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F qp use ir> morning papers of
Sept!ember 6 . 1980




AMERICAN BANKS DURING THE 1970'S AND BEYOND

Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Roundtable on Credit Systems in the 1970's
Sponsored by
Ente per gli Studi Monetari Bancari e Finanziari "Luigi Einaudi
Perugia, Italy
September 5-7, 1980

AMERICAN BANKS DURING THE 1970'S AND BEYOND
Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Roundtable on Credit Systems in the 1970's
Sponsored by
Ente per gli Studi Monetari Bancari e Finanziari "Luigi Einaudi"
Perugia, Italy
September 5-7, 1980

When American bankers look back upon the decade of the 1970's,
they can add up a number of impressive achievements.
innovated vigorously, both abroad and at home.

American banks have

Abroad they have played

a pioneering role in the financing of developing countries and particularly
in the recycling of OPEC funds.

At home new techniques of lending, of

raising funds, and particularly of serving the consumer have been developed.
Through the bank holding company device, banks have been able to break out
of their geographical confinement at least in limited fields such as consumer
and mortgage financing.

They overcame the difficulties of 1974-75 Which

incidentally provided a positive test of the effectiveness of American
institutional arrangements for dealing with a major bank failure.
At the same time, American banks have experienced trends that are
less constructive and call for careful analysis.

Large American banks have

embarked on a program of heavy lending to developing countries, which carries
them into an only partially charted risk area.



As a group, these banks

-2-

nevertheless have fallen behind in the race against foreign competitors
for market shares worldwide.

Domestically, the share of banks in the

total supply of credit has diminished.

The dependence of particularly

the largest banks on purchased funds of a volatile character has increased.
The value assigned to the largest banks by the stock market has fallen to
levels at which it becomes very difficult for them to issue new stock.
Meanwhile their capital has not kept up with the rise in their assets.
These generalizations, to be sure, apply to different U.S. banks
in very different degree.

It is principally the money center banks that

have experienced the problems just noted, and in lesser degree the large
regional banks.

Small local banks have been affected far less.

These differences are crucial to an evaluation of the American
banking scene.

Local banks, with assets of up to perhaps $100 million,

typically have had good earnings, of the order of one percent on assets
or more, compared to one-half to three-quarters of one percent for the
money center banks.

Their capital averages 8 percent of assets, contrasted

with 4 percent or less for the money center banks.

Their stock typically

sells at a sizable premium over book value, contrasted with a discount from
book value for many money center banks that has begun to be corrected in a
few cases only recently.

Considerable regional differences are observable

in the experience of small banks during the 1970's, and it is conceivable
that increasing competition, especially with thrift institutions and perhaps
with larger banks more aggressively deploying innovative techniques, may
change the picture for small banks during the 1980's.
In any event, the following observations concerning American banks
must be understood as applying principally to the money center banks, a term
usually applied to a group ol nine banks, and in diminishing degree only to



-3-

large regional banks, comprising a group of perhaps 15 major institutions.
I shall examine some of the factors giving rise to concern.

From what I

have already said it should be clear that I regard these as compensated by
many positive aspects on which I do not intend to dwell here.

LDC Lending
American banks have pioneered in the development of lending to
developing countries.
price of oil.

This lending began well before the 1973 rise in the

It increased in volume and economic significance as recycling

of the OPEC surplus became necessary.

The developing countries in large part

were unable to maintain a good rate of growth during the difficult years that
followed.

It is not easy to visualize how that result could have been achieved

without the activities of American banks, in which banks of other countries
soon began to join.
LDC lending was seen to involve a new kind of risk —

"country risk."

For many developing countries, however, the market's evaluation of risk in
the course of time became very low, under the pressure of competition and the
ready availability of funds in the Euromarkets.

In justification it was some­

times argued that developing countries constituted a relatively good credit
risk because they could not go out of business and would always have to meet
their obligations or reschedule them in an acceptable way in order to continue
essential development programs.
The validity of this reasoning remains to be tested.

