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Remarks by
John P. LaWare
Member, Board of Governors of the
Federal Reserve System
to the
Algonquin Club
Distinguished Speaker Series
Boston, Massachusetts
February 17, 1993
Good afternoon.

I can tell you right now that it is great

to be home nd to be in the familiar surroundings of the Algonquin
Club, to be in Boston where politics is a passionate hobby
instead of an all-consuming life purpose.

I want to speak with you today about some things which are
on my mind and I hope on yours.

First, the economy —

not the

New England economy which X am sure you have analyzed and
agonized over to the point of no return —
national economy.

but rather the

Where we are today, in my opinion, and where

we might be headed in the months ahead.

Next, I want to talk briefly about the so-called credit
crunch, what it is really all about, and what the future may hold
on that front.

Finally, I want to comment on the condition of the
commercial banking system and the outlook for the industry in the


context of impassioned cries for regulatory relief and structural

The United States economy is doing better currently than
even the most optimistic forecasters would have dreamed only 6-8
months ago.

With reported growth in real GDP of 3.4 percent in

the third quarter and 3.8 percent in the fourth quarter,
unemployment nationally has retreated from a high of 7.8 percent
of the work force to 7.1 percent in January, and inflation is
running below 3 percent on an annualized basis.


interest rates are at their lowest level in more than two decades
and the 30-year Treasury bond yield is just over 7 percent.

These are conditions conducive to growth and key segments of
the economy have responded.

Housing starts have improved

significantly and that activity brings improved conditions to the
businesses of the many suppliers who support housing

Lower interest rates are contributing to

revitalized sales of existing homes.

Sales of autos,

particularly U.S.-built autos, have picked up.
production is growing.


The inventory-to-sales ratio of U.S.

businesses is at a very low level.

This has triggered, and

should sustain, an increase in inventory investment through 1993
and 1994.

Retail sales are stronger than expected and personal

consumption expenditures have returned to their strongest rate of
growth since 1988 after a period of two years when consumers were
more intent on reducing their personal debt burden than on
acquiring more goods, particularly durables.

Remember, I am speaking now about the macro-economy —
regional economies.


New England remains very sluggish, Southern

California is showing signs of continued deterioration, and the
Pacific Northwest is soft due to the dramatic slowdown in
commercial aircraft orders and restrictions on timber harvesting.
The Mid-Atlantic states are doing better, and the Southeast
states, the rust belt, and the plains states continue to look
quite healthy.

At the same time, the outlook for inflation in 1993 and 1994
is for a continued downward trend approaching an annual rate of
2 percent or less by 1995.

The challenge from the point of view of pure economics is to
sustain present trends.

The political challenge is the need to

improve the job environment, since the average voter measures the
health of the economy by the unemployment numbers and the
difficulty in finding work.

The economic challenge may be tougher to meet than the
political one.

There is a lot of soft ground out there which

could bog down even as strong a growth pattern as we are now

The current expansion is largely consumer driven

and, in my opinion, results from a renewal of consumer
confidence, beginning in August.

I think the Democratic

Convention sounded an upbeat note which was contagious.

But, I

also think the public began to feel that, whichever candidate won
the election, the economy was going to receive more attention and

things would be better.

Clinton's victory, based on more pro-

active campaign promises, lifted expectations and moved
confidence up the scale.

But confidence is a fragile, psychological phenomenon which
needs nourishment and reinforcement.

The question now is:


confidence survive what lies ahead?

Tonight we will hear the details of the President's plan for
the economy.

Almost certainly it will contain spending proposals

to create jobs.

That is a prime expectation and will be received

eagerly by those who are out of work.

But if the proposals are

for spending on rebuilding the physical infrastructure of the
nation —

roads, bridges, railroads, and airports —

will it do

much for the displaced defense production employee, the military
serviceman returning to the civilian work force, or the computer
technician laid off in the restructuring of that industry, or the
middle manager from a bank or insurance company, who is out of
work because the company that employed him has had to thin
management ranks in pursuit of greater competitiveness?

What will happen to the confidence of a member of the middle
class who has been planning on a tax cut since last November, but
is now faced with a tax increase to reduce the budget deficit,
which is, in itself, a concept hard to relate to?

How will the Gray Panthers feel about higher taxes on their
Social Security income?

How will those in the higher income brackets react to higher
taxes on their income?

Will they continue to increase their

More important, will they continue to invest in

American business or will they and their middle class compatriots
turn cautious, slow down spending and investment, and help choke
off this strong recovery.

Attitudes are of enormous importance in this environment and
a great deal depends on the President's ability to sell the
nation a menu of sacrifice without squelching the confidence
which is fueling the current growth pattern.

