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Statement by

G. William Miller

Chairman, Board of Governors of the Federal Reserve System

and

Philip E. Coldwell

Member, Board of Governors of the Federal Reserve System

before the

Committee on Banking, Housing and Urban Affairs

United States Senate

May 25, 1978




Governor Coldwell and I appreciate the opportunity to
appear before this Committee today to testify on the condition
of the U.S. banking system.

Before commencing our testimony, I

want to emphasize the Board of Governors1 support for these annual
hearings.

The Board believes that the impact that our banking

system has on our economy is too important to go without periodic
review and hopes that hearings of this kind will add to the public's understanding of the banking system and will enable all of
us to view specific problems in a better perspective.
The Board's testimony today will be in two parts.

In

the first part, I will discuss several fundamental changes taking
place in the banking environment, and will present, in general terms,
the Board's current assessment of the condition of the banking system.
In the second part of our testimony, Governor Coldwell will review
in greater detail recent trends in the principal indices of bank
soundness.
Perhaps the factor that has resulted in the most far
reaching changes to the banking environment has been the rapid
development of a more interdependent world-wide economic system.
This modern-day phenomenon was brought about by improvements in
communications, transportation and by the uneven distribution of
resources among countries.

Responding to the opportunities afforded

by the global economy, American banks have substantially expanded

-2-

their service offerings and have increased greatly the number of
locations at which these services are provided.
Accelerating demands for new banking services can have
both positive and negative implications for bank soundness.

On

the plus side, they can open up important new profit opportunities.
For example, some American banks that blazed the trail in international banking have found this area to be particularly profitable
and now derive a substantial amount of their current earnings from
this source.

Moreover, developing new products and serving additional

geographic areas enable banks to diversify their operations, thereby
reducing risk.
On the other hand, serving new product and geographic
markets can present problems.

Such expansion requires bankers to

acquire new skills and to assimilate a great deal more information.
It also requires bankers to cope with new types of risks.

For

example, the expansion of U.S. banks abroad has required management
to deal with such forms of risks as country risk and foreign-exchange
risk.
A second major change in the banking environment in recent
years is that banking has become considerably more competitive.
trend is evident almost everywhere we look.

This

We see the large money-

center banks opening loan production offices throughout the nation
and competing against the large regional banks for business loans.







-3-

We see banking organizations, through the holding company structure,
expanding throughout much of the nation to serve local mortgage and
consumer lending markets•

We also see large U.S. banks competing

more and more with large foreign banks in the major financial
centers abroad.

And, finally, we have seen foreign banks enter

the U.S., sometimes on a more favorable basis, and win a significant
portion of the business loan market.
In addition to this increasing competition within commercial banking, we are witnessing a gradual homogenizing of the entire
financial sector.

Little by little, savings and loan associations,

mutual savings banks and credit unions are becoming more like banks
as limiting legislation is removed and new ways to avoid restrictive
barriers are found.

To a lesser extent, banks are also experiencing

increased competition from other types of financial institutions and
even from some firms outside the financial sector.
This constantly increasing competitive environment is
certainly desirable for bank customers.

But for banks, increased

competition may exert downward pressure on profit margins.

With

profit margins falling, banks in recent years have had the option
of accepting these lower margins or taking greater risks in order
to maintain them.

Banks have responded by doing both.

Finally, during the 1970s, banks also have had to operate
in a much less hospitable economic environment than during the two

-4-

previous decades*

This was most dramatically demonstrated by the

deep recession in 1974-75 when banks experienced large loan losses
and had to contend with the only significant erosion of public confidence in banks in several decades.

However, the banking system

did weather the problems of the mid-1970s, and since then bank
managements have become more conservative in their philosophy and •
operations.

Yet, given the key role that banks must play in financing

our economy, there are obvious limitations in the adjustments that
managements can make.

Consequently, if the domestic and international

economy in the future should continue to exhibit the degree of instability of the 1970s, we must expect that some banks will experience
occasional problems.
Having discussed some of the recent fundamental changes
in the environment in which banks operate, I would like to turn to
the Board's overall assessment of the current condition of the
banking system.