So far

the record of loan losses of American banks in LDC lending has been very
good and certainly much superior to domestic experience.

Nevertheless,

during the last few years, American banks have tended to limit their activities
in LDC lending, leaving a growing share to banks of other countries.




This

-4-

has somewhat reduced their comparative exposure, although for the money
center banks, which have done the bulk of this business, non-OPEC LDC
exposure continues to be higher than for banks of other countries, averaging
176 percent of capital for the money center banks.
American bank regulators have been concerned to limit concentration
of exposure in particular countries.

An examination system has been established

which focuses on the percentage of capital exposed in each country.

So far

this emphasis on diversification has been justified in that a domino effect
among borrowers which one might anticipate has not so far materialized.
Research seems to indicate that the circumstances influencing the ability
to pay of particular countries are sufficiently different to limit significantly
any correlation in their debt service behavior.

At the same time, however,

the low level of spreads has made LDC lending a seriously unremunerative
form of risk.

It seems clear that LDC lending has proceeded at a pace

that cannot be sustained, at least by the U.S. banks that have carried a
large part of the burden until now, and that eventually other banks or
other sources of finance will have to be opened up for the developing
countries to supplement bank lending.

The Diminishing Role of American Banks
In 1956, 44 U.S. banks ranked among the world's top hundred
banks, measured by deposit size, and accounted for 52.4 percent of the
deposits of these hundred banks.

In 1978, the number of U.S. banks among

the top hundred had dropped to 15, with 14.8 percent of deposits.

These

data, developed by The American Banker and quoted from the Comptroller
1/
of the Currency,
are subject, of course, to numerous qualifications.

1/

C. Stewart Goddin and Stephen J. Weiss, U.S. Banks Loss of Global Standing.
Comptroller of the Currency, Staff Paper, June 1980, p. 2.




-5They are not, however, at all surprising.
been growing more slowly than most others.

The American economy has
The role of American banks

in international lending has been diminishing relatively recently.

The

devaluation of the dollar, while conceptually offset by the higher rate
of U.S. inflation which was one of its causes, probably contributed on
balance to the reduction in the U.S. share.

The difficulties that

American banks have had in increasing their capital likewise may have
played a role.

So did the diminishing demand for noninterest-bearing

money, relative to income, i.e., the rapid increase in velocity, in the
face of mounting inflation.
More fundamental, however, than the foregoing factors, because
it is more closely related to the structure of the American banking system,
is the constraint placed upon the expansion of banks by U.S. banking
legislation.

The Glass-Steagall Act and the Bank Holding Company Act

closely limit the financial activities the banks can undertake, especially
with respect to the securities business, and so restrict product extension.
The McFadden Act and the Douglas Amendment restrict geographic market
extension —

the McFadden Act, by prohibiting interstate branching, and

the Douglas Amendment by restricting interstate acquisition of banks by
bank holding companies.

These are the principal expressions of U.S.

structural policy in the field of banking.

Other countries have been

far more generous regarding the ability of banks to move into other
fields of activity and in allowing them to merge and branch on a nationwide
basis.
Geographic restrictions on expansion are, in part at least,
also responsible for the diminishing share of the money center banks in
the total domestic banking business in the United States.



The demand

-6-

deposits of large corporations, Which at one time were their principal
source of funds, have shrunk drastically as interest rates have risen
and cash management techniques have improved. The money center banks
do not have access to small business and household deposits beyond
their operating area.

As a result, regional banks and, even more, smaller

local banks have increased their share of the commercial banking business
at the money center banks' expense.
Even more, however, commercial banks as a group have fallen
behind as suppliers of credit in the United States.

Thrift institutions,

other financial and nonfinancial institutions, and the federal government
all have cut into the share of the banks Which has gone from 33.0 percent
in 1970 to 30.9 percent in 1980 (QI).

