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NOT RELEASED
Remarks by
John P. LaWare
Member, Board of Governors of the
Federal Reserve System
to the
23rd Annual Bank Symposium
sponsored by the
Bank and Financial Analysts Association
New York City
March 24, 1993

It is always a great pleasure for me to get back to New
York.

And this is a special occasion, because it gives me an

opportunity to share with you my views of the banking industry,
an industry in which we have a keen common interest.
I believe that a strong, aggressively competitive, and
innovative banking system is vital to the economic health of the
nation.

I also believe that Congress is unintentionally

smothering the vitality of banks under countless layers of
increasingly restrictive statutory operating constraints and
detailed consumer protection laws which are largely unneeded and
compliance with which is a costly burden.
But before we consider what needs to be done, let's take a
closer look at where we are today.
In the past 15 years, banking has been on a roller-coaster
ride that was a rather dramatic change from the gentler passage
of the preceding 45 years.

Quite aside from the much discussed

and probably over-analyzed S&L debacle, commercial banks have had

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to deal with a switch from regulated deposit interest rates to a
free market.

That eagerly sought change contributed fatally to

the S&L mess and was in part mismanaged by the commercial banks.
It was closely followed by the LDC crisis.

Then the LBO, HLT and

junk bond era came along while simultaneously the commercial
banks were in a feeding frenzy to replace lost C&I loans with
commercial real estate and pick up the slack left by the failed
thrifts.
For the commercial banks the chickens came home to roost
toward the end of the Eighties.

Commercial real estate collapsed

with a thunderous roar in New England, the Eastern Seaboard, and
most recently in Southern California.
Less than two years ago alarming conditions were generally
present in the industry.
From year end 1989 to year end 1991 problem assets increased
by nearly $30 billion to 2.6 percent of industry assets.
Provisions for loan losses over the two years totaled
$66.1 billion or nearly double the combined net income of $34.5
billion for those two years].

During that same period, 263 banks

failed with about $53 billion in assets.

At the same time the

number of problem banks stayed stubbornly high at about 1,100,
and the assets of problem banks jumped from $188 billion to $528
billion.

As a result of the high level of problem banks, the GAO

required the FDIC to establish a $16 billion reserve for the bank
insurance fund that placed it temporarily in a $7 billion deficit
position.
Those trends and conditions prompted Congress to authorize
the bank insurance fund to borrow up to $30 billion.

At the same

3
time Congress unleashed an onslaught of new bank regulatory
statutes

including prompt corrective action, annual audit

requirements, real estate loan standards, safety and soundness
standards, improvements to risk-based capital, and what I call
the nonsense provisions of Section 132 which call for standards
of compensation, earnings, growth rates, and most unbelievable of
all a standard for the market to book value of bank stocks.
However, time, tide, a refreshed economy, lower interest
rates and eager capital markets have changed the fundamentals dramatically.
1992 was a banner year.

The industry had record annual

earnings of $32.2 billion, nearly as much as the combined net
income over the previous two years.
average assets was 0.96 percent —

And the industry return on
respectable by any standard.

There was a $12.5 billion reduction in nonaccrual loans and
OREO in just that one year span.
Capital continued to improve to an equity-to-assets ratio of
7.5 percent, the highest level since 1965.

Perhaps most

surprising, 99 percent of banks meet the new total risk-based
capital standard.
Ninety-seven banks with $16 billion of assets failed in
1992, down from 105 failures with $43 billion of assets in 1991.

At the same time, the number of problem banks has declined
from 1,016 with $528 billion in assets at year end 1991 to 787
with $408 billion at year end 1992, and those numbers appear to
be heading down further.

Only a handful of banks are critically

undercapitalized at less than 2 percent and the assets in that
group are less than $7 billion.

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undercapitalized at less than 2 percent and the assets in that
group are less than $7 billion.
What the latest results show is that things can change and
change dramatically in a relatively short period of time, and it
is in that context that I think we should approach an effort to
talk about the outlook for the industry with caution.
I will divide the remainder of my comments into a separate
observations on the short- and long-term outlook for the
industry.
Over the short term, I think we can rely on some of the
recent trends as a guide to what to expect next.
The dramatic earnings improvements during 1992 over 1991
levels came primarily from wider margins and lower loan loss
provisions.

That raises the reasonable question whether that

level of earnings is sustainable over the longer run.
Recent spreads have been high in historical terms . Net
interest margins had trended up gradually throughout the 1980's
but the 1992 margin jumped to 4.0 percent,

That is, high

relative to the 3.5 percent spread of just two years ago and the
3.0 percent level at the start of the 1980's.
What was the source of the recent sharp increase?

