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MANAGEMENT, CREDIT AND PUBLIC CONFIDENCE

Recent events once again have focused the hanking industry's attention
on the cost-earnings squeeze.

The pressure not felt during the war years has

built gradually to become a major fact of life.
The existence of this squeeze is of primary concern to every credit man
in the audience, because in the long run the credits you make and manage will
play a major role in assuring the success of your banks in meeting this problem.
For that reason a brief review of why and how that squeeze exists seems
appropriate.
The recent events to which I have referred were the increase in the
discount rate by the Federal Reserve Board, and the increase in the permissible
legal ceiling of interest paid on time and savings deposits jointly authorized
by the Fed and by the Federal Deposit Insurance Corporation.

These two actions

had the net effect of increasing the cost to bankers of their basic tool of
operation, money.
At the same time the President strongly suggested that the banking industry
maintain existing loan rates, when he expressed apprehension that banking
generally might increase rates.

The excess of funds in the market -- at a

price -- at the present time supports the President’s request; this excess has
become so apparent that some of your savings and loan competitors have stated
publicly that they do not want any additional funds because they cannot safely
place them.

Additionally, some sectors have shown a weakening in loan demand,

most notably the housing sector.
Actually, the average rates on all loans have remained remarkably stable
from the i960 midyear.
small.

This has been true for all classes of loans, large and

If anything, there has been a slight easing of rates over the past

few months.



2

Back in the 1950’s the hanking industry was confronted for the first time
with a tremendous increase in costs, generated not only by the increase in
wages and other costs prevalent throughout the country but also by a tremendous
increase in paperwork.

To a large extent the industry met this problem with

internal economies, including automation.
For the past three or four years there has been superimposed upon this
problem another problem.

While the cost of money has gone up (and money is

still the basic raw material of any bank) the earnings generated from use of
that money have not gone up proportionately.
perfectly clear.

One figure makes the point

Net current operating earnings, as an amount per hundred

dollars of current operating revenues, have declined from about 35 percent as
of i960 to 28 percent as of

1963.

The result has been for many banks to

compensate by shifts into new types of loans, or into higher earning areas,
and, in many instances, into service type earnings which do not require the use
of large amounts of money as a raw material.
The cost of money is up.

From December,

1961,

to October,

196^-5

all short­

term money market rates had advanced about one full percentage point; during
the same period the rates paid on time and savings deposits have gone from
the 1-2J-3 percent basis to the present k-kj? percent basis.

There have been

other equally important developments, including a restructuring of deposits.
Corporate treasurers and others who control demand deposit balances have
become more skillful and more careful in the use of their funds.

They too

have had to trim costs as the first flush of prosperity after the end of
World War II gave way to a more competitive environment.

As the rates on

Treasury bills and other alternative short-term investments inched upward,




- 3 -

corporate treasurers have turned to these markets as places to invest their
short-term funds.

And they have restricted their demand deposit balances,

seeking more and more services for less and less in the way of hard cash.
Thus the banking industry's ratio of "free" funds has dropped.

Actually,

of course, these funds are not "free" even though no interest is paid on them,
because maintenance of demand deposits represents one of the major costs of
doing business.

From December 1961* through June 196 b, total deposits of the

banking industry rose dramatically, but the actual amount of demand deposits
adjusted in the commercial banking industry for the same period actually
declined slightly.

At the same time, time and savings deposits in the commercial

banks rose some *+4 percent.

These, of course, are funds upon which interest

must be paid, in addition to which there are some of the same expenses to a
bank in maintaining these accounts as there are in demand deposits.
The deposit mix has changed drastically, and the change has been a factor
in increasing costs.
There have been other peripheral changes which have had the net effect of
increasing the cost of money to banks.

The time lag represented by "float"

has been reduced a good deal as banks have introduced new, streamlined methods
of presentation and collection.

New lockbox services, new 2^4— hour collection

procedures, armored car runs, automated clearance of checks, and other methods
of responding to customer desires for speedy collection have proved the
banking industry’s ability to offer better service.

The net result has been

also to trim "float" time and eliminate to a large degree the short term
earnings which "float" may produce.

Additionally, while demand deposit velocity

has increased many times during the past ten years, that increase seems to be
slowing up somewhat as the system probes ever closer to the outer limits.




