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ADDRESS BY GEORGE A. LE MAISTRE, DIRECTOR FEDERAL DEPOSlt INSURANCE CORPORATION BEFORE THE MONTGOMERY COUNTY BANKERS ASSOCIATION GWYNEDD, PENNSYLVANIA MARCH 19, 197b f/RECENT BANK FAILURES IN PERSPECTIVE" Pi a y r o y Ma g a z i n e began an a r tic le in its Fe b r u a r y ISSUE WITH THE ASSESSMENT "AMERICA'S BANKS ARE IN TROUBLE," THE TITLE OF THAT ARTICLE WAS "BANKS ON THE BRINK." NUMEROUS OTHER POPULAR JOURNALS HAVE PUBLISHED ARTICLES WHICH RAISE QUESTIONS REGARDING THE SOUNDNESS OF OUR BANKING SYSTEM, T h i s i s , of c o u r s e , t o b e e x p e c t e d . N i n e t e e n s e v e n t y four WAS A DIFFICULT YEAR FOR THE INDUSTRY, SUCH FACTORS AS THE PROTRACTED ORDEAL OF FRANKLIN NATIONAL BANK, UNPRECEDENTED INTEREST RATES, THE SUDDEN DEMISE OF AMERICAN BANK AND TRUST in So u t h Ca r o l i n a , t h e d i s t r e s s m e r g e r of S e c u r i t y Na t i o n a l in New Yo r k , n o t o r i e t y g i v e n b a n k f a i l u r e s a n d o t h e r d e v e l o p m e n t s a b r o a d , a n d t h e c u r r e n t p r o s p e c t of l a r g e l o a n l o s s e s r e s u l t i n g f r o m t h e e c o n o m y 's d e c l i n e h a v e c r e a t e d an and c o n c e r n . AIR of u n c e r t a i n t y W h i l e t h e b r o a d b a s e of p u b l i c c o n f i d e n c e r e m a i n s UNSHAKEN, BANKING^ IMAGE HAS BEEN TARNISHED. - 2 - M o r e o v e r , t h e e c o n o m i c o u t l o o k for t h e r e m a i n d e r of 1975 a n d 1976 is m o r e g l o o m y t h a n a n y s i n c e t h e T h i r t i e s , Pr e s i d e n t Fo r d in his r e c e n t Ec o n o m i c Re p o r t of t h e P r e s i d e n i STATED I "The e c o n o m y is in a s e v e r e r e c e s s i o n . Un e m p l o y m e n t is t o o h i g h a n d w i l l r i s e h i g h e r . inflation T he r a t e of is a l s o t o o h i g h , a l t h o u g h s o m e p r o g r e s s has been ma de in l o w e r i n g i t ." An d , s t i l l m o r e r e c e n t l y , A r t h u r O k u n , r e s p e c t e d e c o n o m i s t a n d former Ch a i r m a n of t h e Pr e s i d e n t ’s Co u n c i l of Ec o n o m i c Ad v i s o r s is r e p o r t e d t o h a v e u s e d t h e t e r m "d e p r e s s i o n " in r e f e r r i n g t o t h e c o n d i t i o n of t h e e c o n o m y . The "Ba n k i n g Ho l i d a y of 1933" m a y h a v e o c c u r r e d m o r e THAN FORTY YEARS AGO, BUT THE DISLOCATION AND SUFFERING THAT RESULTED FROM THE MASSIVE CLOSINGS ARE ALL TOO VIVID IN THE MINDS OF MANY. - 3 T h u s , it is i m p o r t a n t t h a t y o u a s b a n k e r s kn o w t h e f a c t s ABOUT RECENT BANK FAILURES SO THAT YOU CAN RESPOND TO QUERIES IN YOUR OWN COMMUNITY WITH CANDID AND PLAIN TALK. Ca r t e r Go l e m b e s t r u c k w h a t s e e m s to b e a p r o p e r b a l a n c e in his r e c e n t r e p o r t "Ba n k Fa i l u r e s a n d A ll T h a t "— w h i c h , ALTHOUGH I DO NOT AGREE WITH EACH OF HIS CONCLUSIONS, I WOULD RECOMMEND TO THOSE OF YOU WHO WISH TO PURSUE THIS SUBJECT FURTHER. A p p r o p r i a t e l y e n o u g h , in l i g h t of p r e s s c o v e r a g e s u c h as the P l a y b o y a r t i c l e s , he b e g a n h i s d i s c u s s i o n w i t h t h i s f a m i l i a r EXCERPT FROM A c h i l d r e n 's STORY: "One d a y H e n n y P e n n y w a s p i c k i n g up c o r n in t h e FARMYARD, WHEN AN ACORN FELL OUT OF A TREE AND STRUCK HER ON THE HEAD. 