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PR-76-75 (9-27-75)


3Gtl* rarö
S EP 2 6 1975

Digitized fed
er a l d e p o s i t INSURANCE

Address by

George A. LeMaistre
Federal Deposit Insurance Corporation

Before the
Executive Management Seminar
of the
First City National Bank of Houston
Houston, Texas

September 27, 1975

CORPORATION, 550 Seventeenth St. N. W.( Washington, D. C. 20429

202 389-4221

Address By
George A. LeMaistre
Federal Deposit Insurance Corporation
at the
Executive Management Seminar
of the
First City National Bank of Houston
Houston, Texas
September 27, 1975

Lhen economic historians consider the mid-seventies, the period
Lay well be seen as a watershed in the banking industry. The
[shape and direction of resulting change are far from clear in some
respects. For example, electronic banking is upon us; yet its
evolution and impact on banking structure depend on policy choices which await the attention of Congress.
Similarly, Congress must
resolve the difficult issues involving the structure of competition
among financial institutions and interest rate regulation raised
by the Hunt Commission as well as the hard questions posed by the
increasing dominance of the largest holding company systems.
(forces are at work, however, where the direction of change is more
I will focus on developments in one such area:
the response
of bank regulators to problems revealed by large bank failures and
(other shocks of the past eighteen months.
(However traumatic, these problems have taught us a number of valuable
lessons. For example, the Franklin failure illustrated dramatically
some of the risks of international operations and liability management
banking. Moreover, they proved conclusively that the giants of the
industry are no more exempt from the penalties of incompetence or
¡overreaching than a $5 million unit bank in west Texas.
As a consequence, bank supervision is undergoing a reappraisal which
could have more significant long-run consequences than the recent
'retrenchment by bankers.
Each agency is undertaking careful and,
at times, painful study and revision of supervisory procedures, regu
lations aimed at insuring safety and soundness, and enforcement powers.
In addition, the tripartite framework of regulation has been questioned
and is undergoing vigorous scrutiny in the Congress.
The efforts o
the Comptroller of the Currency are, of course, reflected in the
recently released and well-publicized study of his office by an ou si e
consulting firm.
As indicated in the testimony of Chairman Wille
and Governor Holland before Congressman St. Germain's House Subcommittee
on Financial Institutions, Supervision, Regulation and Insurance, both
the FDIC and the Federal Reserve System have conducted programs of
review and modernization.
Of immediate practical consequence for you, as bankers, are recent
and forthcoming changes in regulation and examination procedures,
demise of U.S. National Bank in San Diego, which awakened the country



to the fact that a billion dollar bank could fail, has been
responsible, at least in part, for new or proposed regulation
in two areas.
You are all familiar with the letter of credit
regulations issued by each of the agencies last year as a direct
outgrowth of USNB use of this device to avoid lending limit restricj
Of more far-reaching import may be the attention focused on insider
USNB's insolvency was caused by the wholesale and unsound
extension of credit to persons and entities controlled by or asso­
ciated with the controlling stockholder and former board chairman
or, in the words of Comptroller of the Currency Jim Smith, a
" . . . riot of self-dealing."
Involving 200-300 corporate entities
the insider related transactions amounted to between $400 and $450
In response to this graphic demonstration of the harm tha
flows from abuse of an insider's relationship with his or her bank]
the Comptroller has implemented a disclosure regulation aimed at
uncovering abusive self-dealing.
The need for more vigorous supervision of insider transactions by
bank boards of directors and bank supervisory agencies is not based
on the USNB case alone.
Abusive self-dealing has been a significanj
contributing factor in more than half of all bank failures since
1960, including the failure of 29 nonmember insured commercial
Losses to the deposit insurance fund as a result of these
failures are likely to amount to at least $175 million.
A review
of existing and past "problem" bank cases also revealed a similarly!
high incidence of abusive self-dealing as a source of serious diffi
Even where the immediate result is not the bank's failure
or its designation as a bank requiring close supervision, an inside!
transaction that is not effected on an "arm's length" basis might
lead to a diminution of the b a n k 's earnings and an erosion of its
capital — thereby increasing the risk of loss to depositors and
minority shareholders and ultimately to the deposit insurance fund
In response to these facts the FDIC published for public comment on!
September 3 a proposed regulation which takes an approach somewhat
different from that of the Comptroller.
The proposed regulation
would seek to minimize abusive self-dealing through the establishmen!
of procedures which will insure that bank boards of directors super
vise such transactions effectively and better enable Corporation
examiners to identify and analyze such transactions.
The Board of
Directors of each insured nonmember commercial bank would be requir
to review and approve each insider transaction involving assets or
services having a fair market value greater than a specified amount
which varies with the size of the bank.
In addition, certain recor
keeping requirements would be imposed in order to foster effective
internal controls over such transactions by the bank itself and to
facilitate examiner review.

