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SI 15 A.M. MST f10:15 A.M. EST)
January 24, 1992

Remarks by
John P. LaWare
Member, Board of Governors of the
Federal Reserve System
to the
Assemblies for Bank Directors
Scottsdale, Arizona
January 24, 1992

Good morning everyone.
and sunny?

Isn't it nice to be somewhere warm

I am very glad to be here and to participate with you

in this important conference.

I have three missions this morning.

The first is to debunk

what is common copy in the media to the effect that the banking
system is in a state of collapse and the end of the world is at

The second is to gaze into my crystal ball and share with

you my view of the future direction of banking in the context of
upcoming changes in the regulatory environment as the result of
recent federal legislation.

Finally, I have some thoughts about

the role of bank directors in today's world.

On one point there is not much disagreement:

The banking

industry is battered and deeply scarred by the events of the last

Lending to lesser developed countries, once a cash cow,

has become a cow giving sour milk.

Leveraged buy-outs, junk bond

financing, and the general multiplication of debt ratios for
corporations and consumers soon reached the point where debt
service became a major problem when a slowing economy cut back
revenue flows for corporations and lay-offs made debt service
almost impossible for many consumers.

The junk bond market took

a nose dive, corporate and personal bankruptcies escalated, and
banks found themselves participating in creditor committees,
foreclosing residential real estate and repossessing cars.


the biggest losses to the industry derived from the commercial
real estate loan portfolio.

Rosy expectations of ever-increasing

asset values and higher and higher rents created a competitive


feeding frenzy among bankers who adulterated sound lending
standards in pursuit of market share.

The price paid for a place

at the table has been heavy in terms of loan losses, additional
reserve provisions, and foreclosure and carrying costs on
repossessed collateral.

At the end of the third quarter of 1991 there were 1,100
problem banks, almost 10 percent of the commercial banks in the
United States, with $500 billion of assets.

While bad real estate constitutes the major portion of
nonperforming assets, commercial and industrial loans and some
consumer obligations are also included among the $96 billion of
problem assets.

At the same date, other real estate owned through
foreclosure totaled $24.9 billion, up from $21.4 billion at the
end of 1990.

Net charge-offs for the first three quarters of 1991 were
running at an annual rate of $31 billion vs. $29 billion in 1990.

Obviously these trends spell real trouble for the banks if
they are not reversed.

Indeed, the rate of deterioration has

slowed, but the level of deterioration already realized remains a
matter of concern to regulators and to the insurance fund.


Having recited that litany of gloomy statistics, I hasten to
add that by no stretch of the imagination should we extrapolate
those numbers to the whole industry.
of banks are healthy.

The overwhelming majority

Many banks are more profitable today than

they have been in many years.

During the first nine months of

1991 almost 5,600 banks or 46 percent of the industry had returns
on average assets in excess of one percent.
percentage since 1983.

That is the highest

It is good performance in any year, and

in 1991 it was very good indeed.

Obviously small banks constitute the majority of these high
performance banks, but there are a number of larger banks with
better earnings as well.

It is interesting to note that during

the first half of the Eighties only one bank larger than $10
billion reported an ROA for a full year of better than one

During the most recent two years, more than a dozen

large banks have earned a better than one percent ROA.

In fact, during the years since 1988 more banks have had
returns on assets better than one percent than in any other year
in the last two decades.

Those numbers reflect improvement in

earnings performance of many large banks as well as smaller

Although 1991 was a very tough year, the industry earned
almost $15 billion in the first nine months, or nearly $20
billion on an annualized basis, compared with $16.6 billion for
the full year 1990.

Projecting the results for the first nine


months to the full year 1991, it looks as though the industry
return on assets may have improved by as much as 10 basis points
to about .60 and the return on equity one full percentage point
to about 8.7.

Those figures are certainly not wonderful, but

neither do they represent an industry in a state of collapse.

Capital has become a focus of Congressional attention as
attested to by the recent legislation and regulatory attention as
the Basle risk-based capital standards are being phased in.
this front the industry has made real progress.
third quarter 1991 figures —


Again, using

the latest we have —

the industry

had an equity to total assets ratio of 6.7 percent compared with
6.0 percent at the end of 1987.

And I might add that that is the

highest level for that ratio in at least 20 years.

In reference to the new risk-based capital standards, which
become fully effective at the end of 1992, more than 96 percent
of all banks currently meet those year-end standards.


actually, they have capital in excess of minimum standards of
about $70 billion.

The two-tiered Basle capital standards

require a minimum of 8 percent capital on a risk-weighted basis.
In fact, the U.S. industry average at the end of the third
quarter of 1991 was 10.7 percent.