If he succeeds, then the outlook is favorable and my
personal forecast would be for growth in real GDP of 3 to 3%
percent in 1993, with inflation, as measured by the consumer
price index, falling to the 2% to

2% percent range.

Unemployment tends to lag somewhat but by the fourth quarter of
1993 I would expect it to be between 6% and 6% percent of the
labor force.

But, if the President's program as proposed tonight and
subsequently implemented by Congress is seen as too sacrificial
and not enough beneficial, then the pace of economic growth could
slow dramatically, and, perversely, the expected improvement in
employment could abort.

Corporate restructuring will, in my

opinion, continue to be a fixture of the Nineties.

And, the race

to improve productivity is not consistent with rehiring those who
have been laid off.

Moreover, much of the rest of the world,

including our major trading partners, is in the doldrums, lagging
our own recovery and dampening the growth of our export sector.
And the depressed state of the commercial real estate sector is
likely to continue for some time.

The recovery, therefore, has

its fragile elements and the needed efforts to reduce the deficit
may, in themselves, be counter-productive to sustaining our
present rate of growth.

An important issue in the debate over the sustainability of
the recovery is the "so-called" credit crunch.

I say "so-called"

credit crunch because this current phenomenon does not fit the
classic definition of a credit crunch.

Classically, a credit

crunch is when the demand for credit far outstrips the ability of
the financial system to meet the demand.

In the current instance

there is ample capacity to lend in the banking system and there
has generally been only slack demand.

This is a phenomenon which has both supply and demand
elements in it, on a selective basis.

On the supply side, the battered and still bruised
commercial banking system has been through a series of trauma
which have imposed priorities on lending policies which do not
necessarily apply to all applicants for credit.

Certainly, given

the state of the commercial real estate markets in most parts of
the country, the availability of credit for commercial real
estate development is restricted to pre-leased and pre-permanent
financed facilities with developer equity and take-out


That is not hard to understand given the experience

of failed banks brought down by non-performing real estate loans,
or survivor banks whose capital accounts were decimated by
charge-offs and higher reserve requirements.

And, given the

current state of commercial real estate markets, with up to ten
years' supply of inventory, it is not hard to understand why
developers find credit hard to obtain.

Interestingly , some of

the loudest complainers are the ones who did not pay back their
loans last year.

In addition, many would-be business borrowers, both large
and small, have themselves been hurt by the recession and recent
business conditions.

This makes their balance sheets and

operating statements less attractive to loan officers at the same
time that banks are tightening lending standards to avoid future

Add to all of that higher capital requirements for banks at
year-end 1992.

This one factor caused many banks actually to

down-size their balance sheets to improve capital ratios.
part this was accomplished by asset sales.


But many banks also

restrained loan originations, particularly in loan
classifications where they felt they were over-concentrated.
Finally, many banks simply stopped making certain types of loans
because the documentation requirements to satisfy over-eager
examiners or secondary market requirements made it unprofitable
to originate the loan given the pricing structure of the market.
This is particularly true of mortgage loans and small business loans.

Another factor in credit demand is need.

In past

experience, the early months of a recession often put heavier
credit needs on businesses due to slower receivables and

In recent years, we have had a major revolution in

inventory management to the extent that it substantially reduced
the need for inventory financing as the economy slowed.

And, indeed, a slower growing economy ultimately produces
less demand for credit due to a lower level of commerce.

Add to all of these factors overzealous application of
examination standards, especially by young, inexperienced
examiners who use a cookbook approach to their job, and you have
the recipe for slower credit growth and the feeling of many
applicants that they are being dealt with arbitrarily.

On the

other side of that argument would be the banks who would plead
self defense.

Self defense against the repetition of previous

mistakes, self defense against higher capital standards, self
defense against concentration in troubled industries, and self
defense against restrictive and suffocating regulation often
administered by inexperienced examiners and indifferent

This was not so much a credit crunch as a credit
reallocation to satisfy external forces which changed bank
management behavior in a major way and also affected the
credentials of prospective borrowers.

In conclusion, I would like to discuss briefly the condition
of the banking system, the burden of over-regulation, and the
urgent need for substantial structural reform in the United
States financial system.

The condition of the commercial banks in the United States
taken in the aggregate is probably the best it has been in more
than two decades.
assets in 25 years.

Capital is at its highest level in relation to
Earnings are at record levels with the

return on average assets of the nearly 12,000 banks at about one
percent and for the 50 largest at .83 percent.

There are

literally only a handful of banks in the country who do not meet
the minimum risk-based capital standards, and there are less than
50 who are considered critically undercapitalized and therefore
subject to government intervention.

