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Statement of K. A. Randall
Chairman, Federal Deposit Insurance Corporation
Before the Subcommittee on Economic Progress
of the Joint Economic Committee
Wednesday, July 10, 1968

This opportunity to appear before the Subcommittee on
Economic Progress of the Joint Economic Committee to present the
views of the Federal Deposit Insurance Corporation on municipal
bond ratings and the problems of municipal financing and on some
general aspects of some of the current legislative proposals on
these subjects is greatly appreciated.

The Corporation's primary

responsibilities relate to the Federal deposit insurance system
and to our supervisory activities over banks in connection with
these responsibilities.

The problems of municipal finance are

thus outside the immediate purview of our operations, although
certain aspects of bank examination practices and procedures are

I shall therefore confine my comments today to those

topics on which the Corporation might be able to contribute some
additional information and insights.
The Corporation recognizes the importance of providing
State and local government units with the financing needed to supply
their communities with essential facilities and services, such as
highways, public utilities, and schools.

With the expansion of the

economy, rising population, and increasing urbanization, the financial
requirements of the local government units have been growing rapidly.



The financing of governmental activities at every level of responsi­
bility -- from the States down to the smallest unit -- is a task of
tremendous complexity and ever increasing urgency.
Throughout the years, banks have furnished municipalities
with a significant portion of their credit requirements.


banks now account for the largest single investor group in municipal
securities, they may be expected to play an even more important role
in future financing.

Banks are ideally situated in the savings market

to act as intermediaries between the small savers and municipalities.
In the absence of an intermediary, the small saver would not be likely
to invest his funds in municipal issues -- both because he would
derive virtually no benefit from their tax-exempt status and because
municipal securities typically are not issued in suitable denominations.
As a consequence of the banks' activities in the market for
municipal securities, the obligations of the municipalities appear in
the asset structure of banks and come to the attention of the bank
supervisory authorities in the course of the regular examination

The relationship between the examination process and municipal

securities, however, is a subsidiary one and one that is really
peripheral to the problems of municipal financing.
It seems to me that the Subcommittee on Economic Progress is
concerned at this time with ways whereby local units of government can
very greatly improve their channels of access to capital markets.


capital requirements of these local government units -- for the construe*
tion of new schools, highways, sanitary facilities, and similar projects *|
entail long-term borrowing.

Financing of all these activities competes


with home building and the related commercial and industrial construc­
tion for the same limited supply of funds in the capital market.
Logically the situation calls for rationalization of the complex of
these capital demands placed on the market as well as for imagination
in devising new ways for municipalities to tap, either directly or
indirectly, the accumulated funds of savers who are seeking investment
If municipalities are to make real progress in bettering
their access to capital funds, it will probably be necessary to move
in entirely new directions.

Not only would it be desirable to increase

the overall supply of credit for municipalities but it would be desirable
to broaden the investor base that can be tapped for funds.

To illustrate,

municipalities might improve or develop the machinery for mobilizing
the funds of small savers in their own communities -- either on a direct
basis or through improvements in intermediation by existing financial

Another possibility might be the creation of a new,

standardized investment security that could be offered in the capital
market by financial intermediaries who in turn would use the proceeds
to finance municipalities.

Such an instrument (large in denomination)

might prove attractive to potential investors because the obligor would
be better known than many of the smaller local government units and its
standardized form might improve its marketability.
Both of these suggestions are advanced merely as rough
skeletons of ideas.

No doubt legislation would be required at both

the Federal and State levels of government, and perhaps this would not
be easy to achieve.

Moreover, there may very well be insurmountable


practical difficulties not obvious at first glance, or untoward effects
on existing financial arrangements.
Because income from the obligations of States and their
political subdivisions is not subject to Federal income taxes, moreover,
another complication is introduced to any discussion of possible changes
in the methods of financing the capital requirements of these governmental

Owing to the great variation in the tax status of prospective

investors, it is extremely difficult to trace the impact of the tax
exemption feature on the securities marketing process or to generalize
with any assurance of being right as to the consequences for long-term
municipal financing of its retention or elimination.

To further compli­

cate the situation, there are fifty different State jurisdictions.
overj municipal finance and taxation involve


legal relationships between

the States and the Federal Government that are exceedingly intricate.
In addition, it is exceedingly difficult to appraise the incidence under
existing law of exemptions from Federal income tax of the income from
the obligations of the States and their subdivisions and possible
shifting of the tax burden.
Yet another complication stems from the fact that some States
also accord tax advantages to taxpayers holding their obligations.
Resolution of these various tax problems is likely to be most difficult
because of the complexity of existing Federal-State government relation®hips and the troublesome questions of tax policy and equity among
Another proposal recently advanced as a possible solution to
easing the problems of financing municipalities suggests a guaranty --


or adoption of the insurance principle for the obligations of local
governmental units.