'Go o d n e s s g r a c i o u s m e !' s a i d H e n n y P e n n y , SKY IS FALLING. I MUST GO AND TELL THE KlNG.'" Br . Go l e m b e w e n t o n t o s t a t e : is f a l l i n g . 't h e "We do not b e l i e v e th at the sky . . . But w e d o b e l i e v e t h a t t h e t i m e is p r o p i t i o u s FOR A CLOSER LOOK AT SOME OF THE IMPORTANT ISSUES RAISED BY ..RECENT BANK FAILURES." IN MY JUDGMENT.. Dr . Go LEMBE IS CORRECT ON BOTH COUNTS. S ince o u r t w o l a r g e s t b a n k f a i l u r e s w e r e e x p e r i e n c e d I IN 1973 AND 1974, t h e r e has b e e n a t e n d e n c y t o f o r g e t t h a t I BANK FAILURE HAS BEEN A RARE EVENT IN RECENT TIMES. THE ESTABLISHMENT OF THE I I SINCE FDIC IN 1933 THE TOTAL NUMBER OF " . . :. V FAILED BANKS, BOTH INSURED AND UNINSURED, IS APPROXIMATELY THE SAME AS THE AVERAGE ANNUAL NUMBER OF BANK FAILURES DURING THE PROSPEROUS YEARS OF THE TWENTIES. 1934, there have been only 647 INSURED AND UNINSURED INSTITUTIONS. BEEN ONLY AN 634 BANKS FAILED PER YEAR FROM 1921 THROUGH 1929. AVERAGE OF S in ce SPECIFICALLY: failures in a l l , i n c l u d i n g SIGNIFICANTLY, THERE HAVE 63 FAILURES OF INSURED BANKS SINCE 1961—AN AVERAGE OF ABOUT 5 PER YEAR DURING THIS PERIOD OF RELATIVELY FREE ENTRY AND INTENSE GROWTH AND COMPETITION. MOREOVER, DESPITE THE VERY SEVERE STRAINS ON OUR ECONOMY AND THE INDUSTRY, THE - 5rate of f a i l u r e h a s n o t increased. In 1974 fo ur b a n k s f a i l e d AND THUS FAR IN 1975,, TWO BANKS HAVE FAILED. A l t h o u g h I w o u l d n o t b e s u r p r i s e d if t h e r a t e of b a n k FAILURE INCREASES SOMEWHAT IF ECONOMIC CONDITIONS CONTINUE TO WORSEN, THESE FIGURES ARE, IT SEEMS TO ME, REMARKABLE TESTIMONY TO THE BASIC SOUNDNESS OF THE BANKING SYSTEM. W h i l e t h e n u m b e r of b a n k f a i l u r e s has not increased IN RECENT YEARS, THERE HAS BEEN A MARKED INCREASE IN THE SIZE OF FAILED INSTITUTIONS. DURING THE 20-YEAR PERIOD FROM 1943 THROUGH 1963, NO INSURED BANK LARGER THAN $17 MILLION IN TOTAL DEPOSITS FAILED. IN CONTRAST, SIX HAD DEPOSITS IN EXCESS OF THE $17 MILLION FIGURE. THE $1,028 BILLION BANK OF THE Co m m o n w e a l t h w o u l d h a v e f a i l e d in 1972 b u t f o r a $35.5 m i l l i o n INFUSION OF SHORT-TERM CAPITAL BY FDIC. IN 1975, THIS TREND HAS ACCELERATED. IN 1974 AND THUS FAR OF THE SIX FAILURES DURING THIS PERIOD, THREE HAD DEPOSITS IN EXCESS OF $100 MILLION. One, the Fr a n k l i n Na t i o n a l Ba n k , h a d $1.3 billion in d e p o s i t s a t -6 - the t i m e of c l o s i n g — -a f i g u r e w h i c h , t h o u g h d r a m a t i c in its OWN RIGHT, UNDERSTATES THE CASE, SINCE FRANKLIN HAD DEPOSITS 0F $3.7 BILLION AND ASSETS OF $4.9 BILLION AS OF JANUARY 1, 1974. Wh i l e d i s t u r b i n g t o m a n y , t h e f a c t t h a t v e r y l a r g e INSTITUTIONS MAY FAIL REFLECTS CERTAIN BASIC TRENDS IN THE INDUSTRY AND SHOULD NOT HAVE COME AS A SURPRISE. The past fifteen years were undoubtedly the most INNOVATIVE PERIOD IN BANKING HISTORY. RESPONDING TO COMPETITION AND THE NEEDS OF CUSTOMERS, BANKING BURST OUT OF ITS STODGY AND CONSERVATIVE SHELL. GEOGRAPHIC BARRIERS IN COMPETITION FELL AS THE HOLDING COMPANY MECHANISM ALLOWED A MULTI STATE PRESENCE, BRANCHING RESTRICTIONS WERE MODIFIED AND BANKS DEVELOPED EXTENSIVE INTERNATIONAL OPERATIONS. INNOVATIVE TECHNIQUES IN STRUCTURING AND MANAGING ASSETS AND LIABILITIES ALLOWED BANKS TO RESPOND TO BOTH THE INCREASED DEMAND FOR CONSUMER SERVICES AND THE SOPHISTICATED REQUIREMENTS OF BUSINESS CUSTOMERS. IN SHORT, BANKS WERE IN TUNE WITH AND RESPONDED AGGRESSIVELY TO - 7 the