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J J«M /"• c.
F o r R e l e a s e on D e l i v e r y
Wednesday, June 29, 1988
8:45 A.M. E.D.T.

CAPITAL AND DIVERSIFICATION:

THE P I L L A R S OF B A N K S A F E T Y

By

H. Robert H e l l e r
M e m b e r , B o a r d of G o v e r n o r s of the F e d e r a l R e s e r v e S y s t e m

U . S . L e a g u e of S a v i n g s I n s t i t u t i o n s R e g u l a t o r y P o l i c y C o n f e r e n c e
Grand Hyatt Hotel, W a s h i n g t o n , D.C.
June 29, 1988

^

CAPITAL AND DIVERSIFICATION: THE PILLARS OF BANK SAFETY

Since coming to the Board two years ago, I have found
regulatory issues to be enormously fascinating and
challenging.

Unlike monetary policy, where decisions are

made affecting the economy for the next year or two,
regulatory changes affect the future of the banking
industry for decades to coma.

For instance, the Glass-

Steagall Act is well over half a century old, but it is
still the cornerstone of our current financial system —
although many would argue it is best described as a
millstone around their necks.

Today I would like to update you on some of the regulatory
issues currently being considered by -the Board.

Some of

the issues are placed deliberately on the Board's agenda as
part of the "rule-making" process, while other issues on the
agenda are the result of bank applications or other bank
actions forcing the Board to act.

Instead of telling you the Federal Reserve's position or my
position on this or that issue, let me outline some of the
basic principles that I have found useful in analyzing
regulatory issues.

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When confronting regulator

issues it is important to

maintain a consistent perspective and a coherent view of the
world.

This is sometimes more difficult with respect to

regulatory issues than it is in monetary policy.

Everyone

knows that it is the basic function of a central bank to
follow policies that will foster price stability and
economic growth.

In the regulatory arena, the maintenance of a stable financial environment constitutes the basic goal.

But

translating that objective into a precise action program is
a rather complex task.

If I were asked to single out the two factors most important
for the health of the financial system, I would name capital
and diversification as the pillars of bank safety.

In

addition, equity and flexibility are also important.

Capital is of central importance because capital represents
the cushion enabling financial institutions to absorb the
losses that result from unforeseen events.

However, we should recognize that capital invested in a
financial institution has to earn a sufficient rate of
return to induce people to place their own funds at risk.
Thus, there exists a creative tension between the guest for
more safety, which presumably could be satisfied if banks
2

were to invest all their funds in T-bills, and the quest for
higher earnings, which, by necessity, involves a certain
amount of risk.

Managing that equation is the essence of

good banking, as it provides the income to earn, or attract,
the capital that makes the bank safe.

Perhaps the single most important tool for the banker to
achieve that goal is diversification.

The diversification

of assets, liabilities, and earnings sources not only limits
the exposure of an institution to any singular event, but
enhances the safety of the entire financial enterprise, the
'*

safety of the depositors, and the stability of the earnings
stream.

In a way, diversification is the essence of fin-

ancial intermediation and provides much of the value added
by a financial enterprise.

I also mentioned ec[uitableBjruleg> as an important regulatory
objective, because without equity there can be no fair
competition.

This applies to the equity of the rules appli-

cable to the various domestic as well as the international
institutions that compete in the same marketplace.

Equity

also requires that the regulations fit into a consistent
framework and be implemented in an impartial manner.

But with regard to all rules, a certain flexibility is
required as well so that the financial system can respond to
the needs of the economy and to unforeseen developments.

Flexible rules allow individual financial institutions the
leeway they need to adapt to the changing requirements of
their customers over time.

That is, regulatory changes

should be evolutionary rather than revolutionary.
Uncertainty and abrupt change are not conducive to the
development of trust and financial stability, without which
the investments necessary for growth simply will not be
undertaken.

That, then, is my regulatory ABC: All bank regulation (that's
the A and the B) should emphasize adequate capital (here is
the C) and diversification (my D) in an equitable and
flexible manner.

That takes me through the letters E and F.

SAFETY THROUGH "ADEQUATE CAPITAL

Let me now take you through the various issues on the
regulatory agenda and show how they relate to capital and
diversification as the two pillars of bank safety.

Risk-Based Capital

These days, no discussion of regulatory issues can begin
without mentioning the new risk-based capital rules proposed
by the Basle Group of bank supervisors.
4

While former

international supervisory agreements typically relied upon
reciprocal recognition of national supervisory standards,
the proposed risk-based capital framework represents the
first attempt to formulate a global set of regulations.