During last year's testimony, Chairman Burns stated

that the condition of the banking system had improved during 1976.
I am happy to report that—by most traditional measures—this
improvement continued during 1977 and into early 1978.

Moreover,

in the Board's judgment, the banking system today is in good condition.
Probably the most important factor accounting for the
improvement in banking in the last year or so has been the continued
expansion of the economy.




Last year, real gross national product

-5-

rose almost 5 percent, after rising 6 percent the previous year.
This steady expansion in the economy clearly played a role in the
decline in bank failures in 1977 to only six.
But the improvement in the condition of the banking system
has been due to more than a healthier economy.

In the past several

years, bankers have demonstrated a more conservative approach to
lending, capital and liquidity than they exhibited during the early
1970s.

Moreover, bankers have been diligent in trying to work out

the large amount of loans that became troublesome during the recent
recession.

Finally, I believe that bank supervisors can claim some

credit for the improvements in banking.

During the last few years,

they have used a variety of measures to persuade individual banks
to strengthen their financial conditions and to avoid unwarranted
expansion.
So far I have painted a rather positive picture of recent
trends in the condition of the banking system.

However, I want to

emphasize that problems and challenges still remain.

The number of

problem banks is still large by historical standards and the volume
of troubled loans in bank portfolios is still uncomfortably high.
These and other problems will continue to require the close atten-




tion of both bankers and bank supervisors.
Another important challenge is posed by the continuing
erosion of membership in the Federal Reserve System.

Over the past

-6-

five years, 254 banks have left the System, and the proportion of
total bank deposits held by member banks has dropped from 77 percent
to 72 percent.
The increased willingness of banks to drop their membership in the Federal Reserve System has a simple cause.
too costly to be a member.

It is just

Member banks are required to hold a

significantly larger proportion of their assets as non-earning cash
reserves than are other banks and savings institutions.

And in this

period of inflation and increased competition between banks and other
institutions in providing payments services, the burden of membership
is particularly severe.
Fair competition among member banks and other depository
and credit institutions requires that this membership burden be
eliminated.

If it is not, we can expect a continued, probably an

accelerated, erosion of membership in the Federal Reserve.

This

threatens to weaken our financial system, as more and more of the
nation's payments and credit transactions are handled outside the
safe channels of the Federal Reserve, as fewer and fewer banks have
immediate access to Federal Reserve Bank credit facilities, as a
national presence in bank supervisory and regulatory functions becomes
increasingly diluted, and as implementation of monetary policy becomes
more difficult.
I have now completed my general remarks.

Governor Coldwell

will now present the balance of the Board's testimony.







Mr. Chairman, I would first like to review recent trends
in the principal indices of bank soundness.

These indices include

bank asset quality, liquidity, capital and earnings.

In our

judgment, an understanding of trends in these indices is crucial
in evaluating the current condition of the banking system and
formulating bank supervisory policy.
The quality of bank assets is reflected by the volume
of assets classified by bank examiners and by the volume of nonearning assets being carried by banks.

During 1977, the amount of

classified assets of insured banks declined by about 10 percent,
after more than tripling between 1973 and 1975.

Moreover, the

amount of assets classified by examiners as doubtful and l o s s —
the two most serious classifications—declined by about 20 percent.

Banks with assets exceeding $5 billion experienced a slightly

greater relative decline in classified assets than did the rest of
the banking system.

However, these large banks still have a much

higher level of classified assets relative to their capital than do
other banks.
Other measures of bank asset quality also have shown
marked improvement.
assets (which include

Available data indicate that nonperforming
non-accruing loans, renegotiated loans, and

real estate acquired in foreclosure) fell roughly 15 percent last
year—despite a 13 percent rise in total bank assets.

-8-

The major asset problem still facing banks is troubled
real estate loans.

Many of these loans were made during the real

estate boom of the early 1970s to finance projects that became at
least temporarily difficult to market.

Many banks have been forced

to carry large amounts of these loans on a non-earning basis, thereby
depressing their earnings.