But, let's not forget there are still some problems out

Banks which do not meet the Basle standards have about

$325 billion of assets or about 9 percent of the industry, and a
few very large banks account for most of those assets.


We are not out of the woods yet.

This will be another year

marked by the failure of a rather large number of banks.
Preliminary figures for 1991 show that 127 commercial banks with
more than $63 billion assets failed.
record similar numbers.

Conceivably 1992 might

That means that the FDIC will continue

to incur heavy costs to resolve failed banks.

Some estimate

those costs could be as high as $15-25 billion in the next two

Chairman Taylor of the FDIC has already indicated that

those circumstances might require a further increase in insurance
premiums which would be another blow to bank earnings just at a
time when margins have widened and the general outlook has
somewhat improved.

A return to more vigorous growth in the macro

economy and some firming of values in the real estate sector
would help, but it is too early in the game to predict that
outcome with any certainty.

On the whole, for those banks not struggling with massive
nonperforming asset problems, the earnings outlook is quite

Net interest margins have improved materially.


cost of funds has dropped far more than rates earned on assets,
and the cut-throat competition that accompanied the aggressive
pursuit of market share in the booming Eighties has diminished.
Also, markets tend toward strong participants.

Not only have the

capital markets reopened to banks with high asset quality, but
customers prefer to deal with someone they expect to be around
for a while and in a position to meet their needs so strong banks
will tend to reap the harvest of public concern about the health
of weaker ones.


Bankers have also put their overweight institutions on
strict regimens to slim them down.

In the 21 months from January

1990 to September 1991, banks reduced staff by 2.6 percent or
40,000 jobs.

And more of the same is in store in 1992.

In fact,

the pace of cost-cutting, largely through staff reductions, will
probably accelerate in the next 12-24 months.

Out-sourcing of

services, particularly data processing and back-office
operations, is too new to evaluate accurately as yet, but there
are high hopes for further cost saving in that direction.

One major opportunity for improved earnings is inherent in
the wave of intra-market bank consolidation which I expect to be
a major characteristic of banking in the United States in the

The elimination of redundant facilities and personnel

could materially improve operating efficiency and adjust the
level of competition to the actual requirements of the market.
Curiously, the industry's record in achieving economies from
these kinds of mergers has been disappointing.


determination to realize savings and materially improve earnings
as fervently expressed to regulators and analysts before a merger
has often moderated in the afterglow of consummation.


sometimes apparently ruthless staff reductions and branch
closings which may be required to realize the expected benefits
are relatively easy to rationalize away, and heartrendingly
difficult to execute.

The winners in the 90's will be the tough-guy managers and
directors who are willing to stick to pre-merger plans and cut


the fat.

The results will be ample reward.

Eager capital

markets will embrace new issues from aggressively managed
institutions, shareholders will rejoice with the improved results
and rating agencies will look favorably on upward revisions of
credit ratings.

The losers will be the fainthearted who have

lifted expectations with rosy projections but have not had the
courage to make them happen.

This is a hard-ball game and its

not fun to play, but the winners will be the real leaders of a
revitalized industry.

As you know, the Federal Reserve Board has approved some
mega-mergers recently which can be models for industry

The Chemical-Manufacturers Hanover merger is an

example of an intra-market consolidation in a contained
geographic area with little market concentration but many
opportunities for cost reductions.

The NCNB-C&S/Sovran deal has

less overlap of facilities, but will still offer significant
opportunities for enhanced earnings.

The pending Bank of

America-Security Pacific merger also involves a much bigger
geographic area, but because of the extensive branch systems of
both banks there is considerable overlap and cost elimination

Since 1985 alone 136 banks over $1 billion in size

have been merged or affiliated with other institutions, and the
trend will undoubtedly continue.

But make no mistake, the opportunity for intra-market
consolidation and subsequent earnings enhancement is not just for
big banks.

Small and medium-sized banks in urban, suburban, and

rural areas should move in the same direction.

The earnings

improvement opportunities for two $100 million banks in the same
market are relatively as attractive as for giant money market

The cry should be 'come on in the water is fine!"

There will be more of these moves in the future and I predict
that the opportunities presented will not be ignored.


and directors will be tough and demanding and get all or most of
the savings they saw in advance.
new era in banking —

It will be the beginning of a

an era in which management emphasis will be

on asset quality, market segmentation, tight expense control and
strong capitalization.

In order to look ahead intelligently to the future of
banking in a changing regulatory environment, it is important
that we understand one of the dominant phenomena in the current

The famous, or infamous, credit crunch has been a

subject of controversy and concern for nearly two years.

It has

been coincident with the lapse of the economy into recession and
its subsequent sluggish recovery.

