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WHAT'S AHEAD FOR BANKING

Remarks.,f y
e
John P. LaWare
Member. Board of Governors of the
Federal Reserve System
to the
77th Annual Robert Morris A s sociates Fall Conference

It is a pleasure to welcome you to Washington.

Washington

is that part of the United States known as "inside the Beltway"
and most of us in government, particularly those of us involved
in regulation of one industry or another, are accused of having
an "inside-the-Beltway mentality" that clouds vision, impairs
reason, and puts at risk the very industries we are supposed to
be trying to assist.

It was not long ago that I was on your side

of the table — one of those regulated,

Now I find myself, with

some discomfort, on the other side of the table as "the
enforcer."

Enforcing, to be sure, an incredible burden of

federal regulation, much of which has nothing to do with safety
and soundness.

Much of which is the realization of some

legislator's dream to have something to "point to with pride" as
his contribution to government.

In my opinion, banking today is

seriously overburdened with consumer compliance regulations which
sound like motherhood and the flag but which accomplish little or
nothing for consumers, while imposing an enormous cost and
administrative duty on the banks.

Once these requirements are

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imposed it is difficult or impossible to get them lifted, even
after their usefulness or purpose has been forgotten.

But the

Solons on the Hill have legislated, the regulators have made
rules, and the banks must comply.

Banking is at an important crossroads and bankers need to
consider carefully which fork in the road they will take.
Congress has been presented by the Treasury with an omnibus
proposal to reform the financial sector of the economy by
removing obsolete restrictions on commercial banks and allowing
the rejoining of the banking and securities industries in order
to provide better service to corporations and government entities
in meeting their transactional and credit-related financial
needs.

The entire thrust of these proposals was to make the U.S.

banking system more competitive in rapidly developing world
markets and to provide better and probably cheaper service to
corporations and consumers.

But the banking industry is haunted by its recent past.

It

is bedeviled by the spectre of hundreds of bank failures and the
prospect of taxpayer funds, for the first time, being used to
assist the FDIC in administering the insurance scheme for
commercial bank deposits.

The press and others often imply that

mismanagement, poor judgment, and downright dishonesty have been
the causes of the mess.

There have certainly been examples of

all of those abuses, but they should not be used to generalize
about the industry.

Have any of the finger-pointers called attention to the
regulatory constraints that encouraged focus on real estate; or
the competitive factors that encouraged some bankers to ease
credit standards and shave pricing to protect market share; or
the economic downturn that caught bankers and developers alike —
victims of over-optimistic forecasting and delusive assumptions
about cash flow?

The fact is that the rescue party, epitomized by the
Treasury proposals, may be cut off at the pass before it reaches
the stranded bankers, and the rationale will be that the banks
don't deserve more liberties.

Rather, it is argued, they must be

more regulated to protect them from themselves.

There is no question there were excesses of overconfidence
and reckless risk-taking in the heady environment of the Eighties
when it looked like prosperity was here to stay and the only way
to go was up.

But bankers, badly injured by their mistakes in

the Eighties and reluctant to repeat them, are now being blamed
for being too timid and for slowing down the recovery of the
economy from recession.

It seems to me absurd to trumpet safety

and soundness in one breath and in the very next to demand more
aggressive lending policies.

The industry still has a peck of

troubles and challenges and some of the remedies for trouble
available in the past are not now readily at hand.

With capital markets casting a jaundiced eye at bank
securities issues and investment bankers shying away from

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underwriting new offerings, banks have resorted to negative
growth or downsizing to redress capital ratios which have been
undermined by massive reserve provisions and charge-offs in the
loan portfolio.

To turn around runaway growth of expenses, banks

have restructured to reduce costs, with all of the attendant
upfront charges for severance pay, lease buyouts, and losses on
under-depreciated excess equipment.

These kinds of heroic measures would be much applauded in a
culture which rewards long-term results, because they cannot help
but improve future performance.

But, with a press which builds

circulation by reporting misfortune and an analyst community
preoccupied with quarterly earnings comparisons, banks aren't
getting much credit for cleaning up their act.

But cleaning it up is what is happening.

LDC problems which

were headline fodder for years have been digested pretty well by
now and the industry LDC malaise has been reduced to an
occasional burp.

The full and final effects of LBO and takeover

financing will take a while to play out.

But, by and large the

banks have had preferred positions in these deals and I can't
remember a single bank which has been brought down by that kind
of lending although it has played an auxiliary role in banks
which have basically failed by reason of large real estate
losses.

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Currently credit card delinquencies and charge-offs are
beginning to be worrisome, but this is more a function of general
economic conditions than bad credit underwriting.

The category which causes me the most concern at the moment
is equity credit lines.

They are vulnerable to both economic

conditions which affect borrowers' ability to pay and the decline
in real estate markets which raises questions about the value of
the underlying collateral.

It is hard to predict the outcome

there, but if the economy continues to recover, as we expect,
both repayment ability and collateral value should improve.

Now this is not all just naive optimism on my part.

There

is hard statistical evidence to support my contention that
banking is coming up out of a long dark tunnel into the light
again.

Item:

In 1987, 18.6 percent of banks reported
losses for the year.

In the first half of

1991, that figure was down to 11.3 percent.

Item:

Almost one-half of the banks earn a return on
assets of better than 1 percent, and they do
it year after year.