During 1977 and early 1978, the demand

for these real estate projects continued to pick up, and as projects
were sold off, the quality of bank real estate portfolios improved.
This progress, however, has been slow, and still more time and
improvement in certain segments of the real estate sector will be
required before these loans are worked down to a more reasonable
level.
At present, the banking system appears to be in a satisfactory liquidity position, partly due to a sizable build-up in U.S.
Government securities during 1975 and 1976.
bank liquidity decreased.

Last year, however,

First, banks significantly increased

their reliance on relatively volatile liabilities such as large
time deposits and Federal funds.

In addition, banks slightly

reduced their holdings of securities with maturities of less than
one year.
From the end of World War II through 1974, bank capital
ratios declined almost steadily.

Moreover, this decline picked up

momentum during the early 1970s when rapid asset growth, particularly







-9-

abroad, far outdistanced the growth of capital.

It was during

this period that the capital ratios of some of the Nation's major
banks declined to what we regard as undesirably low levels.
Since 1974, however, bank capital ratios generally have
improved—rising sharply in 1975, climbing somewhat more in 1976,
before declining moderately last year.

A primary factor in last

year's decline was the rapid 13 percent growth in bank assets.
In recent years, banks have relied principally on retained
earnings to build up their capital.

In the aggregate, banks

typically retain about 60 percent of their net income.

Recently,

most external financing of banks has been supplied by bank holding
companies, which now own almost all of the Nation's largest banks.
These holding companies in turn have resorted largely to long-term
debt issues to obtain funds.

One reason for their heavy reliance

on long-term debt, at least since 1974, is that the market value of
bank holding company stock has been depressed.

Even today, the

stocks of many of the Nation's largest holding companies are selling
at only six to eight times earnings, and many also sell well below
book value.

These unfavorable market conditions have made it very

costly for these organizations to add to their equity capital
through the sale of common stock.

As an alternative, several large

holding companies have recently resorted to issuing preferred
stock.

-10-

Another key factor in determining the condition of the
banking system is bank earnings.

Last year, earnings were impres-

sive, with net income of insured banks up 13 percent over the 1976
level•

Several factors were primarily responsible for this per-

formance.

The first was the rapid growth in earning assets, with

loans alone up over 15 percent.

Second, provisions for loan losses

declined about 11 percent, reflecting an even sharper drop in actual
net loan charge-offs.

Third, the amount of loans on which interest

was not accruing was reduced significantly.
It should be pointed out to the Committee that the favorable earnings presented by the banking data are based on generally
accepted accounting principles which do not take adequate account
of inflation.

As you know, inflation erodes nominal monetary values,

including bank capital, assets, and liabilities.
The one major factor that hindered earnings last year was
narrower spreads between yields on earning assets and the cost of
funds.

For example, the spread between the prime rate, which banks

charge their best domestic customers, and the rate that banks pay
on their large certificates of deposit averaged 1.3 percentage points
during 1977, compared to 1.7 percentage points during the prior year.
Banks also experienced some reduction in spreads on their foreign
business during 1977.

These reductions in spreads, both here and

abroad, are evidence of increasing competition among financial
institutions•







-11-

During the first quarter of this year, banks continued
their strong earnings performance in nominal terms.

While complete

data are not yet available, net income appears to have increased by
about 20 percent over the first quarter of 1977.

Declining loan

loss provisions and a reduction in nonperforming assets again accounted
for part of the improvement.

But foreign exchange operations also

contributed strongly to increased profits for some large banks.
Having briefly reviewed the principal indices of bank
soundness, I would now like to turn to several potential problem
areas that have recently received considerable public attention.
The first area is the agricultural sector, where net income from
farm operations last year was about one-third below the prosperous
years of 1973-74.

This decline has been due both to escalating costs

of production and to declines in commodity prices.

In contrast to

declining income, farm debt has risen by about 60 percent since 1974.
These unfavorable financial trends have made it difficult
for some farmers to service their debt.

As a result, some farm banks

have experienced slower loan repayments and increased requests for
loan extensions.

So far, however, farm banks have not experienced

a serious deterioration in the quality of their loan portfolios.
Moreover, while the loan-to-asset ratios of many of these banks
are significantly higher than normal, these banks generally have
not encountered serious liquidity problems.