While this development may have

many roots, one obvious factor is the impact of legal and regulatory restraints
on market and product extension in a rapidly changing world.

Purchased Funds
The regional segmentation of the U.S. banking system not only
limits growth, but also makes it more difficult to create a national deposit
base.

Funds that in other countries are channeled to a bank's head office via

a nationwide branch system, in the American environment must be purchased
in the federal funds market or through repurchase agreements.

Together with

funds raised through large certificates of deposit and through the Euromarket,
purchased funds account for as much as half the total funds available to
some American money center banks.

Such funds often are interest sensitive

and volatile to a high degree.
The prohibition of interest payments on demand deposits also works
to limit the deposit base.
the banking system.



However, such funds are not necessarily lost to

Banks may be able to attract corporate funds in the

-7form of repurchase agreements and similar devices.

They may also retrieve

funds of small personal holders through the sale of CDs to money market
mutual funds.

In this way, large banks may attract some funds that would

be held as demand deposits in small local banks if interest could be paid
on them.
The interest rate sensitivity of these managed liabilities imposes
certain constraints on banks in terms of the assets financed from such sources.
Fixed interest loans, such as most mortgage, consumer, and also many small
business loans, have less interest flexibility than would be desirable for
the safe investment of these funds.

However, floating rate loans, accounting

for about one-half of total loans, provide enough flexibility to effectively
limit interest rate risk.
Funding risk is another matter.

Compared to a bank with a strong

base of core deposits, a bank relying heavily on purchased funds must
continually meet the market test.

Difficulty in rolling over purchased

funds is a sign of incipient trouble.

In one sense, this imposes a whole­

some discipline upon banks, but it also increases the overall risk element.
Compared to large foreign banks operating in the Eurodollar market,
American banks have the advantage of operating almost exclusively in their
own currency.

They do not face the risks inherent in having to meet rollover

maturities in a foreign currency.

Accordingly, the risks of maturity trans­

formation are of a different order for them than for their foreign competitors.
They do not face the possibility of a run-off of purchased liabilities with­
out recourse to a dollar base or a dollar lender of last resort.

Nevertheless,

no bank, whether operating in its own or a foreign currency, can regard any
short-term liability and especially, of course, demand deposits, as entirely
stable.



Clearly the growth of liability management and consequent reliance

-

8-

on purchased funds by large American banks must be regarded as an element
of flexibility more than of strength.

Liquidity
Liability management is only one part, of course, of the total
picture of a bank's liquidity.

It used to be said that liability management

had totally changed the problem of providing liquidity for a bank.

Instead

of holding liquid assets to meet withdrawals or take advantage of opportunities,
liability management supposedly allowed banks to buy money whenever it was
needed.

Meanwhile it has become apparent that the ability to buy money

is itself dependent on the market's view of the soundness of the bank, as
reflected mostly by earnings and asset quality, but in which liquidity also
plays a part.
American bank supervisors have placed additional emphasis on
liquidity in recent years, by including an evaluation of it in their
so-called CAMEL rating system for banks, which focuses on capital adequacy,
asset quality, management quality, earnings, and liquidity.

In this

framework, liquidity is evaluated in terms of capabilities and performance,
rather than numerical standards.

The rating recognizes that the circumstances

of particular banks vary widely and that quantitative measures would not
adequately capture these disparities.
It is worth noting that, of the five criteria by which liquidity
is evaluated in the CAMEL system, four deal with liabilities:

(1) volatility

of deposits, (2) reliance on interest-sensitive funds, (3) technical
competence relative to the structure of liabilities, and (4) access
to money markets.

Only one —

convertible into cash —

( 5 ) 1

ixty of assets readily

ili

focuses <^\tjh£/as/B,et?.'.side.
w.V

* •'

The degree of

O’/
.0/

maturity mismatching is not specifio^^^.tf^zuded among the liquidity criteria.



-9-

The system has not been in effcct long enough to observe the
evolution of liquidity of U.S. banks over time.

