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INCREASED DEBT LEVELS AND THE
STABILITY OF THE BANKING SYSTEM

A n Ad d r e s s b y

L. W i l l i a m Se i d m a n , Ch a i r m a n
F e d e r a l D e p o s i t In s u r a n c e Co r p o r a t i o n

Be f o r e t h e

F e d e r a l R e s e r v e B a n k of K a n s a s C ity
Sy m p o s i u m o n D e b t ., F i n a n c i a l St a b i l i t y a n d P u b l i c P o l i c y




Ja c k s o n , W y o m i n g
A u g u s t 29, 1986

Go o d

morning.

I'm

not

quite

sure

how

an

accountant

SUCH AS MYSELF FITS IN A PROGRAM WITH SO MANY EMM1NENT ECONO­
MISTS.

I ASSUME

ALREADY.

. . . Hm m , I'm

SOUNDING LIKE AN ECONOMIST,

LET ME JUST SAY IT IS A PLEASURE TO BE HERE WITH

SUCH A DISTINGUISHED GROUP OF PANELISTS AND ATTENDEES.
LY, THE FOCUS OF THIS CONFERENCE ~
”

DEBT AND FINANCIAL STABILITY

IS APPROPRIATELY TIMED.

In d e b t e d n e s s
—

cally

Un i t e d St a t e s h a s i n c r e a s e d d r a m a t i ­

the

INCOME HAS EXPANDED

THE ECONOMY.

U.S.

in

REACHING A LEVEL WHICH SOME CONSIDER ALARMING.

RELATIVE TO

in

CERTAIN­

IN VIRTUALLY ALL SECTORS OF

FOR THE FOUR YEARS ENDING IN DECEMBER

6NP

Go v e r n m e n t d e b t o u t p a c e d

GREW ABOUT THREE PERCENT FASTER.

T he

significance

of

12
GNP,

nearly

DEBT INCREASED SIX PERCENT FASTER THAN

DEBT NOW AMOUNT TO 173 PERCENT OF

DEBT

1985,

6R0WTH

percent; household

AND BUSINESS DEBT

COMBINED FEDERAL AND PRIVATE

GNP.

increased

debt

is

a

matter

of

some

CONTROVERSY, AS SHOWN BY COMPARING THE PAPERS PREPARED BY PROFES­
SORS

Fr i e d m a n

HIGHER

DEBT

and

Su m m e r s .

BURDENS

We

INCREASE

TO ADVERSE FINANCIAL EVENTS.

can

THE

all

agree,

VULNERABILITY

though,

OF

that

BORROWERS

THE CURRENT PROBLEMS IN OUR FARM

AND ENERGY SECTORS HIGHLIGHT THE DANGERS OF 'TOO MUCH* LEVERAGE.

T he




great

danger

is

that

heavy

debt

levels

will

turn

-

2-

A MILD OR NORMAL BUSINESS DOWNTURN

INTO A SEVERE RECESSION.

In THIS SCENARIO, AN ECONOMIC SLOWDOWN CAUSES SOME HI6HLY LEVER­

AGED FIRMS TO DEFAULT ON THEIR OBLIGATIONS.
CAUSE

DEFAULTS

AMONG

SOME

LEVERAGED

ACCOMPANYING LAYOFFS

HOUSEHOLDS.

THE

CYCLE

OF DEFAULTS AND PRODUCTION CUTBACKS COULD FEED ON ITSELF AND
MAKE RECOVERY MUCH MORE DIFFICULT THAN IT WOULD HAVE BEEN WITH
LOWER DEBT LEVELS.

Pr o f e s s o r
A SHARP

BREAK

Su m m e r s

argues

Fr i e d m a n
WITH
that

A COINCIDENCE "
OFFSET

BY

AN

views

PRIOR
the

THAT

the

U.S.

past

ECONOMIC

stability

INCREASES

INDEPENDENT

accelerated

borrowing

BEHAVIOR.

of

the

debt

as

PROFESSOR
ratio

was

IN PRIVATE SECTOR DEBT WERE

REDUCTION

IN

U.S.

GOVERNMENT DEBT,

FROM THE HIGH LEVELS OF WORLD WAR II.

Wh e t h e r

one

views

the

simultaneous

growth

of

federal

AND PRIVATE DEBT AS AN ALARMING NEW DEVELOPMENT OR MERELY A
COINCIDENCE, THE QUESTION REMAINS:

HOW DANGEROUS ARE THE

CREASED DEBT LEVELS TO THE FINANCIAL SYSTEM AND THE
whole?

Pe r h a p s

IN­

ECONOMY

I can best contribute to the discussion

as

a

by

FOCUSING MY REMARKS ON THE APPARENT VULNERABILITY OF THE

BANKING SYSTEM IN THIS HIGHER DEBT ENVIRONMENT.
WITH

SOME

ACTIONS.




GENERAL

VIEWS

REGARDING

APPROPRIATE

I WILL CONCLUDE
PUBLIC

POLICY

w
R ank P e r f o r m a n c e

O

Re a s o n a b l e

men

may

disagree

over

the

implications

to

THE FINANCIAL SECTOR PRESENTED BY THE RISING LEVELS OF PRIVATE
AND PUBLIC DEBT.

