. Ifthings go well the shareholders of an institution benefit, but Ifthings go poorly the insurance fund pays the bill. Of course as competitive opportunities have shrunk in some market areas, the supply of funds has not shrunk. As a result there istoo much money chasing too few oppor tunities and thisleads to assetquality problems, such as commercial real estate problems. When weak institutions are stillable to attract money and compete for loans, asset qualityproblems are inevitable. So the federal safety net has prevented normal capital market disci pline from weeding out weak performers, who have been allowed to continue to raise funds even as they descend into insolvency. Unfortunately Congress simply will not touch deposit insurance in any fundamental form as itisa subsidy which isdeeply embedded in David W. Mullins Jr 53 the banking industry and which also affects the person on the street. As there may be no substantive direct reform of the formal part of deposit insurance, tolerance for undercapitalised institutionsmust be reduced. The other area where discipline is inadequate is regulatory disci pline. With the federal safety net inhibiting market discipline, the task falls to regulators to act as a surrogate for the market and deal with weak institutions. Many have argued that the US has not taken decisive remedial action early enough and has instead waited until these institutions have become insolvent, at great cost to the fund. Regulators in the US are hampered by having to bear the substantial burdens of institutions which have positive but insufficient capital. One of the proposals in current legislation isto shift that burden so that regulators will be in a position to intervene earlier. So the problem confronting the banking industry isa combination ofdiminishedcompetitiveopportunityresultingfrom the evolutionof finance, outdated restrictions on banks which prohibit them from capitalising on their expertise, and insufficient disciplinary mechan isms to deal with the fallout. Many in the US are callingfortougher regulation and tougher discipline,but untilthe fundamental problem of competitive disadvantage is dealt with there may be a more efficient resolution of weak institutions, but the number of weak institutions will not be reduced. As the competitive opportunities of banking institutions have been reduced, ultimately theironly protec tion will be to build a more profitable and competitive industry. To this end the causes of failure and not just the symptoms should be treated. ! Itisnotyetclearhow financialreform legislationisgoingtogo, but ithas been designed with each of the following in mind: to broaden competitive opportunities forbanks; to reduce the federalsafetynet, which politically is a very difficult task; and to increase regulatory discipline. Whether or not the legislation is passed, it is inevitable that some very dramatic restructuring of the banking and financial industries will take place, in the US. This will have very important implications for regulation and monetary policy. There are 1000 S&L’ s in the process of being resolved through the resolution trust corporation process and a large number of banks are also going to go through that sort of process. A very significant percentage of the US depository franchise isgoing to be up for grabs during the 1990s, and ina slow growth industrythiswillbe a unique opportunity forfirmsto make dramatic changes in the way they are structured. Indeed three 54 US Financial Situation and Banking System of the four largest US banks were created in early 1991 in corporate board rooms by mergers. So the process ofchange ismoving along as institutions seek to improve efficiency. The challenge for regulators is to design regulations that protect safety and soundness but also enhance the efficiency of the financial system. If efficiency is not increased the fundamental source of the problem of competitiveness willnot have been dealt with. As for the weaker sectionsofthe industry, Ithink the evolvingprinciplethere is clear. Capital - intolerance with poorly capitalised institutions and early and aggressive intervention as their capital falls. Towards this end a study of unregulated industries could be of advantage. There are finance companies in the US that deal in the same sortofproducts asbanks and lend tothe same sortofcustomers with very similar types of instruments. They do not have the federal safety net to support them and generally they have been doing quite well. They are profitable, they have been growing, they have more capital- despite the factthey do not have the advantage of the safety net. The key challenge then is not try to raise the average level of capital, or the capital of the tetter institutions, but to find ways of dealing with the institutions that are undercapitalised. More generally, the US has a fragmented regulatory system. The securities industry is regulated by the SEC and there ate four separ ate banking regulators. The US should startthinking about financial regulation as a whole, not just banking and securitiesregulation. As technology has broken down the barriers between banking and finance, more uniform regulations are needed. I think we willmove toward more generic regulationsfocused on risk-basedcapitalguide lines and the like, rather than specific detailed regulation of indi vidual industries. The convergence of international regulation through the BIS standards could serve as an example. In terms of international competition, US banking institutions are likely to stay put for a while and focus their attention on the home market. The weaker sections will be trying to husband their capital, and the stronger sections will be concentrating on making dramatic structuraland strategicchanges. Obviously some institutions may be aggressiveinternationally, but Ithinkinthemain US banking isinfor a period of inward focus. As far as the monetary implications of allthe above isconcerned, the major effect has been that money isnot growing atallin the US. For the broad monetary aggregate, M2, the growth rate in July 1991 was negative for only the third month since 1959. In August 1991 it David W. Mullins Jr 55 was zero. Part of the reason for this was the supply effect of banks responding to regulators’requests for higher capital. Banks are re stricting their growth, they are pulling back, and that iscausing the growth aggregates to slow. Some ofthis isnot so worrisome, but one has to be concerned about the supply of credit to the sections of the financialmarket which arestilldependent on thebanking system. Itis not clear whether these changes in aggregates are having a substan tive impact on the economy and are correctly signalling monetary conditions, or whether they are just distortions in these signals and are of littleimportance. We turn now to the international implicationsof reforms inthe US. How will continental European banks adjust to the new rules which are bound to be set up in the US in terms of firewalls and Chinese walls for various financial activities? Three scenarios are presented: first,by checking that the structures they have in their own country meet US requirements; second, by setting up special structuresin the US to meet those requirements; and third, by giving up certain businesses in the US. Congress and the US Treasury have proposed something which fallsbetween scenarios two and three. The Federal Reserve was not pleased with the Treasury’ s proposal, which went against the prin ciples set up in the US International Banking Act: the principle of grandfathering and the principle of not imposing the US banking structure on other countries, but rather as viewing the institution outside the US as the bank holdingcompany. Considerable progress has been made in getting Congress to move away from the Treasury proposal - perhaps moving closer to the first scenario. What may eventuate isthat the Federal Reserve may be given authoritytolook at particular foreign institutions and satisfy itself that they have an appropriate amount of capital. Scenario one would be best for the competitivenessofUS institutionsabroad and alsoforforeigninstitu tions in the US, who have been important lenders at a time when lending by US banks has fallen.
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