While this is generally

more true of smaller banks than the big guys,
in the third quarter of 1991 — a very tough
year for banks — 14 of the 45 largest which

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have reported thus far, have earned better
than 1 percent on assets.

Item:

96 percent of all banks currently meet the
risk-based capital guidelines imposed by the
Basle accord for 1922 and 75 percent of the
banks have risk-based capital in excess of £.£
percent.

Item:

Pure equity in the industry as a whole is now
6.7 percent — the highest level in twenty
years.

Item:

Banks who meet the 1992 Basle standards have
$67 billion of capital in excess of the
minimum.

Parenthetically:

the 4 percent of

banks who don't yet meet the standards have
an aggregate shortage of only $4 billion.

Item:

In spite of lukewarm capital markets, certain
of the 50 largest banking companies have
raised $5 billion in new equity capital and
$3 billion in new subordinated debt this year
and the year still has two months to go.

Not bad, I'd say, for an industry which is regularly
reported to be on its deathbed.

I am not suggesting that there are not some sick puppies out
there and that there won't be more failures, including, perhaps,
some sizeable institutions.

What I am saying is that the vast

majority of U.S. banks are well capitalized, profitable and in
good shape to fund the legitimate credit needs of the recovering
economy.

I am confident that the so-called credit crunch is more

a phenomenon of confidence and slack demand than it is one of
credit constipation.

It is my guess that those who cry most

bitterly about the unavailability of credit are either the ones
who didn't pay back their loans last year or those whose
borrowing credentials have deteriorated as a result of the
economic slowdown.

I mentioned earlier that banking is at a fork in the road
and I want to emphasize how important I think it is that the
industry go down the right fork rather than the left fork.

The

right fork can only be negotiated if Congress enacts
comprehensive reform legislation along the lines proposed by the
Treasury last winter.

In that direction lies appropriate

refinance of the insurance fund, modest limits on the insurance
coverage available to depositors, authority for supervisors and
regulators to prevent bank failures rather than just preside over
them, permission to branch across state lines, broad powers to
engage through affiliates in securities dealing and underwriting,
and permission to establish close relationships with insurance
companies.

On that road the lighting is bright, the surface is

smooth, the curves are well marked, and the opportunities for a
profitable trip are greater.

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The left fork is a continuation of the status quo or, worse,
a rollback of insurance and securities powers for the banks which
have not only been prudently managed but have resulted in better
service to corporations and greater convenience and lower prices
to consumers.

The same competitive constraints which presently

hobble U.S. banks in their ability to compete with nonbank
domestic financial institutions would be allowed to stand and a
new panoply of costly consumer compliance burdens would be added.
The left fork is badly lighted, dotted with axle-breaking
potholes and unmarked mountain roads without guard rails.

It ia

a dangerous route to take.

If Congress in its wisdom chooses to endorse the Treasury
proposals, banks will flourish, albeit in a highly competitive
environment, both domestically and internationally.

If reforms

are not enacted, U.S. banks will continue to be at a material
competitive disadvantage, not only to foreign banks and in
foreign markets, but also to domestic nonbank financial
institutions which freely encroach on banking markets but which
operate from business lines in which banks are forbidden to
participate.

If that scenario is played out for a decade or so,

banks will become public utilities like the post office, and just
about as exciting.

The fork in the road for banks is an important one and the
future well-being of the industry which finances commerce is at
stake.

You must hope and pray that in the political process of

committees, mark~ups, rules, floor debate, conference committees,

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and final action, Congress recognizes the importance of a strong
and competitive banking system, and finally enacts much needed
legislation to modernize the banking system.

Assuming that our democratic process will work for the best
as it so often has in the past, I think the Nineties will be an
era of enormous change.

Today there are 12,400 banks in 9,500 separate banking
organizations.

My guess is that by the year 2000 there

will be 7,000 banks in 4,000 banking organizations.

Intra-market mergers will be the landmark events of the
Nineties.

The trend is already under way.

The results

will be startling in that the new companies emerging
will be leaner, meaner, better capitalized, better
managed, and much more profitable than their
predecessors.

Capital will become the common measurement of safety
and soundness and the ability to earn a market rate of
return on higher capital levels will be the standard
measurement of management performance as well as the
key to the capital markets.

Only sound, well managed and profitable banks will be
permitted to embark on rapid growth patterns,

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aggressive acquisition plans, or entry into newly
permitted nonbank activities.

Banks slipping into substandard capital positions or
serious asset quality problems will be intervened early
on and corrective action will be required.

The risk of

noncompliance will be dividend suspension, management
replacement, or even director dismissal.

Sound public

policy simply cannot tolerate another period of
disruption, failure, and clean-up cost like the one we
have just been through.

By the end of the decade there will be in place several
nationwide systems of subsidiary banks or branches, but
there will also be powerful regional banks and
thousands of community banks, not just hanging on, but
earning circles around their bigger counterparts.

A handful of U.S. banks will be active in international
markets and giving a good competitive account of
themselves.

And the financial industry will have become more
integrated as banking concerns, insurance companies,
and securities firms combine into financial services
holding companies which will supply a full spectrum of
financial services to corporations, governments, and

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individuals, and supply them more conveniently, more
efficiently, and at less cost than ever before.

Most of you will be a part of that Brave New World.

It will

be an exciting and challenging environment in which to find your
way.

I only wish I were young enough to be a participant and not

just an observer.

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