The proposal provides for the same definition of capital, the
same risk asset classes, and the same leverage ratio for all
internationally active banks.

The Basle framework sets a 4 percent equity capital standard
and an overall 8 percent capital standard to be achieved by
1992.

It also sets an interim target of 3.25 percent equity

capital and 7.25 overall capital by the end of 1990.

In the meantime, the current 5.5 percent primary capital
«

standard is still applicable.

However, when considering

capital adequacy of a banking organization, the Board may
also consider, among other factors, how the organization's
capital conforms to the new risk-based standard.

Such

considerations may be given particular emphasis in the case
of foreign bank applications whose capital ratios, as
reflected in their published financial statements, do not
meet the current U.S. primary capital standard.

As a matter

of fact, the Board has recently approved several foreign
applications, when an applicant's capital appeared to be
adequate under the new risk-based capital standard.

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The proposed risk-based capital standard has been put out
for public comment, and certain concerns have been expressed
about the detailed implementation of the proposal.

Let me

comment on some of the issues without committing the Board
or myself on the specific details.

Holding Company Capital

The issue that has probably attracted the most attention is
i

whether the risk-based capital ratios should be applicable
both to banks and bank holding companies.

There is little

difference, as long as we talk about pure bank holding
companies.

In that case, if the sum of the individual

banks' capital requirements are matched by the capital
requirement of the holding company, no controversial issues
are raised, because double-leveraging is not present.

But when holding companies borrow to help finance their
acquisition of bank stock, the question of double leverage
and the degree to which it should be permitted arises.

In

addition, with the broadening of the permissible holding
company activities that has already taken place, and the
further broadening of powers envisaged in the Proxmire
Financial Modernization Act, controversial issues arise
regarding the applicability of the capital requirements to
non-banking activities.

As you know, the Senate bill would

exclude both the capital and the assets of a securities
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subsidiary from the calculation of capital adequacy for the
holding company.

Most people would probably agree that the holding company's
capital should not be less than that required for the
banking subsidiaries.

The more difficult question is how

much additional capital should be required for the nonbanking activities that the holding company engages in.
That question the Board will have to resolve soon.

Goodwill as Capital

There is also the related question of goodwill.

At the

present time goodwill does not count toward the required
capital in the bank.

Furthermore, in processing

applications the Federal Reserve has long followed the
practice of routinely excluding pure goodwill from a holding
company's capital.

But we will consider intangibles that

can be associated with an identifiable earnings stream.
one compares the existing

capital requirement excluding

goodwill with the proposed 4 percent equity standard, it
becomes clear that the new standard is really not more
burdensome, as far as goodwill is concerned.

7

If

Reserves as Capital

Furthermore, general reserves may be included in Tier II
risk-based capital without limit until 1990, up to 1.5
percent until 1992, and up to 1.25 percent after that.

This

long phase-in period should give any bank an opportunity
to establish appropriate reserve levels.

Source of Strength Policy

As you will garner from this extended discussion of capital
requirements, the Federal Reserve considers adequate capital
as central to bank safety.

Last April, the Board reiterated

its long-standing policy that the holding company should
serve as a source of strength to its subsidiary banks and
stand ready to provide additional capital funds in times of
financial stress.

Failing Subsidiary Banks

This principle also applies in situations where one or
several subsidiary banks may be in danger of failing, while
other subsidiary banks continue to function well.
Obviously, the financial integrity of the federal deposit
insurance fund is involved here as well.

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I also believe that an equity issue between branch-banking
and unit-banking states is at stake here.

One cannot allow

owners to walk away from their obligations in unit banking
states, while they would not be able to do so in branchbanking states.

Mergers and Acquisitions

Capital adequacy is of central importance in merger and
acquisition cases.

The Board has long believed that

banking organizations undertaking significant expansions
should maintain capital well above the regulatory minimum.
In that context, we have discouraged the use of creative
purchase accounting techniques that might be used to justify
a payout of capital funds to shareholders.

Obviously, this

point also bears on the earlier discussion of goodwill as a
capital asset.

Dividend Policy

The payment of excessive or unearned dividends by organizations whose capital position needs strengthening is another
practice that we wish to discourage and stand ready to prohibit in extreme situations.