n e e d s of a c o m p l e x , p r o s p e r o u s a n d expanding e c o n o m y . Ho w e v e r , t h e b e n e f i t s w h i c h f l o w e d f r o m t h e s e d e v e l o p m e n t s we re n o t w i t h o u t c o s t s . D u r i n g t h i s p e r i o d , it is u n d o u b t e d l y fair t o s a y t h a t t h e l e v e l of r i s k f o r o u r l a r g e r a n d m o r e aggressive banks increased significantly . A c t i o n s of t h e F ed w i t h r e g a r d to h o l d i n g c o m p a n i e s HAVE HIGHLIGHTED ONE AREA OF INCREASED RISK. WHILE THE TOTAL EQUITY OF SOME HOLDING COMPANY SYSTEMS IS GREATER THAN THAT OF THEIR BANKING SUBSIDIARIES, THAT IS NOT ALWAYS THE CASE. Eq u i t y c a p i t a l m a y a c t u a l l y b e l e s s w h e n c o m p u t e d on a c o n s o l i d a t e d BASIS THAN FOR THE BANK ALONE, As A RESULT, THE AMOUNT OF EQUITY WHICH ONCE SUPPORTED THE RISKS OF A SINGLE BANKING SYSTEM NOW SUPPORTS THE BANK PLUS A VARIETY OF OTHER ENTERPRISES. THE RAPIDITY WITH WHICH THIS CHANGE OCCURRED IS SEEN IN STATISTICS PUBLISHED BY SALOMON BROTHERS LAST YEAR WHICH SHOW THAT THE COMPOSITE RATIO OF TOTAL CAPITAL FUNDS TO TOTAL ASSETS, LESS - 8 - CASH AND DUE FROM BANKS, OF THE TWENTY-FIVE LARGEST BANK HOLDING COMPANIES DECLINED FROM 8.3 PERCENT IN 1972 TO 7.7 PERCENT IN 1973. S i m i l a r l y , t h e r a t i o of e q u i t y c a p i t a l t o n o n -c a s h ASSETS DECLINED FROM 7.2 PERCENT IN 1972 TO 6.2 PERCENT IN 1973. Po t e n t i a l l y m o r e t r o u b l e s o m e t h a n t h i s d e c l i n e in t h e CAPITAL RATIO IS THE FACT THAT THE FAILURE OR DISTRESS OF AN AFFILIATE IN THE HOLDING COMPANY SYSTEM MAY AFFECT THE BANK itself. T he d a n g e r is t w o f o l d . F irst of a l l , t h e r e w i l l be GREAT TEMPTATION TO TAP THE BANK AS AN ANSWER TO THE PROBLEMS OR NEEDS OF AFFILIATES. SECONDLY, EVEN WHERE THE BANK IS EFFECTIVELY INSULATED FROM DIRECT FINANCIAL DRAIN, HOLDING COMPANY PROBLEMS ARE OFTEN REFLECTED IN MARKET JUDGMENTS ABOUT THE BANK ITSELF. THIS IS ENCOURAGED BY THE FACT THAT MANY HOLDING COMPANY EXECUTIVES WOULD AGREE WITH RONALD TERRY, Pr e s i d e n t of F ir st T e n n e s s e e Na t i o n a l Co r p o r a t i o n , w h o s t a t e d : "I t h i n k w e s h o u l d ke ep t h e b a n k 's p r e s t i g e b e h i n d t h e c a p i t a l MARKET ISSUES OF AFFILIATES .M THE DARK SIDE OF THIS APPROACH WAS GRAPHICALLY ILLUSTRATED IN THE BEVERLY HlLLS BANCORP CASE- - 9 UNDOUBTEDLY A SOURCE OF FED CONCERN IN THIS AREA. of t h e A n AFFILIATE B e v e r l y H ills Ba n c o r p , t h e B e v e r l y H ills Na t i o n a l B a n k , HAD BEEN SELLING SOME OF ITS PARENT COMPANY'S COMMERCIAL PAPER. When t h e t r o u b l e d p a r e n t w a s u n a b l e t o m e e t i n t e r e s t p a y m e n t s ON THE PAPER; A RUN ON THE OTHERWISE SOUND BANK WAS TRIGGERED, AS A RESULT; THE HOLDING COMPANY WAS FORCED TO LIQUIDATE THE BANK'S ASSETS THROUGH SALE TO WELLS FARGO, THE GREAT EXPANSION OF INTERNATIONAL BANKING OPERATIONS IS A SECOND SOURCE OF INCREASED RISK. ASSETS RANGE BETWEEN 42.8 AND 30.4 PERCENT OF THE TOTAL ASSETS OF OUR FIVE LARGEST BANKS; AND THEY ARE; IN MANY CASES; RESPONSIBLE FOR THE DRAMATIC DROP WHICH HAS BEEN SEEN IN THE CAPITAL RATIOS OF SOME OF OUR LARGER BANKS. FOR EXAMPLE; ONE MONEY CENTER BANK HAS A RATIO OF EQUITY PLUS RESERVES TO TOTAL ASSETS OF 6.6 PERCENT WHEN COMPUTED ON DOMESTIC BASIS AND 2.9 PERCENT WHEN INTERNATIONAL OPERATIONS ARE INCLUDED. In a d d i t i o n to s p r e a d i n g m o r e t h i n l y