Well, a

declining rate environment during a time of weak demand for
loans; lower need by banks for deposit liabilities; a general
tightening in standards including pricing by banks, which was
made possible in part by a pull back of foreign bank competitors,
insurance companies and thrifts; and finally a reduced emphasis
on asset growth.

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recent years.

Banks are also lagging market price reduction of

commercial, consumer, and credit card loans.

For example, prime

is 3 percent above fed funds, compared to a more typical 1*.5
percent spread historically.
The steep yield curve opened the spread between short-term
liabilities and securities yields to widen.
was about 60 basis points.

That spread in 1990

In 1992 it was 240 basis points.

The

magnitude of that earning opportunity encouraged banks to add
securities in the light of slack loan demand.
What will happen to those margins over the next year or so
if rates remain unchanged?

Certainly repricing of bank

liabilities seems to be approaching completion, but asset yields
will continue to adjust downward as assets reprice or cash flow
is reinvested at lower yields.
In short, the flattening of the yield curve in the first
quarter by 50 basis points or so will tend to narrow net interest
margin as assets and liabilities fully reprice.
All this suggests that margins are susceptible, and unlikely
to remain at present levels.
But we also need to ask what happens if rates rise?

Some

believe if that is the case margins will compress considerably
more.

That is because there has been a lengthening in the

repricing of the banking industry's assets over the past several
years as the industry has shifted the composition of its assets
to some degree.

All else being equal, this would cause margins

to narrow if rates were to rise, but there is certainly a partial
offset in the growth of adjustable rate loans and more

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sophisticated portfolio management.

But the effect of these

offsets is hard to quantify.
In any case, the record indicates the industry has been able
to manage its repricing of assets and liabilities under both
rising and falling interest rate conditions in the past.

But it

should not be assumed that there will not be temporary changes in
margins of varying degrees during periods of rapid change in
rates, either up or down.
It is a fact that when short-term rates shot from average
levels of around 5 percent in the mid-1970's to around 10 to 14
percent in the early 1980's, the industry's net interest margin
actually improved in some years and generally stayed between 3.1
and 3.3 percent.
In the current situation, given how wide spreads are right
now, I believe the odds are that margins will narrow if rates
suddenly increase.
Let's move on to other sources of earnings gains.

The

banking industry also had higher revenues from selling securities
from the investment portfolio and from foreign exchange
activities.

Over the next few years, though, bankers may have to

come to terms with a loss of revenue growth opportunities in
these areas.
Gains on securities sales were $4 billion in 1992 and
$3 billion the year before that.

For the period 1989-92, those

gains accounted for about 7 percent of pretax income for the
industry as a whole.

However, for banks with assets greater than

$10 billion, securities gains represented over 12 percent of
income.

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The opportunity to realize gains on the investment portfolio
is likely to become rarer.

The principal reason is proposed

accounting changes by FASB to introduce market value accounting
for investments that are held for sale.

In addition, increased

focus by the SEC and banking agencies on institutions to
distinguish between securities held for investment and those held
for sale. Partly in response to this pressure, banks had
designated 16 percent of securities on their balance sheets as
held for sale.
Nevertheless, the industry had unrealized gains on
securities of $16 billion at year-end 1992.

Assuming no change

in the markets, some of that may be used to supplement operating
income in 1993.

First quarter reports may indicate a trend.

Income from foreign exchange trading was $3.3 billion in
1992, up from $2.6 billion in 1991, which was the average level
for the preceding five years.

These foreign exchange revenues

accounted for about 7 percent of pre-tax income in 1992.

It

should be remembered that a relatively small number of banks
account for all foreign exchange trading for the entire industry.
Whether those banks can continue to post such strong performance
is open to question, but it does not seem likely that the
conditions in the currency markets which foster the necessary
trading opportunities will change much in the near future.
Another major source of recent earnings improvement has been
lower loan loss provisions as a result of the improved outlook
for asset quality.

Last year's lower provisioning is likely to

continue given the following trends:

First, both nonaccrual

loans and other real estate owned fell during the year for a

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combined reduction of $12.5 billion, or about 14 percent.
Second, delinquent loans, that is to say 30-89 days past due and
still accruing, are down 17 percent from year-end 1991.

Third,

reserves were a conservative 102 percent of nonaccrual loans at
the end of 1992.
While certain pockets of the United States are obviously
still troubled, notably New England and Southern California,
there seem to be, in general, good prospects for a stable lending
environment.