Indeed, Chairman Greenspan has

suggested that the credit crunch has been a major inhibiting
factor in the recovery process.

The classic definition of a credit crunch is a situation in
which credit demand far outstrips the ability of the financial
system to accommodate it.

That is not what we are experiencing

This credit crunch is more a psychologically induced

condition than it is a (function of s u ¡ a n d




adjusting to recent loss experience, new capital requirements and
tougher examination standards, have been busy tightening credit
standards, collecting problem loans, raising new capital or
adjusting balance sheets to improve capital ratios.


experience with commercial real estate loan defaults has prompted
some banks to exit that market entirely, and other loan
categories having higher risk are being de-emphasized.


bankers have retreated to the sidelines to wait out a more
vigorous recovery and particularly more stability in real estate

Consumers, badly shaken by the rise in unemployment
statistics and almost daily media stories about corporate
restructurings and accompanying job losses, have used available
resources to reduce debt and are avoiding new commitments for
cars, big ticket appliances and real estate purchases.

Businesses, many of which are still struggling under a heavy
burden of debt incurred during the high-flying Eighties, are
working down debt positions and postponing new investment in
plant and equipment until they perceive real growth in the
economy and a return of product demand.

In a word, ladies and gentlemen, confidence.

A diminution

of banker confidence has made banks less eager to lend.


depressed consumer and business confidence has resulted in slack

Put them all together and they spell credit crunch.


What to do?

One wag has suggested we retain a behavioral

psychologist to suggest ways to influence people's attitudes and
alter behavior. But, before we bring in a shrink, we are
participating with the other agencies in taking some discrete
steps to promote availability of credit for qualified borrowers
and ease pressure on real estate loans consistent with prudent

We have reminded examiners that the current market value of
real estate collateral should not be the only criterion for
assessing the quality of a loan.

They should also consider

normalized levels of cash flow, financial condition of the
borrower, and other relevant factors.

Traditionally bankers cooperate with troubled customers to
try to work out slow loans.

Even banks with capital problems or

in the process of working down loan concentrations should not
abandon customers with soluble problems.

We urge examiners and

their supervisors to emphasize these points in their meetings
with bank managers and directors.

Other areas under review as I speak include proper capital
recognition of intangibles arising from purchase of mortgageservicing rights and credit card loan portfolios.

We are also

considering changes in the definition of a "highly leveraged
transaction" and the possible phasing out of the reporting
requirement for these items on the call report.


The sum of these moves is to emphasize to examiners the
importance of balanced evaluation techniques and to bankers the
importance of continuing to make credit available to qualified

The Federal Deposit Insurance Corporation Improvement Act of
1991 was a deep disappointment to those of us who worked hard to
support the Treasury proposals for a significant restructuring of
the U.S. financial system.

In the context of perceived weakness

in the banking system, scandals involving BCCI and Salomon
Brothers, and intense lobbying by various special interest
groups, Congress focused on refinancing the Bank Insurance Fund
and tightening regulatory restraints.

Much needed proposals for

scrapping the obsolete Glass-Steagall Act, allowing closer ties
between insurance companies and banks, permitting branch banking
across state lines, and restructuring the federal regulatory
apparatus were finally ignored.

The resulting legislation not

only tightens regulation of banks but it imposes additional
reporting and compliance burdens as well.

And to implement the

legislation will increase the cost of supervision for all of the
regulatory agencies.

I will mention a few of the requirements of the new law
which affect most banks.


All banks must have a full-scope, on-site examination
at least once each year.

A system of early intervention and prompt corrective
action designed to prevent bank failures was adopted.
Five specific levels of capitalization are identified
and specific mandatory and discretionary corrective
actions are associated with each.

In implementing this

section, federal regulators are charged with defining
the appropriate level of capital at each level.


objective here is to provide a due process framework
for intervention and specific authority for regulators
to impose corrective measures of progressive severity.

Annual audits for all banks with assets in excess of
$150 million are required.

For subsidiary banks in a

holding company the requirement is fulfilled by an
audit of the parent.

As it is, by 1990, 95 percent of

all banks over $150 million assets met the requirement.

State-chartered federally insured bank powers are
limited to those permitted to national banks unless
they are adequately capitalized and FDIC determines
that the activity does not constitute a significant
risk to the insurance fund.

Regulators must develop uniform regulations regarding
the standards to be used by banks in real estate


The aggregate of all loans to insiders by a bank,
including officers, directors and shareholders and
their related interests, may not exceed unimpaired
capital and surplus.

The regulators must adopt specific regulations
establishing standards for banks' internal controls,
information systems, internal audit, asset growth,
excessive compensation, and other factors.