t h e s y s t e m 's CAPITAL RESOURCES, SUCH OPERATIONS CONTAIN THEIR OWN PERIL. Fr a n k l i n Na t i o n a l Ba n k 's e x p e r i e n c e in t h e f o r e i g n e x c h a n g e MARKET IS A CASE IN POINT, BUT THE LOSSES OF LLOYD'S SWISS BRANCH IN THE FOREIGN CURRENCY AREA DEMONSTRATED THAT EVEN THE MOST ESTABLISHED AND PRUDENT OF INSTITUTIONS CAN BE BURNED. Fu r t h e r m o r e , t h e p r e c a r i o u s s t a t e of t h e i n t e r n a t i o n a l p a y m e n t s SYSTEM, THE DISRUPTIVE EFFECTS OF THE FLOOD OF PETRODOLLARS AND THE FINANCIAL PROBLEMS OF COUNTRIES WHICH ARE SUBSTANTIAL DEBTORS to Am e r i c a n b a n k s h a v e e a c h s e r v e d t o g r e a t l y i n c r e a s e t h e r i s k OF INTERNATIONAL OPERATIONS. A c c o m p a n y i n g a n d to a s i g n i f i c a n t d e g r e e f u n d i n g EXPANSION ABROAD HAS BEEN THE APPLICATION OF THE LIABILITY MANAGEMENT THEORY OF BANK LIQUIDITY. In ESSENCE, LIABILITY MANAGEMENT MEANT THAT BANKS WERE NO LONGER SUBSTANTIALLY LIMITED IN THEIR TRADITIONAL SOURCES OF FUNDS. by THE NEW VIEW WAS DESCRIBED L e h m a n B r o t h e r s e c o n o m i s t Le o n a r d Sa n t o w w h e n he s t a t e d : -11 - "The p r a g m a t i c v i e w of b a n k s is t h a t y o u c a n 't LOOK AT THE OLD RATIOS. THEY DON'T APPLY ANYMORE WHEN PEOPLE CAN BUY ALL THE LIQUIDITY THEY WANT IN THE MARKETPLACE IF THEY ARE WILLING TO PAY THE PRICE." The BENEFITS OF THIS APPROACH ARE SUBSTANTIAL. NOT CONSTRAINED BY THE LEVEL OF DEPOSITS GROWING OUT OF NORMAL CUSTOMER RELATIONSHIPS, MONEY CENTER AND REGIONAL BANKS RESPONDED TO BURGEONING CREDIT DEMANDS. It ALSO ALLOWED REGIONAL BANKS TO ACHIEVE OR BEGIN TO REALIZE THEIR INTERNATIONAL ambitions. Sm a l l e r b a n k s h a v e b e n e f i t e d a s w e l l s i n c e m a n y PROFITED HANDSOMELY AS NET LENDERS OF FEDERAL FUNDS. THE RAPIDITY OF CHANGE IN THIS AREA IS REFLECTED IN THE FACT THAT THE RATIO OF PURCHASED FUNDS TO ASSETS FOR LARGER BANKS GREW FROM 7.3 PERCENT IN 1965 TO 14.3 PERCENT IN 1970, AND TO 26.5 percent in J u n e 1974. MORE DRAMATIC. For m a n y i n s t i t u t i o n s , g r o w t h w a s f a r - 12 - No t w i t h s t a n d i n g its b e n e f i t s , r e s o r t to t h e m o n e y MARKETS AS A SOURCE OF LIQUIDITY WAS NOT WITHOUT ITS PERILS AND SERVES TO ADD ANOTHER ELEMENT OF RISK TO THE SYSTEM. THESE WERE DRAMATIZED BY EVENTS IN 1974, WHICH INCLUDED THE FAILURES of Fr a n k l i n a n d A m e r i c a n B a n k a n d T r u s t a n d t h e s t r e s s e s c a u s e d BY THE LIQUIDITY SQUEEZE ENGENDERED BY TIGHT MONEY AND BUSINESS BORROWING FROM BANKS, THAT GREW AT AN ANNUAL RATE OF MORE THAN 25 PERCENT THROUGH THE SUMMER. Fr a n k l i n , of c o u r s e , is t h e c l e a r e s t e x a m p l e of a n INSTITUTION WHICH RELIED FAR TOO HEAVILY ON PURCHASED FUNDS AS A BASIS FOR RAPID EXPANSION. ANXIOUS TO ACHIEVE STATUS AS A MONEY CENTER INSTITUTION, THE BANK PURCHASED FUNDS IN INCREASING PROPORTIONS TO SUPPORT RISKY ASSETS. FIORE IMPORTANTLY, AS THE BANK PENETRATED NEW MARKETS, GROWTH FAR OUTSTRIPPED MANAGEMENT skill. W h a t w a s o n c e a r e l a t i v e l y s o u n d Lo n g Is l a n d i n s t i t u t i o n became a mu ltinational enterprise situated in l a v i s h l y a p p o i n t e d - 13 Ma n h a t t a n q u a r t e r s y e t l a c k i n g t h e d e p t h a n d m a n a g e r i a l e x p e r t i s e r e q u i r e d t o run t h e s u d d e n l y c o m p l e x o p e r a t i o n . Un a b l e t o c o n t r o l e x p e n s e s , m a n a g e m e n t