During a period of

economic and financial expansion, liquidity must be expcctcd to dccline, but
the available data do not suggest deterioration among the nine money
center banks.
Not quite as favorable an impression is derived from a tabulation
of four tests of liquidity for a group of 35 large banks, taken from a study
by Salomon Brothers, and shown in Table 1.

TABLE 1.— Measures of Liquidity

Loans as percent of
total assets
Net purchased liabili­
ties as percent of
total assets
Investment securities
maturing in one year
or less, as percent
of total investment
portfolio
Depreciation of invest­
ment portfolio
(percent of book)

Source:




1975

1976

1977

1978

1979

56.2

55.4

55.4

56.3

56.6

36.6

34.9

36.1

39.7

40.1

35.3

30.8

32.1

23.7

17.9

4.0

5.9

Salomon Brothers, A Profile of Commercial Banking in the United
States. 1980 édition, pp. 52-55.

-10-

While there has been no significant deterioration in the loan/asset
ratio, there is evident a weakening in the purchased liabilities ratio, the
short-term investment securities ratio, and the overall value of the port­
folio.

It should be noted that these data, as far as the year 1979 is

concorncd, reflect relatively high interest rates which since have come
down and probably have improved the value of the investment portfolio.
Liability management tends to blur the ancient distinction between
liquidity and solvency.

A bank whose solvency is beyond question is unlikely

to find itself strapped for liquid funds, because it can buy money.

However,

if its solvency comes into question, this source of funds will begin to dry
up, creating a liquidity problem.

If the bank then is compelled to liquidate

assets at depreciated prices, as many happen if interest rates have been
rising, these efforts to provide liquidity may further endanger solvency.
The environment of high and volatile interest rates that has
prevailed in the United States in recent years has confronted the banking
system with many new challenges in the area of liquidity policy.

Attention

to Lhe interest sensitivity of assets and liabilities becomcs very important*
Matching the volume of interest-sensitive assets and liabilities helps to
reduce the impact of interest rate fluctuations upon earnings.

A net long

or short position in interest-sensitive assets becomes a speculation on the
movement of interest rates.
It is becoming apparent that even the voluminous data provided by
U.S. banks on their quarterly call reports are not sufficient to permit a
definitive analysis of intercst-rate sensitivity.

Breakdowns of maturities

within the one-year range would be needed for a more accurate assessment.
It is worth noting that from the end of 1978 to March 31, 1980, most of the
banks in the above-mentioned sample of 35 large banks kept their ratio of




-11-

in teres t-sensitive assets to interest-sensitive liabilities within the
2/
range of 85 to 115 percent.
There was a slight shift, during this
period, toward the lower direction.

Given the upward trend of interest

rates during this period, this was scarcely a profitable move at the time.
But it may have turned profitable once interest rates began to come down.
Analysis of interest sensitivity, however, is not enough in today's
banking climate.

The nature of "interest-insensitive" assets and liabilities

is even more important.

While their interest yield or cost many be fixed,

they respond to interest rate movements in other ways.

Demand deposits

and savings deposits, whose interest rate ceilings are fixed, respectively,
by law at 0 and 5-1/4 percent may be disintermediated as interest rates rise.
Marketable securities with longer maturities will depreciate under these
conditions, even though they can continue to be carried at cost if their
quality is above question.

Mortgages and other medium- and long-term

fixed rate loans have no market quotation, and, of course, continue to be
carried at book value, but their economic value nevertheless is depressed
by rising interest rates.
For these reasons, the meaning of large investment portfolios on
bank balance sheets has changed significantly.

Where in years gone by such

holdings were regarded as elements of liquidity and strength, particularly
if invested in government securities, today they arc looked upon by some
analysts as sources of potential or actual weakness.

For mutual savings

banks and savings and loan associations, the depreciation of mortgages

2/

"Rate Sensitivity Ratios: Tilting to the Liability Side," Salomon
Brothers, Bank Stock Department, June 13, 1980.




