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WSERVES^

Remarks of J . L. Robertson, Member of the
h
Board of Governors of the Federal Reserve System
at the
Washington Forum for Bank Executives
Sponsored by the District of Columbia Bankers
Association in Cooperation with Georgetown University
at
Copley Hall, Georgetown University, Washington, D. C.
October 30, 19$h

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"BANK CAPITAL ADEQUACY"

Some of you know, from painful experience, that I am not
usually reluctant to plunge into a controversial topic, or above introducing the spark of a seemingly fixed (though actually provisional)
idea into a highly-charged atmosphere in the hope that I - and perhaps others - will be educated in the course of the resultant explosion. However, even I am not prepared to jump feet first into the
quicksand of capital adequacy; more capable men than I have atteirpted
that and have sunk from sight without a trace. Instead, what I hope
to do is to present some questions that we can explore together.
The fcrce of tradition is exceptionally strong among bankers,
and any man who has spent his business career in this field has been
exposed throughout that time to innumerable discussions about the relative merits and demerits of capital/deposit ratios, capital/risk-asset
ratios, and the like, especially in recent years. This is because of
the facts that since 1939 (1) total deposits of commercial banks have
trioled ($£8 billion to $172 billion) while capital accounts have cnly
doubled (from $7 billion to $lii billion); and (2) the ratio of capital
funds to risk assets has fallen from 2 < to YJ%.
8£
In this matter, as in so many others, men strive for an elusive and sometimes impossible precision - a will-o'-the-wisp of certainty, expressed in a mathematical formula, that is "correct" and
easy to apply. Let us agree, before going any further, that we are
not going to find any such delightful solution to our question. If
complex banking problems, such as adequacy of capital, were susceptible of solution by formula, the banking system could save a great
deal of money by firing its expensive top management and hiring a few
competent statisticians in their places.
Formulas and ratios do have a useful function - they serve as
economical and valuable shortcuts in screening out those cases which
the supervisor should look at thrice instead of twice,, But they do not
and cannot give us a pat answer as to how much capital is "adequate".
They merely show us which cases call for an extra dose of judgment; a
careful analysis of assets, especially with respect to quality and degree of risk, and of liabilities, with emphasis on their nature, trends,
and volatility; and a thorough review of the past performance of management (since every banker thinks his bank has the best possible management, this is about the only feasible approach, and even it isn't much
good i f the record covers only the last decade or so, when losses were
hard to "make"). This judgment must be based also on careful thinking
about the soundness of present lending and investing policies, the potentialities of growth for both the bank and its community, the profitability of operations, the dividend policy, the amount invested in fixed
assets, and the adequacy of internal audits and controls.

But to my mind, the really crucial question is not the mechanics of measuring capital adequacy. It is an underlying problem that is sometinBS overlooked or taken for granted. Before we
can make any progress in determining whether a bank's capital structure is adequate, we must first know the answer to: Adequate for
what? We may flounder indefinitely if we ask only whether a bank
has "enough'1 capital- the real question is: Enough for what purpose?
From the point of view of one who is interested in the welfare and vigor of the banking system as a vital part of our economy,
bank capital performs two functions. Most obviously it serves to protect the current funds of its customers - its depositors, whose funds
serve as the principal medium of exchange in this country. But perhaps no less important is the fact that adequate capital is necessary
if a bank is to perform effectively the key function of providing adequate credit for the needs of its conwunity. Banks can meet the need
for loans most effectively, without involving risk to depositors, if
they have adequate capital to cover any reasonable risk. When such
protection is lacking, banks tend to become unduly cautious or timid
in extending credit when it is most needed to keep the wheels of our
free enterprise economy turning. For banks to meet the challenge of
a growing demand for credit - as our economy grows - bank capital m u s t
be Increased to support an expansion of risk assets.
The extremes of possible capitalization also are obvious, but
unrealistic and impracticable. Of course, deposits would be absolutely
safe and the bank would never close its doors on account of insolvency
i f the capital cushion were equal to the total risk exposure in the
bank's assets. However, a bank with that much capital simply could
not pay its way- even the most public-spirited shareholders eventually
would liquidate the institution and invest their capital in an enterprise where it would yield a more satisfactory return.
At the other extreme, from the immediate dollars-and-cents
point of view of the bank's owners, the ideal situation would be an
extremely thin layer of capital, which might earn 20% or 3C$ a year.
Put that way, the proposal seems absurd, but I have encountered a
few bankers who have come close to espousing that position, although
they would not have put it so crudely. Let me outline a representative example, vMch is a composite of several actual cases.
Between 19l*0 arrl 1952 the deposits of Bank X increased from
$100 million to $300 million. During the same period, the capital
structure grew from $9 million to
million. The bank had this distribution of assets: some $90 million of loans, $30 million of municiP*