In addition, Congress has limited the Federal Reserve's
ability to lend on an extended basis to troubled institutions.
"Too big to fail" has been addressed tangentially by imposing a
least-cost resolution requirement on the FDIC and shifting a
"too-big-to-fail" determination to a formal action of the FDIC,
Board of Governors, Secretary of the Treasury, and The President.
The real hooker in this one is that, if such a course of action
is pursued, any additional costs resulting will be recovered by a
special assessment on the banks.

I could go on, but I think that gives you the flavor, and I
suspect the flavor is bitter for many of you.

In a sense the

failure of this legislation to address basic needs of the
industry is a failure of the industry itself.

Bankers have

always had difficulty among themselves in reaching consensus,
although the ABA's bank leadership conferences have made some
real progress in that direction.

But when it comes to what is

good for them, bankers fall into a multitude of common interest


groups among which there is almost universal disagreement.


special interest groups which lobby against the interests of the
banks, on the other hand, each have a single purpose.

As a

result, Congress finds itself in the middle of a cacophony of
diverse pleas.

At the end of the day Congress throws up its

hands and does its own thing with the kind of result I have just

Finally, I would like to address briefly the role of
directors in this changing world of commercial banking.

You bank directors carry a heavy responsibility and

The shareholders who elect you delegate to you

their authority to oversee management in the interest of
protecting and enhancing their investment.

If you fall short in

carrying out that trust, they should throw you out, just as you
would throw out a management which failed to meet its

Sadly enough, shareholders for the most part are a

widely diversified mass of individuals —

passive investors often

investing through a third party money manager or other
institutional intermediary.

They are simply not organized to

storm the annual meeting and dismiss the board.

I am sure that fact is a source of comfort to some, but it
should also constitute a sober underscoring of director

For bank directors responsibility and

accountability are also owed in two other directions which are
sometimes less obvious.

The first of those is to regulators and


supervisors, for it is the responsibility of directors to oversee
management's compliance with federal and state laws and
regulations and that management conducts the affairs of the bank
in a safe and sound fashion.

The second is less obvious.

It is

the responsibility both management and directors have to
depositors to use their money in a prudent fashion.

One of the most painful lessons of the last decade is that a
headlong pursuit of rapid growth or greatly expanded market share
is fraught with danger.

Rapid growth in the loan portfolio in a

competitive marketplace is often bought by making loan terms more
attractive than those offered by competitors.

Proceeding down

that slippery slope usually involves cutting prices below
measured risk or lending more than the collateral or cash flow
will support.

The experience of banks in the commercial real

estate market in recent years is a perfect case in point.

Rapid growth through branch expansion or bank acquisitions
is equally treacherous.

In a highly competitive atmosphere it is

all too easy to be persuaded that market expectations justify
aggressive branching or that better earnings opportunities
justify paying too much for another bank.

Again, recent history

provides many examples, the largest and most tragic being the
Bank of New England failure last year.

Steady growth with

capital and reserves keeping pace with risk taking always
provides the winners as in the fable of the hare and the


As directors, you can and should be the balancing mechanism.
In order to fulfill that role you have to be willing to say "no"
even to management's most enthusiastically presented plan if in
your objective judgment it is wrong.

It is not easy to say no to

the person who nominated you to the board in the first place, but
remember it is the shareholders who elected you and it is to
their interests you owe your first allegiance.
definition, outside directors.

You are, by

That means you are not the

captives of the manager even though he may be your best friend.

A well constructed board of directors for a bank will bring
together persons of diverse background and experience from many
fields of endeavor.

It is that diversity which brings strength,

but only if the directors are heard and if they express their
opinions openly and freely.

If your board does not provide an

atmosphere in which you feel you can participate in that fashion
you will find it difficult to discharge your responsibilities
fully and may want to consider resigning.

Perhaps the key role of directors is to evaluate as well as
advise management.

The designation of senior officers,

particularly the CEO, is the responsibility of the board.


means you must pick carefully, you must objectively review and
evaluate performance against established standards, and you must
be willing to cut your losses if you have made a mistake by
dismissing anyone who has failed to meet those standards.


days when an officership in a bank was a sinecure are long gone
even for the chairman of the board.

The demands of a competitive


aarxetplace and a stringent regulatory environment will not
tolerate inferior performance and you must be' th^ arbiters.

You may think this is tough-guy talk and uncalled for in a
conference of this sort.
are tough times.

But I need not remind you that these

You bear an awesome responsibility whether you

are a director of a big bank or a tiny one.
you take that responsibility seriously.

You are here because

I compliment you on

that, thank you for being here, and I look forward to
participating with you in the sessions ahead.