- 1+ -

Some bankers have sought answers to the cost problem by increased volume
of activities, perhaps somewhat analagous to the 11supermarket" thesis that
profits are built up not on the markup as such but on the volume of business
generated and the turnover of inventory.

This seems to be a solution not

available to all institutions, and there may be questions as to just how far
this volume answer can be carried.
With strong pressures sending the costs of money up, both through a shift
in the deposit mix and through national policy which encourages higher short­
term rates as a tool in holding down balance of payments deficits, banks under
normal circumstances might be expected to raise rates on loans.
not happened.

Yet this has

It has not happened for several reasons, among them being a

policy of credit ease, and the related adequacy of funds available, the sharp
competition between banks and other lending institutions, the more sophisticated
approach of corporations, together with better than average retained earnings
for corporate investment needs, and continued and sometimes open pressure on
the part of the Administration.

Additionally, bank rates always have had a

tendency to be "sticky" in movement, both in interest paid and rates charged
for loans.

Bank rates have a strong tendency to become "institutionalized."

This inertia has also played its part in the present rate structure.

There is

a strong tendency on the part of the public and banks alike to treat maximum
permissive rates as the going rate.
The result of all this has been a squeeze on earnings.
Banks have been meeting this pressure through an increase in loans, a
percentage of assets, and also through a shift in the types of loans made.
loan mix has increasingly emphasized the higher yielding, and generally more
risky, areas.



The

- 5 -

Again the figures tell the story.
over 16 percent from December

1961,

While assets have gained somewhat

to June

196^,

loans were up 32 percent.

The loan to asset ratio for commercial banks over the same period moved from
i+5 percent to 51.2 percent, and appears to be continuing upward.

At the same

time the holdings of U. S. Governments dropped, while tax-free municipal
holdings were up.
The composition of the loan portfolio tells the same story.

All the major

categories of loans were up, but the greatest gains were shown in the higher
yielding areas.

The lowest gain was shown in the agricultural loans category,

followed by commercial and industrial loans.

Within that latter category,

increases were posted by such industries as construction, trade, and petroleum.
Much of the over-all increase here was in new types of term loans, developed
for the first time in recent years as attractive alternatives to the conventional
short-term business loan.
Agricultural loans gained 19 percent, and commercial and industrial loans
22 percent.

However, instalment credit loans were up 35 percentj real estate

ioahS,36 percent) loans,to.brokers and dealers? 38 percent; and loans to other
financial institutions were up k3 percent.

' ..

Interestingly enough, the extensions of consumer credit loans are
broadening to the point where extensions of such credit are far outstripping
repayments. The net change in such loans in i960 was negligible, but in

1962

extensions moved ahead of repayments, a trend which has been gradually
accelerating.

The gap is now at about $5.5 billion, and about $500 million a

month is being added to the figures.

The gap between extensions of new credits

and repayment of existing ones is widest in auto paper, widening slightly in
personal loans.



-

6

-

There is no panacea for the cost-earning squeeze confronting industry today.
Some hankers are finding answers in increased non-deposit services to the public.
Some bankers are seeking an answer in further increases

of volume.

Many bankers are devoting a sharper attention to cost reduction in their
institutions.

And, of course, many bankers are re-shaping portfolios and

loan policies to maximize earnings as far as possible.
All of these approaches are valid, and taken together, they offer a
constructive program.

The important point remains that these pressures are

a

fact of banking life today, and that nothing on the horizon suggests any new
pattern, at least in the near future.
I would like to suggest that it is precisely in times like these that the
banking industry must be on its guard against excesses generated to respond to
earning pressures.

It is precisely at times like these when management must

be at its sharpest and soundest in handling credits, when management must resist
temptations to lower standards, and, in the long run, to risk forfeiting the
high confidence the public has today in banks and bankers.
Over the past thirty years the public’s confidence in the banking industry
has gradually risen from the depths to which it sank during the Depression
years.

Thirty years of safe operation, buttressed by the formation of the

Federal Deposit Insurance Corporation, with its guarantee of bank deposits,
has created a pool of public confidence which is now one of the greatest assets
the banking industry possesses.
This confidence is a fragile thing.
not something with which to take chances.

It is not to be tampered with.

It is

And, to a very large degree, its

maintenance is in the hands not only of senior management but of the credit men
whose individual and collective judgments decide just what kinds of loans are
to be made.