Finally, the proposed regulation sets forth factors which will
be considered by the Corporation's Board of Directors in deter­
mining whether such insider transaction or transactions indicate
the presence of unsafe or unsound banking practices and should
be the subject of supervisory action.
These factors include:
whether, because of preferential terms and conditions, such tran­
sactions are likely to result in significant loan losses, exces­
sive costs, or other significant economic detriment to the bank
that would not occur in a comparable arm's length transaction with
a. person of comparable creditworthiness or otherwise similarly
situated; whether transactions with an insider and all persons
related to that insider are excessive in amount, either in relation
to the bank's capital and reserves or in relation to the total of all
transactions of the same type; and whether from the nature and extent
of the bank's insider transactions it appears that certain insiders are
abusing their positions with the bank.
Although the Corporation has determined that insider transactions
require special supervision by bank boards of directors and close
scrutiny by the Corporation's examiners, this determination does
not mean that all transactions with insiders or their interests
are detrimental to the bank in question or that such transactions
should be automatically rejected.
Indeed, in many smaller communities,
commercial life would be virtually impossible absent extensive dealing
between financial institutions and "insiders."
The Corporation has
sought to avoid unrealistic prohibitions or unduly burdensome
reporting requirements; rather the Corporation has emphasized Board
of Directors' responsibility in overseeing the affairs of the
The importance of this approach is dramatically reflected
in the words of a Director of the recently failed Northern Ohio
Bank who is reported to have said:
Most of us, including myself, functioned as a rubberstamp board approving all decisions made by management
and rewarding management with salary increases . . . for
what we were led to believe was an outstanding performance
in guiding us to fast increasing earnings and assets.
The troubles of Franklin and American Bank and Trust and the distress
merger of the Beverly Hills National Bank, which was precipitated by
the difficulties of a non-bank holding company affiliate, have insured
that other facets of banking will also receive greater emphasis in the
examination and supervision process.
Foreign operations and the
operation of non-bank affiliates of bank holding companies will
certainly be subjects of increased scrutiny.
Moreover, as a conse­
quence of excesses in practice of liability management which were
highlighted by the liquidity squeeze of last summer and fall, bankers
will find examiners probing more deeply and critically into a bank s
liability structure.
Most importantly, deference to size, born or


the belief that large banks could not fail, is a thing of the
We have learned that the adverse effects of large bank
failures on public confidence, the banking system and the deposit
insurance fund are of sufficient magnitude that big banks should
be supervised more, not less, strictly than their smaller compe­
In addition to careful review of the adequacy of the examination
process, concern engendered by large bank failures has led to
increased interest in the development of so-called "early warning
systems." An integral part of the program of modernization of the
Comptroller's Office proposed by Haskins and Sells is the implemen­
tation of such a system, called the National Bank Surveillance
The purpose of an early warning system was suggested by
Harry Keefe, President of Keefe, Bruyette and Woods, when he said
of Franklin, "People who can read a balance sheet were out of there
long ago." Essentially, early warning systems employ financial
statement analysis to distinguish potential problem banks.
At the FD I C , we have been at work in this area for at least three
Our Division of Bank supervision and our Office of Management
Systems have developed a program which allows examiners to compare
any bank with its "peers" in terms of twenty financial ratios.
this program does not purport to be a certain method of detecting
"problem" or failing banks, it does provide supervisory personnel
with a quick indication of potentially troublesome trends.
At the same time our Research Division has employed somewhat more
sophisticated tools of statistical analysis to develop a model
employing a group of variables that is most successful in distinguishing!
problem and nonproblem institutions.
While we are optimistic that the
use of such a system, when fully operational, may be a useful super­
visory tool, I should hasten to point out the limitations of all
"early warning systems." Most importantly, such a system is not
a "black box" which will magically grind out a list composed of all
the problem institutions existing at a particular time.
Nor is
it possible to develop such a system.
Inevitably some banks which
are identified by the model will be perfectly sound institutions,
while severe problems will be missed, especially where there is fraud.
Accordingly, such systems should not be blindly relied upon in
evaluating an institution nor can they eliminate the function of the
examiner in the bank itself.
Rather, it is hoped that they will be
an effective tool of examination, enabling the agencies to allocate
examination resources more efficiently and, at times, identifying
a potential failure that might otherwise have been overlooked until
it was too late.
In addition to improving techniques for identifying problems, the
agencies are seeking to improve supervisory procedures for remedying
problems when they occur.
This has resulted in intensified monitoring