soon f a c e d a s e r i o u s e a r n i n g s p r o b l e m , w h i c h w a s p r o b a b l y t h e u l t i m a t e c a u s e of t h e b a n k 7s d o w n f a l l . In d e e d , o n e m i g h t s p e c u l a t e t h a t Fr a n k l i n s w e l l -p u b l i c i z e d f o r e i g n e x c h a n g e l o s s e s w e r e t h e r e s u l t of ATTEMPTS TO RECOUP LOSSES. T he m o s t d r a m a t i c e l e m e n t of r i s k i n v o l v e d in t h e v i e w of b a n k e r s t h a t t h e y "c a n b u y a l l t h e l i q u i d i t y t h e y w a n t in t h e MARKETPLACE IF THEY ARE WILLING TO PAY THE PRICE LIES IN THE FACT THAT ACCESS TO THE MONEY MARKETS CAN BE LOST. As THE Fr a n k l i n a n d Am e r i c a n B a n k a n d T r u s t e x p e r i e n c e s s u g g e s t , o n c e THE LIQUIDITY PROVIDED BY THE ACCESS TO SUCH MARKETS IS LOST, IT IS DIFFICULT, IF NOT IMPOSSIBLE, TO REGAIN. In EACH CASE A SETBACK WHICH OTHERWISE MIGHT NOT HAVE PROVEN COMPLETELY DISASTROUS TRIGGERED A LOSS OF CONFIDENCE AND THE OUTFLOW OF "h o t " f u n d s . T h e r e is e v i d e n c e w h i c h s u g g e s t s t h a t w h i l e d e p o s i t INSURANCE MAINTAINED THE CONFIDENCE OF MOST SMALL DEPOSITORS IN - M - the f a c e of t h e w o r s t s o r t of a d v e r s e p u b l i c i t y , w i l l i n g n e s s OF THE LENDER OF LAST RESORT TO PROVIDE FUNDS AND THE STABILIZING EFFORTS OF OTHER AGENCIES DID NOT STIMULATE THE CONFIDENCE OF U R G E INDIVIDUAL AND INSTITUTIONAL DEPOSITORS. As THIS DISCUSSION INDICATES, THE ADDED ELEMENTS OF RISK PLAYED A PART IN THE FAILURE OF BOTH FRANKLIN AND AMERICAN Ba n k a n d T r u s t a s w e l l a s t h e d i s t r e s s m e r g e r of B e v e r l y H ills National Ba n k . Ev i d e n c e s h o w s t h a t , n o t o n l y t h e s i z e of t h e bank f a i l u r e , but the preci pi tat ing causes have changed with t h e p a s s a g e of t i m e , a n d I would suggest that the major bank FAILURES OF 197A MAY INDICATE ANOTHER SUCH CHANGE. A STUDY PUBLISHED IN THE 1958 ANNUAL REPORT OF THE FDIC DISCUSSED THE CAUSES OF BANK FAILURES BETWEEN THE YEARS OF 1934 a n d 1958. "In T he s t u d y s t a t e d : t h e m a j o r i t y of t h e s e c a s e s , p a r t i c u l a r l y t h o s e OCCURRING DURING THE FIRST DECADE OF DEPOSIT INSURANCE, THE PROBLEM WAS THAT OF POOR ASSET CONDITION AND - 15 CONSEQUENT CAPITAL IMPAIRMENT, WHICH IN TURN COULD BE TRACED TO A NUMBER OF CAUSES, SUCH AS MISMANAGEMENT, DETERIORATING LOCAL ECONOMIC CONDITIONS, OR AN INABILITY TO RESTORE FINANCIAL POSITIONS WHICH HAD BEEN SERIOUSLY IMPAIRED DURING THE 1930-33 DEPRESSION IN APPROXIMATELY ONE-FOURTH OF THE BANKS, YEARS. DEFALCATION OF LOSSES ATTRIBUTABLE TO OTHER FINANCIAL IRREGULARITIES BY OFFICERS OR EMPLOYEES APPEAR TO HAVE BEEN THE PRIMARY CAUSE OF FAILURE. SUCH IRREGULARITIES HAVE BEEN RESPONSIBLE FOR MOST OF THE CASES OCCURRING since W o r l d Wa r II." Th u s , m o s t b a n k f a i l u r e s p r i o r t o 1946 w e r e t h e r e s u l t of a FAILURE TO RECOVER FROM THE BANKING PROBLEMS WHICH LED TO THE CREATION OF THE Wo r l d Wa r II the FDIC. THE REPORT SEEMS TO INDICATE THAT AFTER i l l e g a l a c t i v i t i e s of o n e or m o r e e m p l o y e e s WERE BY AND LARGE THE PRINCIPAL CAUSE OF BANK FAILURE. AT THAT TIME, ONLY IN THE SMALLER INSTITUTIONS THAT SUCH If WAS, - 16 ACTIVITIES COULD ACTUALLY BRING THE BANK DOWN, St a t i s t i c s c o m p i l e d b y o u r L i q u i d a t i o n D i v i s i o n s u g g e s t FOR THE PERIOD JANUARY 1, 1960 THROUGH 1973 