-12-

with low interest rates in the face of the rising cost of liabilities
croatcd considerable tensions in some instances before interest rates
came down in April of 1980.

Capital
The capital stated on the balance sheet of American banks
is more meaningful than its counterpart in most other countries.
banks have no hidden reserves in the usual sense of the word.

U.S.

They are

fully consolidated worldwide, at the 50 percent level, so that the assets
and liabilities of subsidiary concerns at least 50 percent owned are
included in the balance sheet of the bank.
similar accounts.

There are no trustee or

Nevertheless, valuation differences can arise between

the book value of the investment portfolio, which can be carried at cost
if the assets are of sound quality, and its market value.
likewise of course, are carried at cost*

Mortgages,

Thus, at times of rising

interest rates, these assets, although booked according to generally
accepted accounting principles, may represent an overvaluation.

At

times of falling interest rates, they would be undervalued.
Large American banks carry valuations to meet loan losses of
the order of one percent of loans, which are in excess of historical loss
experience and may therefore to some extent be considered equity.

Since

all large banks have adopted the character of bank holding companies, and
since the holding company usually has some debt outstanding, thereby giving
a double leveraging to the banks' capital, it is the capitalization of the
holding company rather than that of the bank which is relevant for international
comparison and as a measure of the strength of the bank.




-13-

The capital ratios of American banks, usually measured as equity
capital/total assets, have followed a declining trend for many years.

For

the money center banks, the range is approximately from 3 to 4.5 percent.
International comparisons are difficult to make, because of such factors
as incomplete consolidation, hidden reserves, valuation of assets, and
3/
the use of trustee accounts. In a recent paper,
Wilfried Guth placed
the capital/assets ratios of the three major German banks at 3.93 percent
compared with four British clearing banks at 6.02, and four leading
American banks at 3.58 percent.

American banks appear at the low end

of this distribution, while the entire three country group would be out­
ranked by the leading Swiss banks.

On the other hand, French and Italian

banks would probably rank lower, with the leading Japanese banks at
about the same level.
For nine U.S. money center banks, the average capital ratio declined
from 5.36 in 1970 to 3.90 in 1979, with a brief interruption in 1975
and 1976, when the expansion of the banking system diminished.

The

expansion of bank assets underlying this decline was more a function of
inflation than of expansionary policies on the part of the banks.

This is

particularly true with respect to the money center banks, whose share
in total domestic commercial bank assets dropped from 19.1 percent in
1970 to 18.2 percent in 1979.

These banks compensated in some measure

for their relative decline at home by faster expansion abroad.
The downward trend in capital ratios has been a serious concern
to U.S. bank regulators.

3/

They see bank capital principally as a means

Wilfried Guth, "Problems Raised by the Growth of International Bank
Lending" delivered at the International Monetary Conference, June 1-4,
1980, New Orleans.




-14-

of protecting bank depositors and other creditors against possible losses.
Some banks, to be sure, seem to believe that losses even of a size very
unlikely to occur could and should be taken care of out of earnings.

With

pretax earnings of leading banks in the range of 20-30 percent of capital,
there is indeed much scope for absorption of losses before capital would
have to be invaded.

Nevertheless, capital remains the ultimate source of

solvency.
U.S. bank regulators —

the Comptroller of the Currency, the

Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC) —
from time to time have urged particular banks to strengthen their capital.
The Federal Reserve has also at times slowed down the merger and acquisitions
process of all bank holding companies in order to encourage consolidation
rather than expansion.

For smaller banks, the Federal Reserve has been

somewhat more demanding than for large banks as regards the level of capital
required for approval of bank holding company applications, on the grounds
that smaller banks, with their less broadly based business, have less
opportunity for risk diversification.

Recently, the Comptroller of the

Currency has urged individual banks to strengthen their capital from existing
levels.