and increased senior staff review of problem situations, an
increased flow of information among the federal agencies, con­
sideration of the use of teams specializing in the work-out of
problem situations and réévaluation of the legal remedies and
sanctions available to the agencies to effect corrective measures,
In this last regard, the three federal banking agencies have made
recommendations to the Congress which would enhance considerably
our ability to deal with practices which have produced bank failures
and problem institutions.
First of all, we have recommended legis­
lation which would allow the supervisory agencies to aggregate
loans or other extensions of credit to insiders and their interests
for the purposes of application of the lending limits thereby closing
serious loopholes in these provisions.
Second, the proposed legis­
lation would greatly expand the power of the agencies to impose
fines for serious violations.
Third, we have proposed that the
existing cease and desist powers be amended to specifically apply to
officers, directors, employees, agents or other persons participating
in the conduct of the affairs of the bank.
Fourth, the proposed
legislation would allow removal of officers who are grossly negli­
gent or demonstrate a willful disregard for the safety and soundness
of a bank.
And, finally, the package would authorize the Federal
Reserve Board to order divestiture of a bank holding company subsi­
diary or termination of a nonbanking activity when the Board has
cause to believe that the ownership or activity constitutes a
threat to the holding company's subsidiary bank or banks.
In addi­
tion, the agencies have under serious consideration a broader defi­
nition of the term "affiliate" for lending purposes.
The most significant change that might come about as a result of
recent industry difficulties would, of course, be agency restruc­
turing. Periodically since the Depression, proposals have appeared
suggesting restructuring of our tripartite system of federal bank
Consistently, they have been relegated to library shelves.
In the present environment, however, the impetus for change has come
from a variety of sources.
Describing the existing regulatory frame­
work as a "jurisdictional tangle that boggles the mind," Chairman
Burns of the Federal Reserve indicated soon after the closing of
Franklin that the Board staff had been studying the subject of
agency restructuring and would come forward with a proposal this
Since that time, two governors of the Federal Reserve
liBoard have advanced alternative plans: one calling for consolidation
fof all bank supervision and regulation in the Fed and the other suggesting
the creation of a new single supervisory agency separate from the
Fed. However, the Board indicated in July that it does not now
favor radical agency realignment as suggested by Chairman Burns,
Governor Bucher, and former Governor Sheehan.
Instead, it has come
forward with a modest proposal involving the formation of a Federal
Bank Examination Council by the three federal agencies.


Nevertheless, there appears to be strong sentiment among the
leadership of the banking committees in Congress favoring sub­
stantial modification of the existing regulatory structure.
Senator Proxmire has introduced legislation which would create a ne
bank supervisory agency along lines proposed some years ago by
former Governor Robertson.
The FINE study now being conducted
bY the House Banking Committee also addresses this issue and is
likely to make specific recommendations.
As Chairman Wille indicated in his testimony before the House
Banking Subcommittee on Financial Institutions, Supervision,
Regulation and Insurance, neither he nor I oppose significant
restructuring of the regulatory framework.
At present, we are
guardedly optimistic that we will be able to recommend proposals
which would achieve significant improvement over the present frame-1
work without concentrating undue power in a single agency.
In assessing the likelihood of agency restructuring, I would have
to say quite candidly that I do not believe that it will happen
in this Congress.
However, given the interest of the chairmen of
the respective Congressional committees, the groundwork may well
be laid for the passage of legislation in the Congress following
the 1976 elections.
In any event, I do think that it is safe to
say that agency restructuring or no, bank supervision will be sig­
nificantly improved as a result of the difficulties of recent
In conclusion, I would simply like to thank you for inviting me
to share these developments with you.
Because they involve the
ongoing interaction of the FDIC and the other agencies with your
banks, I hope that you will share with me your thoughts, concerns
and criticisms in the next few minutes.

o 0 o