In sum, most farm banks

-12-

are now in satisfactory condition and should continue to prosper,
assuming that the recent squeeze on farm profits does not continue
for an extended time.
Another area of concern is the financial condition of
New York City.

As we all remember, the near-default of New York

City in 1975, following the severe recession and the failure of
several large banks, sent shock waves throughout the financial community.

Since 1975, New York has made considerable progress toward

putting its financial house in order.

However, it has not been able

to regain access to capital markets, and since 1975 it has had to
rely on the Federal Government for financial support in the form
of seasonal loans.

Continuation of some form of Federal aid beyond

this June is now being considered by the Congress.
In order to determine the exposure of U.S. banks to a
possible default by New York City on its obligations, the three
Federal bank supervisory agencies, in early 1978, completed a survey
of the ownership of New York securities by commercial banks.

The

obligations covered included those issued by New York City, by New
York State, by New York State agencies, and by the Municipal Assistance Corporation.
Briefly, the early 1978 survey indicated that 306 banks
held New York securities exceeding 20 percent of equity capital.
New York City obligations held by these 306 banks totalled $554 million







-11-

During the first quarter of this year, banks continued
their strong earnings performance in nominal terms.

While complete

data are not yet available, net income appears to have increased by
about 20 percent over the first quarter of 1977.

Declining loan

loss provisions and a reduction in nonperforming assets again accounted
for part of the improvement.

But foreign exchange operations also

contributed strongly to increased profits for some large banks.
Having briefly reviewed the principal indices of bank
soundness, I would now like to turn to several potential problem
areas that have recently received considerable public attention.
The first area is the agricultural sector, where net income from
farm operations last year was about one-third below the prosperous
years of 1973-74.

This decline has been due both to escalating costs

of production and to declines in commodity prices.

In contrast to

declining income, farm debt has risen by about 60 percent since 1974.
These unfavorable financial trends have made it difficult
for some farmers to service their debt.

As a result, some farm banks

have experienced slower loan repayments and increased requests for
loan extensions.

So far, however, farm banks have not experienced

a serious deterioration in the quality of their loan portfolios.
Moreover, while the loan-to-asset ratios of many of these banks
are significantly higher than normal, these banks generally have
not encountered serious liquidity problems.

In sum, most farm banks

-12-

are now in satisfactory condition and should continue to prosper,
assuming that the recent squeeze on farm profits does not continue
for an extended time.
Another area of concern is the financial condition of
New York City.

As we all remember, the near-default of New York

City in 1975, following the severe recession and the failure of
several large banks, sent shock waves throughout the financial community.

Since 1975, New York has made considerable progress toward

putting its financial house in order.

However, it has not been able

to regain access to capital markets, and since 1975 it has had to
rely on the Federal Government for financial support in the form
of seasonal loans.

Continuation of some form of Federal aid beyond

this June is now being considered by the Congress.
In order to determine the exposure of U.S. banks to a
possible default by New York City on its obligations, the three
Federal bank supervisory agencies, in early 1978, completed a survey
of the ownership of New York securities by commercial banks.

The

obligations covered included those issued by New York City, by New
York State, by New York State agencies, and by the Municipal Assistance Corporation.
Briefly, the early 1978 survey indicated that 306 banks
held New York securities exceeding 20 percent of equity capital.
New York City obligations held by these 306 banks totalled $554 million







-15-

for the banks to obtain full information about the capabilities
of individual foreign borrowers and of borrowing foreign countries
to service external indebtedness.
In the last year, U.S. bank supervisory authorities have
made considerable progress in adding to the information available
on the external lending of U.S. banks.

A new comprehensive report—

jointly developed by the Federal Reserve, the Comptroller of the
Currency and the Federal Deposit Insurance Corporation—now periodically obtains information from the major banks about the country
distribution of their international loan portfolios with breakdowns
by broad category of customer and by maturities.

This information

is structured to provide a better assessment of the country risks
in the banks 1 international loan portfolios.