THAT A NEW FACTOR ASSUMED PARAMOUNT IMPORTANCE. AMONG THE SIXTY-THREE BANK FAILURES, SELF-SERVING TRANSACTIONS WERE A SIGNIFICANT FACTOR IN 37 OR 58,8 PERCENT OF THE CASES. DEFALCATIONS, EMBEZZLEMENTS AND MANIPULATIONS CAUSED 20, OR 31,7 PERCENT OF THE FAILURES WHILE MANAGERIAL WEAKNESS IN LOAN PORTFOLIO MANAGEMENT ACCOUNTED FOR ONLY 6, OR 9.5 PERCENT OF THE FAILURES. AS YOU PROBABLY KNOW, THE FAILURE OF U, S, NATIONAL BANK in Sa n D iego a w o k e t h e f i n a n c i a l c o m m u n i t y to t h e f a c t t h a t a BILLION DOLLAR BANK COULD FAIL. USNB's INSOLVENCY RESULTED FROM THE WHOLESALE AND UNSOUND EXTENSION OF CREDIT TO PERSONS AND ENTITIES CONTROLLED BY OR ASSOCIATED WITH THE CONTROLLING STOCKHOLDER AND FORMER BOARD CHAIRMAN, Or , IN THE WORDS OF !) Co m p t r o l l e r of t h e Cu r r e n c y J im Sm i t h , i n s o l v e n c y w a s l a r g e l y THE RESULT OF A ". . . RIOT OF SELF-DEALING." In EFFECT, - 17 U. $. Na t i o n a l Ba n k w a s n o t o n e , b u t t w o b a n k s . O n e , an APPARENTLY SOUND AND EFFICIENT INSTITUTION, SERVED THE SAN DlEGO public. The SECOND PROVIDED CREDIT t o ENTERPRISES RELATED to OR AFFILIATED WITH THE DOMINANT STOCKHOLDER. INVOLVING 200-300 CORPORATE ENTITIES, THESE TRANSACTIONS INVOLVED BETWEEN $400 AND $450 MILLION. Nor was USNB a n DURING THIS PERIOD. aberrration among large bank failures O n JANUARY 25, 1971, THE SHARPSTOWN STATE Ba n k in Ho u s t o n , T e x a s , w i t h a s s e t s a m o u n t i n g t o a p p r o x i m a t e l y $81 MILLION WAS CLOSED. IN FDIC HISTORY. The It WAS THEN THE SECOND LARGEST FAILURE p r i m a r y c a u s e w a s t h e s e l f -s e r v i n g ACTIVITIES OF A DOMINANT SHAREHOLDER. THREE WEEKS LATER IT WAS DROPPED TO THIRD PLACE BY THE FAILURE OF BlRMINGHAM-BLOOMFI ELD, UNTIL USNB, THE LARGEST FAILURE OF AN FDIC-INSURED BANK. HERE, AS WELL AS IN THE BANK OF THE COMMONWEALTH CASE, SELF-DEALING WAS COMBINED WITH AN UNSAFE AND UNSOUND INVESTMENT POLICY DICTATED BY THE DOMINANT SHAREHOLDER. - 18 - In contrast with these ca s e s . , abusive insider dealing DOES NOT SEEM TO HAVE BEEN A PRIMARY CAUSE OF BANK FAILURE DURING 1974 AND THUS FAR IN 1975, RATHER/ MAJOR BANK FAILURES/ AS WELL AS THE PROBLEMS OF THE SECURITY NATIONAL AND BEVERLY H ills b a n k s / s e e m t o h a v e b e e n c a u s e d by a v a r i e t y of i m p r u d e n t AND ENEPT BANKING PRACTICES/ INCLUDING UNCONTROLLED GROWTH/ A LOSS OF CONTROL OVER COSTS/ POOR ASSET JUDGMENT AND SPECULATION, As WE HAVE SEEN/ RISK INCREASED SIGNIFICANTLY AMONG OUR LARGER INSTITUTIONS DURING THE PAST FIFTEEN YEARS/ AND AS YOU KNOW/ 1974 AND 1975 PRODUCED THE WORST ECONOMIC ENVIRONMENT IN THE POST”WAR ERA. In THIS ENVIRONMENT/ BANKERS AND BANK REGULATORS LEARNED THAT CARELESS BANKING PRACTICES WHICH WERE ADEQUATE AND EVEN PROFITABLE DURING THE GO-GO DAYS OF THE SIXTIES AND early Se v e n t i e s w o u l d be penalized under a d v e r s e and un sta bl e ECONOMIC CONDITIONS, MOREOVER/ WE ALL HAVE LEARNED THAT LARGE BANKS ARE NOT EXEMPT FROM THE DISCIPLINE OF THE MARKETPLACE AND THAT THEY CAN AND WILL PAY THE PRICE OF UNSOUND BANKING PRACTICE - 19 Re a c t i n g t o t h i s s i t u a t i o n ., m a n y b a n k e r s h a v e r e c o g n i z e d PROBLEMS IN THEIR OWN INSTITUTIONS AND MOVED QUICKLY TO REMEDY them. Ce r t a i n g e n e r a l p r i n c i p l e s h a v e b e e n a c c e p t e d . Ne i t h e r EXPANSION NOR CREDIT COMMITMENT CAN ANY LONGER BE BASED ON THE PRESUMED AVAILABILITY OF PURCHASED FUNDS. SIMILARLY, VOLATILE