9

SAFETY THROUGH DIVERSIFICATION

Let us leave the capital adequacy issues and turn to actions
that may increase the safety and soundness of the banks by
providing greater opportunities for diversification of
activities, assets, and earnings.

Increased Product Diversification

I stated at the outset that diversification is a key riskreducing technique.

Following that principle, the Board

last year liberalized the rules regarding securities
activities in subsidiaries and has now been upheld by the
Supreme Court.

The Board also endorses the removal of

Glass-Steagall barriers by Congress allowing banks to offer
a broader product range to their customers.

International Investment Powers

In the international arena, the Board has recently
liberalized Regulation K to permit banks to engage in
debt-to-equity swaps in developing countries with debt
service difficulties.

While in earlier days Regulation K

was often cited as a block to progress in that area, things
have been remarkably quiet since the liberalization was
undertaken.
10

It would be helpful to see more active use of

the opportunities for debt-equity swaps to reduce the debt
service problems of the developing countries.

Foreign Underwriting Powers

As you know, the limitations of the Glass-Steagall legislation do not apply to the foreign activities of U.S. banks.
American banks are currently permitted to underwrite
non-equity securities abroad without limits.

However,

Regulation K places a $2 million limit on equity underwriting abroad.

We have recently granted approval to

Security Pacific to underwrite up to $15 million in several
foreign subsidiaries.

We will review this issue to

determine whether these limitations should be relaxed
further.

Foreign Exchange Activities

Let me note that the draft bill in the House that would
prohibit banks that are affiliated with securities companies
from conducting their foreign exchange business in the bank
would be counterproductive. Foreign exchange is an integral
part of the banking business and the customary reciprocal
credit lines among banks are based upon the capital position
of the bank.

Prohibiting American banks from engaging in

foreign exchange activities would place them at a
competitive disadvantage against foreign institutions and
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could have a negative impact on the profitability of
American banks.

Let's not tie our hands behind our backs in

this intensely competitive international arena!

Real Estate Powers and Healthy Thrift Acquisition

As you know, broader real estate powers and the ability to
acquire healthy thrift institutions are two issues that are
of continuing interest to the Board.

While we will review

these issues from time to time, Chairman Greenspan has stated
that we will, inform Congress before taking action on these
issues.

Interstate Banking

Greater geographic diversification should also enhance the
safety of the banking system.

This point is illustrated

forcefully by the high failure rates encountered by
insufficiently diversified unit banks in the agricultural
and energy producing regions of our country.

This situation

contrasts with the one prevailing in other countries, where
nationwide banking has increased the safety and soundness of
the financial structure through diversification.

While the states have taken the lead in this area, interstate
banking is by its very nature an area where a national
policy is needed.
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Let's apply the interstate commerce

clause, which has been the basis for a prosperous and
competitive national marketplace, to the banking industry as
well!

Interstate banking will enhance diversification

opportunities, and thereby increase the safety and soundness
of the banking system.

In addition, we face equity and flexibility issues here,
because current law prohibits Americans to do business as
they please regardless of their domicile.

Americans should

be able to do business anywhere in this nation and not be
subject to artificial geographic barriers.

It makes no

sense that American banks are free to do business around the
world, but are not allowed to service the customer in an
adjacent state.

Conclusion

As I stated at the beginning, our regulatory agenda is full
and our life as regulators is interesting and challenging.
I hope that I have shown that we are trying to make progress
in enhancing the safety and soundness of our banking system.
I need not tell you that this is a most urgent task.
year, almost 200 American banks failed.

Last

This constant

hemorrhaging has to cease if we are to maintain a stable
financial system and if we want to be a leader in international financial markets.

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I have emphasized the enhancement of safety through capital
and diversification, while providing for equity and
flexibility for the banking institutions.

In the capital area we will soon implement a global riskbased system of capital adequacy that should also enhance
fairness.

I have talked about the holding company as a

source of strength for the bank and outlined our policy with
regard to reserves, dividends, and mergers and acquisitions.

At the same time, we are trying to enhance bank safety by
providing increased opportunities for diversification of
earnings and assets.

New international.investment and

underwriting powers will move us closer to that goal.
Congressional action is needed to remove the Glass-Steagall
barriers and in consolidating the move towards interstate
banking.

All this has to be accomplished while providing for
equitable treatment of all domestic and foreign competitors
and permitting enough flexibility so as not to stifle the
creativeness and inventiveness that we all need if we are to
prosper in the future.

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