Hard numerical capital ratios, however, have never been applied to

large banks.
Uniform ratios could probably be enforced by the regulators even
without statutory backing because of their wide range of supervisory and
regulatory powers, including the control of mergers and bank holding company
acquisitions.

Proposals for establishing uniform ratios have nonetheless

always come up against the fact that banks not only have very different
ratios at the present time, but by the nature of their circumstances can




-15-

justify differences within a considerable range.

Uniform ratios might

limit the credit expansion of strong banks while perhaps leaving scope
for undesirable expansion of less strong institutions.
The most obvious way of augmenting bank capital -- issuance of
new stock -- is made very burdensome for most of the large banks by the low
price of their stock, in most cases selling below book value and equal to
4-5 times annual earnings.

Moreover, given the damage that inflation does

to bank capital, which I shall spell out in the following section, the
question can be asked whether raising new capital would not be throwing
good money after bad.

Alternative techniques would be to deliberately

slow the rate of credit expansion of undercapitalized institutions or to
reduce dividends.

Both approaches, however, would probably further depress

the price of bank stocks and thus further reduce prospects for new stock
issues in the future.

A widespread slowing of bank credit expansion, more­

over, would probably have macroeconomic effects, even though the relative
reduction in bank credit could to some extent be made up by faster expansion
of other forms of credit.

Still another approach would be an increase in

the coverage of deposit insurance, perhaps to 100 percent of bank liabilities.
The drawback of this seemingly very rational approach is the probable relaxation
of market discipline over banks and prospect of much greater government control
over banks' affairs.
Probably the most economic and natural solution to the problem of
bank capital would be an increase in bank earnings, which would lead to
higher retentions of profit as well as better chances for new stock issues.
I shall comment presently on some aspects of this solution.




Over the last

-16-

three years, the earnings of the banks have indeed grown sufficiently to
raise the rate of return on capital.

For a group of 35 leading banks, the

return on equity rose from 12.5 percent in 1977 to 15.2 percent in 1979.
With dividend payout close to one-third, this allows retentions equal to
about 10 percent of capital.

The earnings picture, however, is far more

complex than this and needs to be examined separately.

Earnings
Bank earnings suffer from inflation in a way that bankers,
regulators, and even some analysts find hard to appreciate.

Some analysts

seem to take the view that all that is needed to adjust bank earnings for
inflation is to divide them by a price index, yielding an earnings series
in constant dollars.

Unfortunately, inflation accounting, whether by the

constant dollar technique (also known as general price level accounting),
or by the current cost technique (also known as the current value method) is
not as simple as that and the outcome more damaging than that.

Some seem

to take the view that, since bank assets and bank liabilities both depreciate
at an equal rate during inflation, bank capital and earnings are altogether
unaffected.

They overlook that the bank's capital is also invested in

depreciating paper assets, except for a small portion that may be invested
in nonmonetary assets such as real estate.

In the United States, banks'

nonmonetary assets, usually the bank building and a small amount of equip«
ment, account for about one-quarter of the banks' capital.

If that part

is regarded as protected, at least conceptually, against inflation, about
three-quarters of the capital remain vulnerable.

The loss that the bank and

its stockholders suffer on this part of the capital must be deducted from




-17-

the rate of return in order to arrive at inflation-adjusted earnings.

At

a rate of inflation of 10 percent, this means a "hair cut" of about 7.5
percent or one-half of a 15 percent nominal rate of return.
This form of inflation adjustment has become more widely under­
stood since it was mandated, in a more elaborate form, by the Financial
Accounting Standards

Board.

Major banks must now provide inflation-

adjusted earnings data in their annual reports.

Nevertheless, these adjust­

ments do not yet seem to have been fully accepted by bank management or
bank stock analysts.

The market, however, seems to understand them since

it places so low a valuation on bank stocks, although conceivably this
could have other reasons such as concern about LDC lending.
Given the low level inflation-adjusted bank earnings, it seems
clear that earnings will have to rise further if banks are to protect them­
selves effectively against inflation.