In the long run the soundness of a bank’s loan portfolio governs

the soundness of the bank -- and you credit men decide the soundness of the
loan portfolio.




- 7 -

In a large sense, when a bank is under a cost-earnings pressure to
increase loan portfolio amounts and yields, the first line of defense against
any unsound approaches which might weaken the bank and the public's confidence
is the credit man.
In recent months several banks have failed, and back of each failure
among many other problems was the problem of unsound credits.

Some of these

cases involved men not trained as bankers, but in some instances which have
shown up in bank examinations, trained bankers have made some credits with
equally poor standards.
universal problem.

I should like to emphasize that this is not a

Indeed, the great majority of bank credits are sound.

But these fringe problems do exist.
Some examples of these borderline -- or worse —

credits follow:

Mortgages have been based on highly inflated values, or upon questionable
appraisals.

Mortgages where the actual cash equity of the borrower is non­

existent or marginal.

Mortgages advanced on properties on the basis of

projected earnings, where there is no earnings history, and expectations are
promotional.
Loans to out-of-territory interests, unless backed by full, accurate,
and impartial credit checks and a high degree of credit skill on the part of
the lending officer.
Term loans not supported by adequate collateral, nor by adequate income
schedules from which payments will be met.
Loans to corporate interests which have not been checked thoroughly,
and

which actually turn out to be a corporate "shell" through which promoters

divert funds to other interests.




Otherwise questionable loans which are accepted because of so-called
"compensating balances," actually placed in a form of link financing,
affording no assurance that the balances will not be removed.

These loans

often may be brought in by so-called "finders," and may bear attractive rates
to the bank.

All too often this means a loan which should be unacceptable

under normal circumstances.
Loans on collateral which may be forged.
not always simple:

The answer is obvious, but

Investigate collateral carefully - - d o not assume that

what is presented for collateral is always what it is represented to be.
Some borrowers, under pressure themselves, may offer supposed collateral
which either covers non-existent assets, or which may be forgeries of document
the originals of which are sound.
Unsecured loans based on statements so good as to raise doubts as to
why a loan may be necessary in the first place.

Too often beautiful state­

ments of net worth, or company balance sheets, may be presented, which have
no more truth to them than the latest bestselling novel.

The answer to this,

or to the other problem loans we have outlined, is adherance to well developed
credit standards.
Loans made without regard for the fact that no loan is safer than the
borrower.

Too many bankers have made loans on the strength of excellent

collateral, forgetting that’in many instances that collateral continues sound
only if the borrower maintains its value.

For example, there have been

several loans -- too well known by us -- which were collateralized by bank
stocks.

When the borrowers committed actions which destroyed the banks, I

suspect there were some rather agonizing reappraisals of collateral, and some
interesting discussions between a lending officer and his front office.




- 9 -

Basically, the answer to these problems is adherance to well developed
credit standards.
Now is the time for bankers to redouble their vigilance against unsound
loans, and unsound borrowers.

Now is the time to resist competitive pressures,

and to maintain sound credit operations.

There are perhaps two key rules

which can help every banker to resist such pressures, no matter how tightly
he may be squeezed by the cost-earnings pattern prevalent today.
In the first place, it is not sound banking to let credit standards be
set by a competitive bank, or by a competitive non-bank institution.

The

banker who lowers his own standards to match some other banker's, or the
standards of some mortgage lender or other non-bank lender, all too often is
surrendering his own judgment and jeopardizing his institution.

The only

sound operation is still that operation which makes its own judgments as to
the safety of the credits it advances, its own judgments as to the recover­
ability of the funds advanced, and which tailors its loan portfolio to its
needs, management skills, and its ability to absorb losses.
In the second place, making credit advances on the basis that continued
expansion in the economy, or in an industry, will cover unsound approaches,
is a positive danger.
of risky situations.

No banker should count on the future to bail him out
There are times when a banker may want to lend on

future prospects, but there should be a sound, legitimate analysis that the
operation is geared to succeed in the forseeable future, withoutthe necessity
of continued economic advance, or of inflation, to push it along.
Public confidence in the banking business is based on the public's
belief that the banks of the nation are sound, with competent managements,
and prudent, workable credit policies.




This is a priceless asset, perhaps

10

the single most priceless asset the banking industry can have.

Every

bank manager, every bank credit man should do all in his power to maintain
a sound operation which justifies the public’s confidence now and in the
future.




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