As such, it allows

the banking agencies to be more watchful about these risks in
individual banks.
Aggregate data from the first country exposure survey,
which was conducted in June, 1971, was released early this year.
This survey included all U.S. banks with total assets exceeding
$1 billion.

These banks reported having, in aggregate, $164

billion in claims on foreigners which were denominated in currency
other than that of the foreign country.

They also had an additional

$45 billion in local currency claims that were largely funded by
local deposits.

Seventy percent of these $209 billion of claims were

-16-

on, or were guaranteed by, residents of developed countries, usually
Group of Ten countries.
The survey also showed that banks had $46 billion of credit
outstanding to non-oil producing less developed countries (LDCs) and
Eastern European countries*

This amounted to about 6.5 percent of

the total assets of these banks.
In December of last year, the second survey of the foreign
lending of U.S. banks was conducted, and the results should be available shortly.

This survey will furnish valuable information to the

banks in their own efforts to assess, control and monitor their
international lending.

In addition to the survey results, coopera-

tive efforts among central banks and international institutions are
continuing to add to the information available to commercial banks
about external borrowings and external indebtedness of the main
borrowing countries.
While country risk is a proper subject for concern,
perspective must be maintained on the country exposures of U.S.
banks.

Actual defaults by countries on their external debts,

public or private, have been rare in recent experience.

The

risks to the banks, therefore, are less in terms of ultimate
collectibility of credits than in terms of liquidity and income
resulting from possible failure of countries to service properly
their external borrowings.







-17-

While the recent, slower pace of international lending
by U.S. banks and the apparent heightened sense of caution in that
lending are healthy developments, there are still several areas
for concern.

First, a few countries to which U.S. banks have made

loans are having serious economic and financial problems and are
having difficulty in servicing their external debts promptly.
Second, some U.S. banks have a rather sizable exposure in individual
countries relative to their capital and reserves.

Finally, interest

rate spreads on some recent international loans have narrowed and
maturities have lengthened to an extent where the return to banks
may not be commensurate with the risks involved.

This development

is somewhat worrisome because international earnings now comprise a
substantial portion of the total earnings of our largest banks and
because earnings remain the principal source for strengthening their
capital positions.
Before concluding this testimony, I would like to inform
the Committee what the Federal Reserve has done in the last year
to improve our policies and procedures for supervising state member
banks and bank holding companies.

Some of these changes have

resulted from problems that had surfaced in recent years.

In

November, 1977 the Board approved an expanded program for the
inspection of large bank holding companies.

The two essential

elements of the program are an increased frequency of inspections
and the standardization of the inspection report.

-18-

All bank holding companies with consolidated assets in
excess of $300 million will now be inspected annually—unless nonbanking activity and parent company debt are considered minimal,
in which case inspections will continue to be conducted once every
three years.

The impact of the increased frequency of inspections

will be approximately to double the number of large holding companies inspected on an annual basis and to increase the percentage
of total holding company assets inspected annually from about 45
percent in 1976 to 85 percent when the program is fully operational.
The standardization of the report form is expected to
provide a variety of benefits, including the framework for a comprehensive review of nonbank assets and holding company debt levels,
greater consistency, an increase in the on-site efficiency of the
inspection process, the capacity for centralized training of inspection personnel, and the ability to allocate personnel more efficiently
among the Reserve Districts.
During the past year, the Board, in conjunction with
the Reserve Banks, has implemented a bank surveillance system that
aids in the identification of actual and potential financial problems of banks.

In addition, several new bank holding company sur-

veillance capabilities were developed to enhance existing screening
techniques, data collection systems, and analytical reports.

Recently,

resources have been devoted to improving supervisory reports used in







-19-

the surveillance process, to streamlining the reports so as to
reduce reporting burden on respondents, and to expediting the use
of the data.
I want to emphasize that 1977 saw further accomplishments
in interagency cooperation and standardization of procedures.
Central to the success of this effort was the formation of the
Interagency Supervisory Committee in March of 1977.

This Committee,

which is an adjunct of the Interagency Coordinating Committee,
consists of the senior supervisory officials of the Federal Deposit
Insurance Corporation, Office of the Comptroller of the Currency,
Federal Home Loan Bank Board, National Credit Union Administration,
and Board of Governors of the Federal Reserve System.