Beginning in the 1930's, the Federal Government

has experimented with insurance of assets and, by and large, the
experience seems to have been reasonably successful.

Whether this

could be applied to the financing of the various subdivisions of
government poses questions both of a technical nature and with regard
to desired public policy that cannot be easily resolved.
The proposal for guarantees also contemplates tapping, in
part at least, the resources of the Federal deposit insurance fund
for the initial financing.

Use of the Federal deposit insurance fund

for this purpose is, in my opinion, inconsistent with the principles
of good public administration and, in addition, violates the trustee
relationship between the Federal Deposit Insurance Corporation and
depositors in insured banks.

Diversion of even a small part of the

deposit insurance fund, which consists of the proceeds from assess­
ments levied on banks for deposit insurance, for other purposes than
that for which it was established -- irrespective of how meritorious
the objective -- can only be viewed as an extension of the taxing
power in an entirely new direction.
Nevertheless, the consideration of new and "radical"
approaches to the long-term financial problems of municipalities is
essential -- and I am using the term "radical" in the sense of attack­
ing the root of the problem.

Methods of insuring municipal credits,

some form of Federal subsidy to offset the Federal income tax exemption
feature of municipal obligations, or improvements in the availability
of data concerning the finances of municipalities could perhaps be




Yet these proposals may not augment greatly the volume of

funds necessary to meet the large and rapidly growing financial
requirements of municipalities.
Let me turn now from this broad consideration of problems
in the field of municipal financing and direct my remarks to the bank
supervisory use of ratings in evaluating bank portfolio investments in
municipal securities.

To be sure, the subject is only of limited

concern to the committee's primary interest.

Nevertheless, it may

be helpful at this point to review briefly the essential features of
the bank examination process relating to ratings and investments in
municipals in order to contribute to a better understanding of the
problem of municipal financing as a whole.
Whenever a bank is under examination by the supervisory
authorities, one of the crucial determinations in that process is
the amount of net sound capital in the institution.

Speaking now at

the risk of gross oversimplification, this figure is ascertained by
subtracting the amount of the bank's liabilities to depositors and
others from the book value of its assets after certain adjustments.
These adjustments include an estimate for losses stemming from
qualitative deficiencies in some of the items.

On the basis of

information in credit files and any other data available to the
examiner, individual loans are tested for quality, and the book
value is adjusted for elements of loss deemed to be present.


in the securities portfolio likewise need to be checked for quality
and soundness.


Prior to 1938, when banks were examined, securities in the
investment portfolio usually were appraised at market prices on the
day of examination.

Rationalization of this method was not difficult.

Especially in the early decades of this century, banks invested in
substantial amounts of corporate issues that were actively traded on
the securities exchanges, and these holdings were viewed as a so-called
secondary reserve which could be readily converted into cash if necessary
The Great Depression of the 1930's demonstrated that bonds
in the securities portfolios of banks could not be readily converted
into cash through sale on the exchanges when many distressed sellers
placed a large volume on the market simultaneously.

Such securitites

could only be shifted from one holder to another bank or individual

Large losses were incurred as holders of bonds were obliged

to sell in a falling market -- even though the basic quality of the
credit was sound.

Nevertheless, bank examination practices continued

to use market prices of securities for appraisal purposes.
The lesson of the Great Depression was repeated in a some­
what milder form not long after.

A sharp recession in 1937 was

accompanied by a shrinkage of market values for securities.


the situation was especially acute because the appraisal of securities
in bank portfolios at market prices for the purpose of determining
net sound capital -- superimposed on already depressed values -- would
have necessitated the closing of many banks.

Notwithstanding the fact

that the underlying quality of the securities in bank portfolios was
generally satisfactory, the price declines tended to result in the
erosion of capita] margins under the prevailing bank examining procedures



To deal more realistically with this situation, the Federal
and State supervisory authorities in 1938 adopted an examination
procedure which valued investment quality securities on a cost basis
and only speculative issues at market prices.

Implementation of this

new policy required that examiners differentiate between the latter
issues and investment grade securities deemed to be suitable for bank
Determination of the credit quality of securities follows
precisely the same procedure used by examiners in appraising a loan

The examiner utilizes analytical methods and information

developed by the financial community as well as other information
available to him to reach a judgment based on facts.

With respect

to municipal securities rated since the 1930's by the investment
advisory services in the four highest grades (which incidentally
comprise all but about 5 percent perhaps of the amount of obligations
so covered), the quality of the obligation is virtually certain to be
suitable for bank investment purposes.
of the rated issues is

In dollar amount, the bulk

floated by large obligors and information to

support the quality determination for these issues is readily available
in the publications of the investment advisory services.
The issues at the lower margin of this comprehensive rating
band composed of four grades receive closer scrutiny by examiners,

For these issues and the issues outside of the scope of the

rating system, it is necessary for the bank examiner to obtain
relevant information from publications of the advisory services when
available, from the credit files of the bank under examination or



The issuer's past record of performance in servicing

debt, the current financial situation such as the relative debt
burden, the margin of protection against default on interest or
principal payments, tax levies and collections, and future prospects
for the community all must be considered in assessing the investment
quality of marginal or unrated investments.