AND POTENTIALLY HIGH-PRICED FUNDS OUGHT NOT TO BE USED TO FUND RISKY OR LONG-RANGE ASSETS TO ACHIEVE MARKET PENETRATION. Ra t h e r , e x p a n s i o n s h o u l d be a f u n c t i o n of t h e n a t u r a l l e v e l OF DEPOSITS, ADDITION OF CAPITAL AND RETENTION OF INCOME, AND THE COMMITMENT OF RESOURCES BASED ON CAREFUL PLANNING, BALANCING PRESENT AND FUTURE CREDIT DEMANDS WITH ANTICIPATED RESOURCES. B a n k s s h o u l d a l s o r e c o g n i z e t h a t , in t h e s h o r t to m e d i u m RUN, AT LEAST, CAPITAL NECESSARY TO SUPPORT EXPANSION MUST BE GENERATED FROM EARNINGS, SINCE THE PRESENT PRICE OF BANK STOCKS AND THE COST AND UNSUITABILITY OF DEBT FINANCING FORECLOSE THE CAPITAL MARKETS FOR A GREAT MANY BANKS. ACCORDINGLY, BANKS - 20 - WISHING TO EXPAND WILL HAVE TO RELY ON THE BASICS OF SOUND banking. Gr e a t e r a t t e n t i o n m u s t b e pa i d t o c o s t s , t h e p r i c i n g OF SERVICES AND THE PROFITABILITY OF LINES OF SERVICES AND LARGE CUSTOMER ACCOUNTS. Yet exist. a t t h e s a m e t i m e , t h e d a n g e r of o v e r r e a c t i o n d o e s T he f a c t t h a t s o m e i n s t i t u t i o n s h a v e b e e n o v e r z e a l o u s DOES NOT MEAN THAT IT IS NOW APPROPRIATE FOR ALL TO PULL IN THEIR HORNS, ADOPTING AN ULTRARESTRICTIVE ATTITUDE TOWARD THE PROVISION OF CREDIT. IT IS TRUE THAT MANY INSTITUTIONS ARE STRETCHED TO THEIR LIMIT AND SHOULD BE RESTRAINED; THE DATA, HOWEVER, WHICH I REVIEW INDICATE THAT OTHER INSTITUTIONS ARE ADEQUATELY CAPITALIZED AND HAVE SECURE AND PRODUCTIVE PORTFOLIOS. In THE PRESENT RECESSIONARY ENVIRONMENT, THESE SHOULD MOVE AGGRESSIVELY TO RESPOND TO THE NEEDS OF CREDITWORTHY BORROWERS. In d e e d , for s o m e i n s t i t u t i o n s , t h e a s s u m p t i o n of a h i g h e r l e v e l OF RISK WOULD NOT BE AT ALL INAPPROPRIATE. T h u s , i n s t e a d of u n i f o r m l y r e a c t i n g t o t h e g l o o m y p i c t u r e PRESENTED BY THE ECONOMY AND THE CAUTIONARY NOTE STRUCK BY - 21 - SUPERVISORY AUTHORITIES, BANKERS SHOULD SIMPLY APPLY IN DISCIPLINED FASHION THE TOOLS OF MODERN ASSET AND LIABILITY MANAGEMENT, ÏHE WIDESPREAD FAILURE OF SOLID INSTITUTIONS TO RESPOND IN THIS MANNER COULD HAVE THE EFFECT OF REINFORCING THE RECESSIONARY SPIRAL. INDEED, THERE IS REASON TO BELIEVE THAT RESTRICTIVE LENDING POLICIES, COMBINED WITH A LOSS OF CONSUMER AND BUSINESS CONFIDENCE, ARE RESPONSIBLE FOR THE EIGHT PERCENT ANNUAL RATE OF DECLINE IN CURRENCY AND DEMAND DEPOSITS WHICH OCCURRED IN JANUARY, THIS POINT UNDERSCORES THAT THE PROPER APPROACH OF BANKERS TO RAPIDLY CHANGING AND TROUBLED ECONOMIC CONDITIONS IS TO RESPOND INDEPENDENTLY TO THE FACTS AND CIRCUMSTANCES OF THEIR OWN MARKET ENVIRONMENT IN LIGHT OF THE PECULIAR STRENGTHS AND WEAKNESSES OF THEIR OWN INSTITUTION AND NOT THE FAD OF THE MOMENT. G i v e n t h e n o t o r i e t y of r e c e n t l a r g e b a n k f a i l u r e s a n d THE APPARENT SERIOUSNESS OF OUR ECONOMIC CIRCUMSTANCES, IT IS ESPECIALLY APPROPRIATE TO DISCUSS, IN CONCLUSION, EXPECTATIONS - 22 - WITH RESPECT TO THE OBLIGATIONS AND CONDUCT OF THOSE WHO OVERSEE OPERATION OF OUR NATION'S FINANCIAL INSTITUTIONS AND THE STANDARDS WHICH DEFINE THOSE EXPECTATIONS. CONFIDENCE, THE KEY TO OUR ECONOMIC SYSTEM, DOES NOT FLOW PRIMARILY FROM THE SIZE OF THE FDIC'S FUND NOR FROM THE F e d 's WILLINGNESS TO OPEN THE DISCOUNT WINDOW, THOUGH THESE CONSIDERATIONS DO HAVE THEIR IMPACT. RATHER IT IS DERIVED FROM THE PUBLIC'S COLLECTIVE EXPECTATIONS ABOUT THE SOUNDNESS AND