The purpose

of the Committee, which meets monthly, is to review supervisory
issues and practices and to develop wherever possible uniform
policies and procedures.

During its first year of operation, the

Committee inaugurated the uniform shared national credit program in
which a team of examiners from the three agencies annually reviews
loans in excess of $20 million that are shared by two or more banks.
Such review eliminates the need for a separate analysis of the loan
at each participating bank and leads to consistent treatment by
examiners.

Second, agreement among the agencies has been reached

on the definition of a concentration of credit.

This agreement will

insure a consistent treatment of credit concentration by the three

-20-

agencies in future years.

Third, staff of the three agencies have

agreed on the principles of a uniform system for rating all banks,
and each agency is currently testing the system.
In closing, Mr. Chairman, I would like to restate the
central thesis of our testimony—that while continued vigilance
is still necessary, the condition of the banking system is now
good and, by most measures, is better than it was at the time of
last year f s hearings.




Chart 1

NUMBER AND TOTAL ASSETS OF STATE MEMBER BANKS
WITH COMPOSITE 3 OR 4 RATINGS, 1972-77
Number of banks
70!

Total assets, billions of dollars
M00

Number of Banks
^
60

80

50

60

40

40

30

20




1973

1975

1977

Chart 2

AMOUNT AND GROWTH OF TOTAL ASSETS AND TOTAL LOANS OF
ALL INSURED COMMERCIAL BANKS, 1970-77
Billions of dollars

1200

1000

800

600
Total Loans

400

I
1970




1971

1972

1973

1974

1975
1976
1977
Percentage increase during the year

H24
20

16

12

1971

1973

1975

1977




Chart 3

AMOUNT OF CLASSIFIED ASSETS OF MEMBER BANKS, 1973-77

Billions of dollars

40

30

20

10

1973

1975

1977

Chart 4

CLASSIFIED ASSETS OF MEMBER BANKS AS
A PER CENT OF TOTAL ASSETS, 1973-77
Per cent
4

1973




1975

1977




Chart 5

PROVISION FOR LOAN LOSSES AS A PER CENT OF
TOTAL LOANS FOR ALL INSURED COMMERCIAL BANKS, 1970-77
Per cent
10.70

0.60

0.40

0.30

0.20
1971

1973

1975

1977

Chart 6

PROVISION FOR LOAN LOSSES AS A PER CENT OF
PRE-TAX INCOME FOR ALL INSURED COMMERCIAL BANKS, 1970-77




Per cent
1 .50

.40

.30

.20

.10

1971

1973

1975

1977




Chart 7

AMOUNT AND GROWTH OF EQUITY CAPITAL
OF ALL INSURED COMMERCIAL BANKS, 1970-77
Billions of dollars

80

70

60

50

40

I

f

I

Percentage increase over prior year

12

1971

1973

1975

1977

Chart 8

CAPITAL RATIOS FOR ALL INSURED COMMERCIAL BANKS, 1970-77




Per cent
10

Equity Capital/Risk Assets

Equity Capital/Total Assets

1971

1973

1975

1977

5




Chart 9

AMOUNT AND GROWTH OF NET INCOME
OF ALL INSURED COMMERICAL BANKS, 1970-77
Billions of dollars

Net Income

1971

1973

1975

1977

Chart 10

NET INCOME AS A PER CENT OF TOTAL ASSETS FOR
ALL INSURED COMMERCIAL BANKS, 1970-77




Per cent
0.85

0.80

0.75

0.70

?
1971

1973

1975

1977




Chart 11

NET INCOME AS A PER CENT OF EQUITY CAPITAL
FOR ALL INSURED COMMERCIAL BANKS, 1970-77
Per cent
13.0

12.5

12.0

11.5

1971

1973

1975

1977

Chart 12

DIVIDEND PAYOUT RATIO FOR ALL INSURED COMMERCIAL BANKS, 1970-77




Percent
45

44

43

42

41

40

39

38

37

36

1971

1973

1975

1977