For securities totally

lacking in bank investment quality -- namely, defaulted issues and
others with little or no margin of protection to insure performance
when interest coupons come due or the bond matures -- the examiner
sets the appraised value at the market price.

The kind of analysis

described above is not exhaustive, however, and need only be pursued
to the point needed to support the conclusion.
Admittedly the definition of an "investment grade" obli­
gation has many difficult facets.
so identified

Viewed in retrospect, a security

will perform precisely according to the terms of the
interest will be paid without delay and the principal

amount will be repaid when the bond matures.

But the buyer of

securities and the bank examiners are looking into the future rather
than the past when they make a judgment as regards investment quality.
The determination rests on judgment supported by as many relevant
facts as can be marshalled and appropriate analysis; it is neither
more nor less than that.
The basic idea embodied in the 1938 statements by bank
supervisory authorities regarding examination procedures (revised
in minor respects in 1949) with respect to the valuation of securities
for bank examination purposes continues in effect to this day, although




there have been other changes in examination practices.


quality securities are still insulated from day-to-day fluctuations
in prices.
The introduction in 1938 of so-called "convention values"
for appraising securities (namely, the uniform basis of valuation
adopted by the bank supervisory authorities) was especially relevant
to the bank investment problem at that time.

Banks held a substantial

amount of corporate issues and the sharp upward movement in interest
rate levels drove prices down on many issues, even though there had
been little or no deterioration in quality.

Since that time, the

structure of bank investment portfolios has changed greatly.


the bulk of the securities in bank portfolios consist of obligations
of the United States, the States, and their minor subdivisions (see
attached table).

Furthermore, market price quotations for the bulk

of the municipal securities in the portfolios of banks are very
difficult to obtain because they are traded on a negotiated basis
over-the-counter and actual transactions are not published.
In the absence of this convention basis for appraising bank
quality securities, the sharp increase in interest rates over the past
few years would have created tremendous problems for the bank supervisory

After all, a high-grade bank quality municipal obligation

issued in 1962 with a 3-percent coupon and a 20-year maturity would be
quoted today at a minimum discount from par on the order of 15 percent
so as to give the holder a competitive yield.

However, such an issue

would be appraised on a cost basis for bank examination purposes.




Alt hough the preponderance of the issues held by banks -as contrasted with the dollar amount -- have not been covered by the
rating system, the qualitative ratings published by the generally
recognized investment advisory services have furnished some useful
guidelines for bank examiners.

Admittedly it would be desirable if

all relevant information were available to cover all issuers of

But, as a practical matter, from the bank supervisory

point of view, the securities not so covered present difficulties to
examiners no greater than the ones that they face in appraising a loan
A few additional remarks about "ratings" in the examination
process may be helpful.

In the first place, the ratings are used only

as indicators in making generalized rather than sharp and precise

For bank supervisory purposes the fine gradations

of quality are ignored.

In examining a bank’s securities portfolio,

it is sufficient to identify on the one hand the bank quality issues
and, on the other, those securities wanting in prospective investment
performance, i.e., so speculative in character that they are not
appropriate for bank investment purposes.
Buyers and sellers of securities are naturally interested
in minute gradations of quality as are underwriters distributing
securities to their customers.

From the point of view of the bank

supervisory authorities, however, it is unnecessary to inquire
precisely into the terms of each transaction.

Presumably banks will

exercise good investment judgment when they acquire securities;
and their total investment activities must measures up to some

acceptable standard of profitability.
that is important.

It is the overall picture

The bank supervisory authorities, therefore,

are careful to refrain from managing a bank's investment activities.
Such efforts would be inconsistent with the supervisors' basic
Worthy of emphasis also in a discussion regarding qualitative
ratings for obligations issued by municipalities -- or for that matter
any other securities -- is the fact the evaluation is in terms of the
individual bank's overall condition and position.

Any determination

with respect to credit quality must always be relevant to the portfolio
of the individual bank under examination:
for inclusion in a specific portfolio.

whether an issue is suitable

Does the management of the bank

have the capacity to cope with the investment problems that may be
anticipated from a particular block or issue of securities?


example, some managements are much more skillful than others in hand­
ling credits or investments that might be classed as marginal in

Or, the relative size of the securities holding, e.g., a

$5,000 block of bonds in a $5,000,000 portfolio, has a bearing on the
importance attached to its quality at the time of examination.


should be obvious that an examiner would not focus the attention of
management on a relatively unimportant problem when other matters
are much more deserving of attention.
From time to time, the rating system has been criticized
for its limited coverage, erroneous judgments of the quality of
specific issues, and the lack of consistency in explanations of the

Since the investment advisory services are business enterprises,


rating coverage tends to be limited for very practical reasons to
the credits deemed to be of most interest to their clientele as the
most effective use of available resources.