And those deeply troubled

institutions have aggregate assets of less than $7 billion, so
even if all were intervened tomorrow, their resolution would not
constitute a threat to the solvency of the FDIC, in spite of all
the wild claims of some academic researchers.

Much has been made of the increase in the Treasury security
holdings of banks and coincident decline in the C&I loan

The allegation is that banks are playing the yield

curve and the lower capital allocation for Treasuries at the
expense of businesses which need credit support.

It is true that

the risk capital allocation for Treasuries is zero while it is 8
percent for commercial loans.

But ask yourselves what bank would

long survive if they put depositors' money only into Treasuries

and denied deposit customers access to loans.

I believe from my

own 35 years of experience in banking that in the absence of
strong loan demand banks invest in highly liquid securities, with
the intent of liquidating securities to make loans as demand

This has been the pattern in the past and will be in

the future as well.

I have no doubt that banks will finance the

growth in the economy, because that is their business, their
reason for being.

I have spoken at length about the economy and about banks
and their ability to finance the economy.

Now I want to comment

on the much more serious and fundamental question of the survival
of banks as meaningful competitors in domestic and international

In a well-meaning attempt to assure the safety and soundness
of banks, protect depositors, and ultimately limit the liability
of taxpayers, Congress has enacted over the years a plethora of
statutes, the implementation of which has created a costly and
stultifying burden of regulation on commercial banks, restricting
severely the activities in which they may engage and more
recently imposing management procedures, reports, and controls
which add enormously to cost and arguably accomplish very little
in assuring sound operation.

In addition, there are a number of statutes enacted
ostensibly to protect consumers, which are in effect devices to
use the banking system for social engineering purposes.


Community Reinvestment Act is a good example.

Discouraged by the

failure of public housing projects all across the country,
Congress passed the CRA in 1977 to recruit the banks to solve
this huge humanitarian problem, saying banks derive deposits from
the community, therefore they are obligated to make sure the
credit needs of that community are being met.

Private capital

has always been more efficient than government spending and that
has been the case with CRA.

And, indeed, an intelligent well-

administered program can be profitable and desirable business for
a bank.

But, the Act has been applied just as stringently to small
banks in rural communities as to banks operating in the inner
city where the real problem exists.

As Congress has clamored for

a more pro-active role for banks, supervisors have had to require
more documentation to provide an audit trail to establish
compliance, and the automatic protest of applications on the
ground of CRA non-compliance adds enormously to the supervisory
cost and the cost to the bank.

Based on years of experience, I

believe these protests have little validity.

The overwhelming

majority of protests are determined to be unfounded and without

By limiting activities, circumscribing management
prerogatives, and requiring banks to sponsor social programs,
regulatory overkill is making banks increasingly uncompetitive
and essentially forcing customers to other sources of financial

brokers, investment bankers, insurance companies,


mutual funds, and finance companies.

If this trend continues,

banks will cease to exist as innovative risk managers, providing
new credit and deposit services to an expanding economy.

I do

not think that is enlightened public policy.

What, then, might happen to change that gloomy outlook.
Well, the question has Congress' attention and has stirred deep
concern in the industry.

Congress asked the Federal Financial

Institutions Examination Council to study unnecessary regulatory
burden and we submitted a comprehensive report on the subject
last December.

I will be testifying in the House tomorrow on the

findings of that study and later in the spring we will submit
recommendations for specific legislative action to remediate some
of the burden.

I am hopeful that this will lead to significant

action, but not overly optimistic.

I am even less sanguine about structural reform which has
been needed for many years.

Repeated efforts to focus

Congressional attention have been thwarted by those in the
leadership who are the captives of special interests opposed to
any move to broaden the powers of banks or permit the integration
of the financial services industry.

Meanwhile, the rest of the

industrial world, our major trading partners particularly, have
moved aggressively to permit the affiliation of banks, securities
firms, and insurance companies.

Safety and soundness concerns

about such affiliations are unfounded, based on long experience
in other countries.

But these concerns have been used as a


smoke-screen to cover the catering to special interests who
profit from an emasculated banking system.

These issues have become so politically sensitized that
normal Congressional or Administration initiatives may not
accomplish much.

To break the impasse, I have suggested that a

non-government commission be appointed to study the
competitiveness of the U.S. banking system both domestically and
internationally and make recommendations to Congress.

This might

defuse the political sensitivities sufficiently for Congress to
take decisive action independent of pressures from the special

I have tried to cover a lot of ground.
economy is OK for the moment, but vulnerable.

In short, the
The credit crunch

isn't what it's represented to be by the pundits.

And the

banking system is currently healthy but subject to secular
decline and extinction if regulatory and structural relief is not