That increased stability, coupled with what I hope

is a wiser and more seasoned industry, should improve loan loss
experience in the immediate future.
It is easy to forget that throughout the 1970's and early
1980's loan loss provisions as a percent of assets hovered around
20-40 basis points.

That was considerably below last year's 77

basis point level and only a fraction of the 100 basis point
level at the peak of the crisis.
What are the other sources of long-term earnings growth?
Well, the lion's share of noninterest income is coming from
service charges on deposit accounts, and trust activities.
Growth in those areas will depend on the industry's ability to
retain market share and provide outstanding customer service at a
reasonable cost.
Another source of recent earnings growth has been cost
cutting.

There is evidence that the industry has made some

headway in this area. The number of employees in the industry has
been pared back from a peak level in 1985 of 1.6 million to about
the level the industry had in 1980 or 1.5 million.

Noninterest

expenses as a percent of revenues, which is a to measure

9
efficiency, have declined from 69 percent in 1991 to 66 percent
in 1992.

Certainly that is an indication that recent

restructuring initiatives are beginning to pay off.

That 66

percent, by the way, is below the industry's average of 67
percent for 1969-92.

I find this indication of better cost

discipline particularly encouraging.
Finally, it is logical that, at some point in the next few
years, deposit insurance premiums may decline, especially for
well-managed institutions.
I believe the outlook for earnings in the next two to three
years appears generally favorable.

But should we conclude on

that basis that all is well with the industry?

I don't think so.

Competitive pressures facing the industry have gained
strength and appear likely to continue to do so.

Banks lost

market share in the business finance sector, including their
"best" customers, to the commercial paper market, to private
placements of debt, and to finance companies and foreign banks.
Market share was also lost in consumer lending from finance
companies, credit unions, and the credit card business of GM,
ATT, Sears, and others.
The deposit side of banking has also suffered from
competitive pressures:
made major inroads.

mutual funds and annuity products have

Also demographic changes.

Younger Americans

are not automatically oriented toward banks for financial
services.

They get them where it is most convenient and where

they get the best deal.
If you look at market share of all lending using flow-offunds data you will see that banks are losing market share to

10
their competitors.

Breaking flow-of-funds data into two periods

of 80-86 and 87-91, bank's share of the lending market declined
from 17 percent to 11 percent.

The capital markets and insurance

companies have made the greatest gains.

Each has gained 7-8

percentage points during those periods.
On the funding side, bank core deposits have been growing,
but that growth may be less than its full potential.

Mutual

funds and annuity products may continue to capture a significant
portion of available consumer funds.

To some extent, there is an

uneven playing field created by the regulatory restrictions on
banks.

On the other hand, maybe banks have not had a strong

enough desire to keep their share of this market.

It was easy to

buy money from the market and less troublesome than wooing
consumers.
So, competition has been and will continue to be intense,
and that poses a major long-term challenge for the industry.
Banks should not be shielded from competition.

The various

developments that have enabled competitors of banks to gain
market share have occurred because customers were offered better
terms on loans or investable funds.

That is the way a market

system is supposed to function.
But there has been and still is an important factor that
places banks in an unfair economic position and impairs the
industry's ability to compete.

The impairment comes in the form

of regulatory burden and unjustifiable legal restrictions.
FIRREA and FDICIA added to an already heavy structure of
regulatory burden.

It must also be emphasized that the various

consumer protection laws, however beneficial they are, impose

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heavy costs on the industry.

An Exam Council study, mandated by

the Congress, reported that various private studies indicate
costs of regulation range from $8 billion to $17 billion.

That

is excessive not only in direct cost but also in time-consuming
management attention.
The agencies took some steps last year to relieve burden.
But to achieve a material reduction, banking laws must be
changed.

The agencies are currently reviewing potential changes

under the auspices of the Exam Council, and a report is expected
to be available around mid-year.
It is imperative that legal restrictions be removed.
McFadden Act and Glass-Steagall should be repealed.

The

Other powers

including most insurance activities should be permitted as they
are in European countries and Canada.
Banks should be permitted to carry out their activities in
ways that are most efficient and cost effective; and they should
be permitted to offer a range of services and products that best
serve the needs of their customers.

The general public will then

be served.
In the interest of breaking the political log jamb which has
blocked banking structure reform for the last five years, I have
proposed a civilian commission to study the domestic and
international competitiveness of the system and propose a
legislative agenda to the Congress.
Such an approach might depoliticize the subject enough to
enable Congressmen to vote for fundamental reform based on a
zero-based reappraisal of regulatory structure and constraint.

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So far there has not been a rush to embrace my suggestion,
but Congressman Steve Neal has shown some interest.
Thank you for letting me share my views.

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Are there any question?