Nonetheless, in recent

years the services have rated a very substantial proportion of the
outstanding dollar amount of municipal securities.

The investment

advisory services also have an impressive record of performance in
judging of quality of credits, especially over the past 30 years and
in the upper rating groups.

Misjudgments, if they could be so called,

have been confined mostly to the margin between the various ratings
comprising the investment category.

The qualitative ratings established

at the onset of the Great Depression and during the crisis years were -not surprisingly -- a poor guide for investors.

However, virtually no

one can point to outstanding foresight during those trying times.
Looking toward the future, the question of how best to pro­
vide examiners with guidance in appraising the quality of securities
in bank portfolios remains as important as ever.

Though the efforts

of the investment advisory services recognized in the financial
community have been helpful in the past, changes in the scope and
method of their operations may and do occur.

Here at the Corporation

we are endeavoring to ascertain the consequences to our examining
activities of recently announced changes in segments of the rating

Our objective continues to be to provide examiners with the

best assistance that the times permit -- and we shall pursue this
objective with steadfast determination.
In the course of bank examination, no determinations of
credit quality by the examiners are made available to the public.


No t only would it be inconsistent with the scope and nature of bank
supervisory authority for such agencies to rule generally on the
credit quality of any issuer of securities, but it would be as
inappropriate as an effort to pass generally on the quality of
commercial or industrial credit.
In the American financial community specialized institu­
tions have developed whose business is concerned both with appraisals
of the quality of mercantile credit and of securities.

There have

been investment advisory services engaged in compiling financial
data of interest to investors in securities floated by private
corporations as well as governments for many decades,


this type of service has developed only in the United States.
Thus, it would be inconsistent with bank supervisory responsi­
bilities to engage in a competition with the established facilities of
the financial community for compiling data on investments and publishing
ratings as to credit quality of securities.

Whether any agency of

government should undertake to compete with the established private
facilities in this area of activity raises questions of public policy
far beyond the scope of bank supervision.

The requirements of bank

supervision itself would not be able to justify an extension of these
investment advisory services as a necessary sphere of governmental
Proposals have been advanced recently to institutionalize
the accumulation of financial data with respect to subdivisions of
State governments.

This is a worthwhile endeavor.

For many years

the Census of Governments has been engaged in efforts along these


lines, but the practical limitations to undertaking such a project
are indeed very formidable.

There are perhaps somewhere between

50,000 and 100,000 separate governmental subdivisions to be covered
by any reporting system, and the difficulties of obtaining reports
on any timely basis would be enormous.
Viewed then in its entirety, it seems quite evident that
ratings of the investment quality of securities in bank portfolios
play a relatively minor part in bank supervision.

To the extent

that the investment advisory services publish material helpful to
examiners in isolating securities which are weak or speculative,
admittedly they can be helpful.

As a matter of fact, virtually all

of the published ratings fall within the scope of investment grade
issues, and only a small portion of the total securities outstanding
are identified by the rating services as lacking in investment quality.
For securities not covered by the investment advisory services, bank
examiners are obliged to follow the conventional methods of financial
analysis in ascertaining the quality of the asset.
As far as we can determine, ratings of municipal securities
by investment advisory services have not been a major factor limiting
bank or other investment in these issues.

Financing municipalities

is beset with numerous more important and exceedingly complicated
problems -- many of them legal or statutory in origin -« which
deserve our concerted efforts at solution.

(Amounts in Millions of dollars)

June 30»

June 30,

June 30,

June 2 9 ,

June 30,
19 5 1

June 30,

June 30,
19 6 1

June 30,

June 30,

June 30,









$381*, 908


1 6 ,1*98

2 2 ,181*








110 ,2 2 0

10 ,3 0 1










Guaranteed obligations







6 1,2 0 8




Other securities - total






l6 ,l86


1*1 ,8 1 1



2,28 0




8 ,31a*


1 8 ,1*90















2 ,16 0




10 7




Total Assets
Total Securities

Obligations of the U. S. Govt. - total

Obligations of States and subdivisions
Securities of Federal agencies and corporations (not guaranteed by the U.S.)
Bonds, notes and debentures of domestic
corporations - total

Public utilities
Real estate corp.
Other domestic corp.

3 ,35^


13 1






Other corporate stocks - total










Foreign securities - total





19 1



Real estate corp.
Bank and bank affiliates
Other domestic corp.


1/ Not available separately.
SOURCE: FDIC published reports of assets, liabilities and capital accounts of insured banks.


902 )
i )


Federal Reserve bank stock