INTEGRITY OF THESE INSTITUTIONS. AT A TIME WHEN SEVERAL RECENT LARGE BANK FAILURES HAVE REFLECTED THE DOMINATION OF AN ENTIRE BOARD BY A SINGLE INDIVIDUAL, IT IS IMPORTANT TO EMPHASIZE THE NECESSITY OF EACH BOARD MEMBER S EXERCISING AND EXPRESSING HIS OWN INDEPENDENT JUDGMENT. WHENEVER A BANK DIRECTOR FUNCTIONS AS A RUBBER STAMP FOR MANAGEMENT OR CONTROLLING INTERESTS, OR MERELY GOES ALONG WITH THE MAJORITY AS A RESULT OF RETICENCE OR IGNORANCE, HE HAS CEASED TO SERVE HIS INSTITUTIONAL FUNCTION AND HAS THEREBY ABDICATED HIS LEGAL RESPONSIBILITY. It HAS BEEN SAID AND I AGREE THAT THERE ARE - 23 TIMES WHEN A "DIRECTOR SHOULD RISK HIS POSITION TO THE EXTENT OF BRINKMANSHIP IF HE IS TO CONTRIBUTE TO THE WELFARE OF THE BANK AND TO DISCHARGE HIS TRUST," The TO DESCRIBE. DUTIES AND o b l i g a t i o n s of a d i r e c t o r a r e n o t d i f f i c u l t HAD THEY BEEN ADHERED TO CONSCIENTIOUSLY, BANK FAILURES WOULD BE SIGNIFICANTLY LESS LIKELY. In SUMMARY: — A DIRECTOR SHOULD INSIST UPON SUFFICIENT INFORMATION TO MAKE CONSIDERED DECISIONS; MOREOVER, HE SHOULD SATISFY HIMSELF THAT THE BANK'S INFORMATION AND DECISION-MAKING SYSTEMS PROVIDE HIM AN ACCURATE PICTURE OF WHAT IS GOING ON IN THE INSTITUTION. — A DIRECTOR SHOULD ANALYZE AND QUESTION CRITICALLY THE INFORMATION PROVIDED UNTIL SATISFIED THAT A GIVEN TRANSACTION OR POLICY IS IN THE BANK S BEST INTEREST AND CONSTITUTES A SAFE AND SOUND BANKING PRACTICE. - — 24 - A DIRECTOR SHOULD EXERCISE AND EXPRESS INDEPENDENT JUDGMENT; NOT FEARING TO GO ON RECORD AS A DISSENTER, — AND; OF COURSE; THE REQUIREMENT OF GOOD FAITH DEMANDS A DIRECTOR RESPECT HIS FIDUCIARY DUTY IN HIS OWN DEALINGS WITH THE BANK; EXERCISING EXTREME CAUTION AND RESOLVING CLOSE QUESTIONS IN THE BANK'S FAVOR, " T h e s e p r i n c i p l e s a r e a p p l i c a b l e w h e t h e r a d i r e c t o r is REVIEWING A TRANSACTION BETWEEN THE BANK AND ITS DOMINANT STOCKHOLDER; DECIDING WHETHER THE OPENING OF A NEW BRANCH IS WARRANTED OR COMING TO GRIPS WITH HIS BANK'S ENTRY INTO INTERNATIONAL MARKETS. B y APPLYING THEM; A DIRECTOR PROTECTS HIMSELF FROM POTENTIAL LIABILITY; AND; MORE IMPORTANTLY; SATISFIES HIS OBLIGATION TO THE PUBLIC WHICH RELIES ON THE SOUNDNESS AND INTEGRITY OF HIS INSTITUTION, ÏHE FAILURE AND DIFFICULTIES OF A FEW LARGE FINANCIAL INSTITUTIONS IN RECENT - 25 YEARS OFFER ILLUSTRATIONS OF WHAT CAN OCCUR WHEN THEY ARE NOT APPLIED. In s i m p l e r a n d m o r e s t a b l e t i m e s , t h e c o s t s of a l e s s RESPONSIBLE APPROACH MIGHT HAVE BEEN IGNORED. Fr a n k l i n Na t i o n a l B a n k a n d its c o n s e q u e n c e s , for i n d i v i d u a l s the on ÏHE FAILURE OF Lo n g Is l a n d a n d t h e i n d u s t r y g e n e r a l l y , i n d i c a t e t h a t t h e y CAN NO LONGER BE COUNTENANCED. ÏHE PUBLIC HAS A RIGHT TO EXPECT THAT BANK DIRECTORS TAKE SERIOUSLY THEIR FIDUCIARY DUTIES. Ac c o r d i n g l y , it s e e m s t o m e t h a t t h e b a n k i n g a g e n c i e s a n d INDUSTRY ASSOCIATIONS MUST CONSIDER SERIOUSLY WHAT MORE CAN BE DONE TO INSURE COMPLIANCE WITH STANDARDS WHICH ARE GENERALLY AGREED UPON. In that conclusion, I w o u l d l i k e s i m p l y to r e i t e r a t e m y v i e w A m e r i c a n b a n k s a r e n o t "on t h e b r i n k "— t h a t t h e s k y is n o t falling. In d e e d , if w e p r o p e r l y a p p l y t h e l e s s o n s to b e l e a r n e d FROM RECENT BANK FAILURES, THE RESULT WILL BE A SOUNDER, MORE RESILIENT BANKING SYSTEM.
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