- 3 and corporate securities, and $100 million of Governments,
The Comptroller of the Currency ( I was there then) had suggested the sale of
additional stock, and the bank's president was explaining why he was
dragging his feet.
He told me candidly that he and several other large shareholders could take up their proportion of an additional bank stock
issue only by selling other lucrative securities. He pointed out that
if the bank's capitalization were increased from $1$ million to $20
million, there would be a relatively small increase in earnings and
the dividend rate probably would have to be reduced from eight dollars to six. In a word, his own annual income from securities would
drop substantially, and he did not like that.
He seids "You know we'd want to do it if it were really necessary, My father founded the bank, and most of the stock has been in
the same families for more than forty years. The bank is almost sacred to most of us, and I , for one, would gladly give up my personal
fortune rather than have the bank lose prestige or have any depositor
lose a dollar." And I know he really meant it.
"But", he continued, "the bank has plenty of capital cushion
right now, and I don' t relish reducing my family's standard of living
just because of an old banking shibboleth about a l-to-10 ratio or
something like that. Here's a schedule", he said, "of our loans and
investments, and if you can honestly show me five million of probable
losses, I ' l l get behind any capital increase program you want."
Those words may sound familiar to you; you may have said something like that at some time or another, or heard it from someone on
the other side of your desk. There is nothing ridiculous about his
argument. In an econon^y that has grown great under the stimulus of
private initiative and profit motive, there is no justification for
insisting on an increase of bank capital merely for the sake of a fatter
figure near the lower right corner of the balance sheet, or to fit some
arbitrary mathematical formula. We have no right to demand more capital unless there is a real need for it 0
I went over that list with my friend. I was not able to show
him
million of prospective losses. What I did try to do was to
stress that we were running along in a boom period of unprecedented
duration and magnitude; that loans never look bad when they are made,
particularly in such an economic climate; that the very best bonds
with twenty years to run can drop from par to 86 if current interest
rates rise from three per cent to four; and that he would not always

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be around to insist upon "quality" and proper supervision of loans
and investments. I called on precedents, including the portfolios
of banks apparently in a similar situation in 1928 and in the hands
of a receiver in 1933.
I need not burden you with the rest of our conversation. The
man on the other side properly brought out that the banking situation
had changed fundamentally in the past twenty years. He hadn't thought
that point through completely, but certainly i t behooves all of us to
bear in mind that there are many factors in the pictiire today which
may tend to avert bank liquidity crises, and thereby eliminate the
strain on bank capital which at times in the past has resulted from
emergency liquidation to satisfy panic withdrawal of deposits. For
examplet (l) broader lending authority of the Federal Reserve, (2)
deposit insurance, (3) government guarantees of various classes of
assets, (U) better supervisory policies, and (5) governmental policies and actions contributing to economic stability, such as crop
support programs, disaster aid, old age and unemployment insurance,
fiscal, debt management and monetary policies, etc. But let's remember, too, that these factors, while beneficial to the banking system
and helpful to individual banks, do not assure the solvency of any
particular bank. Individual institutions must have capital strength
and liquidity to meet prudent business tests.
Well, anyway, it would be pleasant - but false - to tell you
that the several bankers who enter into ray composite story were overwhelmed by tte cogent logic of my arguments and joyfully boosted their
capital to a lush figure. For the most part, they reluctantly went
ahead with a capital-increase program, sometimes for substantially
less than the supervisor recommended - but almost always, I am glad
to say, with subsequent gratification that they had taken the step,
and sometimes with remorse that they had not gone the whole way.
But I am not prepared to brand bankers who cannot see their
way clear to increasing their capital as selfish and shortsighted men.
Ours is still a dynamic economy. That has been said so frequently
that it has almost ceased to mean anything to us, but it remains true.
Our economic situation is very different from that of the 20's, as
that was very different from the l 8 9 0 , s . Perhaps our "built-in stabilizers" will so greatly moderate future downturns that a relatively
thin capital cushion will prove to be "adequate" for our lifetime.
However, it seems to me that we must make haste slowly in this
matter. Commercial banks perform such vital functions in our economy,
and any interruption of those functions is so profoundly injurious,

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that we are justified in leaning in the direction of conservatism in
reaching a decision that may determine whether American banking will
stand firm in economic crises or will collapse.
As many of you know, the last few years have seen several
serious efforts at analysis of bank capital adequacy. Some of these
have been broad and sweeping, dealing with principles developed from
decades of banking or bank supervisory experience. Others have been
factual, even statistical - based on what actually has happened to
the several classes of bank assets in periods of stress, and deriving
therefrom some approximation of the "risk element" in the various
classes of assets. We certainly do not have the answer, as yet, but
we do have a solid foundation of fact, figure, opinion, and tentative
methodology. Our job now is to analyze, criticize, and refine this
material; to correct its flaws, to supply its omissions, and to coordinate its several phases.
I repeat: We will never develop a formula that determines by
arithmetic whether the capital of a bank is adequate. We never will
be able to measure mechanically the attitude and competence of a bank's
management and staff, and how those may change within a few years.
Nor can we forecast with any precision the economic future of a community or area. But we can strive to give suitable weight to each of
these factors, judged with experienced intelligence, as well as the
nature and quality of loans and securities. Having done that, we must
add a generous margin of safety, as do the engineers: like a great
arterial bridge, the banking system is too vital - too much depends on
it - to take a chance that it might ever again collapse. If we measure
and maintain adequate capital by these tests, with integrity, intelligence and courage, we shall have honorably oerformed, in this field,
our responsibilities as bankers and bank supervisors.