This increase could, of course, take

the form of a further lowering of capital ratios, but that would be highly
undesirable.

On the contrary, one of the principal reasons for increased

earnings, as noted earlier, would be to raise retentions in order to over­
come the attrition of capital by inflation.

Questions would likewise have

to be raised if banks were to attempt to reduce their positive net monetary
asset position by acquiring more nonmonetary
to their business.

assets not strictly germaine

Conceivably, after-tax earnings could be improved if

the tax were made to apply to inflation-adjusted earnings.

There would be

justification for such legislation, because the tax rate on the adjusted
earnings is far higher than the stated rate —
dividend pay-out ratio.

as is, incidentally, the

But such legislation would probably have to be

part of a more general adaptation of the tax system to inflation.




-18-

Earnings could be raised also if reserve requirements were to be
reduced, a measure justifiable in terms of their high interest cost under
inflation.

A substantial reduction in reserve requirements already has been

legislated under the Monetary Control Act, over a period of eight years.
This does not make a decisive difference, however, in the banks' ability to
raise their earnings and retentions.
A more likely alternative is wider interest-rate margins, as noted
earlier, which would mean lower returns to depositors and higher costs to
lenders.

For the banks it would mean slower growth and a diminishing share

of banking in total credit.

Such shrinkage indeed is the expectation one

must have about the future of the banking system and the entire financial
sector in an inflationary economy.

There would also be political difficulties

about an increase in bank earnings that, before adjustment for inflation, might
appear excessive.

Nevertheless, it seems to be the economically most plausible

and the most feasible way in which banks could defend themselves against
progressive decapitalization by inflation.

Conclusions
1.
and problems.

American banks during the 1970's have encountered both successes
The present paper focuses on the problems, in the belief that

even though they are outweighed by the successes, problems need to be analyzed
before they can be effectively dealt with.
2.

The large money center banks, by lending to IDCs, have assumed

a new and not well explored form of risk —

country risk.

While loss

experience so far has been very good, the financial returns have been unrewarding
and the banks have tended to limit their participation in this area.




-19-

3.

American banks have been limited in their growth by legislative

and regulatory restrictions, principally by the Glass-Steagall Act and by
the McFadden Act and the Douglas Amendment, which impede product extension
and market extension respectively.

As a result, their rank among the world's

largest banks has declined, the share of the money center banks in the total
U.S. banking system has declined, and the share of the entire banking system
in total domestic credit has declined.

Inability to acquire a larger volume

of core deposits through a wider branch system has pushed the money center
banks toward increasing liability management.

Easing of restrictive banking

legislation would improve the position of the money center banks and strengthen
the financial system and perhaps also improve the share of the entire
banking system in total credit.
4.

The capital ratios of large banks have trended downwards, under

the impact principally of inflation.

Sales of new stock have been difficult

because of the depressed price of the stock of large banks.

Earnings have

been inadequate to maintain capital ratios through retentions.

Among the

possible remedies would be a slowing of expansion imposed by the regulators
(which would be painful for the banks and for the economy), a move toward
100 percent deposit insurance (which carries with it the threat of government
domination), and action by government or the banks themselves to improve the
banks' after-tax earnings.
5.

Bank earnings are grossly distorted by inflation and typically

overstated by 50-100 percent.

Inflation-adjusted accounting has been

mandated by the Financial Accounting Standards Board, but has not found
full acceptance.

Among the consequences of the overstatement of profits

are low price/earnings ratios, market values below book values, excessive
effective tax and dividend payments, and inadequate profit retentions.



-20-

Inflation adjustment of taxes would be economically justified but is
unlikely.

Regulatory encouragement of greater investments in nonmonetary

assets would be undesirable.

The most promising remedy would be the widening

of profit margins sufficient to produce adequate inflation-adjusted profits,
which would restore the ability of banks to sell stock, limit and preferably
reverse the shrinkage of capital ratios, and end the decapitalization of
banks by inflation.




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