THE

SCENARIO OF SNOWBALLING DEFAULTS WOULD

NOT SEEM TO BODE WELL FOR BANKS —
THE

INDUSTRY

WITHSTAND

SUCH

THE "DEBT OWNERS."

PRESSURES?

HOW

STRONG

COULD
IS

THE

INDUSTRY?

He r e , t h e
HAVE
OWN

INCREASED
RELIANCE

news

is

mixed.

IN RECENT YEARS

ON,

AND

Ba n k
—

equity

capital

DECREASING THE

EXPOSURE TO,

LEVERAGE.

levels

INDUSTRY'S

I THINK

BANKS

ARE BECOMING MORE INNOVATIVE, BETTER MANAGED, AND LOOKING FOR
NEW WAYS TO

INCREASE EFFICIENCY,

DIVERSIFY RISKS.

HOWEVER, NO ONE

EXPAND BUSINESS AS WELL AS
CAN DISPUTE THAT SOME MEASURES

OF THE INDUSTRY'S PERFORMANCE ARE FAR FROM REASSURING.

Ba n k s

have

been

failing

at

ADVENT OF FEDERAL DEPOSIT INSURANCE.
FROM 1941 TO 1980,

YEAR,

SOON

BE

not

seen

since

the

OVER THE 40"YEAR PERIOD

ONLY 262 BANKS FAILED.

400 BANKS HAVE FAILED.
WILL

rates

SINCE 1980,

OVER

LAST YEAR'S RECORD OF 120 BANK FAILURES

ECLIPSED AS 97 BANKS HAVE ALREADY FAILED THIS

AND WE EXPECT ANOTHER 40 TO 60 MORE.

NEXT YEAR WILL

LIKELY BE AS BAD OR WORSE.
T he s i z e of t h e f a i l i n g b a n k s is a l s o i n c r e a s i n g d r a m a t i ­




cally.

Fo r

the

30-y e a r

period

up

1970,

through

BY FAILED BANKS TOTALED $560 MILLION.

assets

held

SINCE THEN, ASSETS HELD

BY SUCH BANKS, EXCLUDING CONTINENTAL, HAVE EXCEEDED $40 BILLION,
AN AVERAGE OF $3 BILLION PER YEAR.

While
BANKING

failure

INDUSTRY,

OTHER

WHAT LIES AHEAD.
NUMBER OF

statistics

reflect

MEASURES

past

PROVIDE

A

problems

CLEARER

in

VIEW

the

OF

A LEADING INDICATOR OF BANK FAILURES IS THE

PROBLEM BANKS.

1,411 BANKS AS "PROBLEMS."

CURRENTLY,

THE FD1C HAS CLASSIFIED

THIS COMPARES TO 1,140 AT YEAR-END

1985 AND 848 THE YEAR BEFORE THAT.

IN FACT, THE NUMBER OF

PROBLEM BANKS HAS ABOUT QUADRUPLED SINCE 1981.

Ot h e r

indicators

portray

a

similar

trend.

Ba n k e a r n i n g s

RELATIVE TO AVERAGE ASSETS HAVE DECLINED NOTICEABLY IN RECENT
YEARS.

T h i s h a s o c c u r r e d d e s p i t e a n i n c r e a s e in c a p i t a l l e v e l s ,

WHICH SHOULD HAVE A POSITIVE EFFECT ON BANK

ROAs.

Ba n k e a r n i n g s a r e a l s o m u c h m o r e v o l a t i l e .
ALL BANKS OPERATED PROFITABLY —
out.

To d a y ,

many

ARE IN THE RED.

banks,

SAVE FOR NEW BANKS JUST STARTING

including

many

established

banks,

IN 1980, LESS THAN FOUR PERCENT OF ALL INSURED

COMMERCIAL BANKS FINISHED WITH NEGATIVE EARNINGS.
TAGE HAS STEADILY INCREASED —

THAT PERCEN­

RISING TO 11 PERCENT IN 1983,

14 PERCENT IN 1984, AND OVER 16 PERCENT LAST YEAR.




On c e , a l m o s t

-5-

To

A CONSIDERABLE EXTENT, THIS VARIANCE IN BANK PERFOR­

MANCE CAN BE ATTRIBUTED TO GEOGRAPHICAL DIFFERENCES.

FOR EXAM­

PLE, ONLY 10 PERCENT OF THE BANKS EAST OF THE MISSISSIPPI RlVER
LOST MONEY LAST YEAR,
WERE UNPROFITABLE.

WHILE 22 PERCENT OF THOSE TO THE WEST

SIMILARLY, 86 PERCENT OF THE BANK FAILURES

IN 1985 AND 1986 HAVE BEEN IN STATES WEST OF THE MISSISSIPPI
River.

Th e r e a r e a l s o s i g n i f i c a n t d i f f e r e n c e s b e t w e e n t h e p e r f o r ­
mance

OF SMALL VERSUS LARGE BANKS,

OVER 25 PERCENT OF COMMERCIAL

BANKS WITH UNDER $25 MILLION IN TOTAL ASSETS LOST MONEY LAST
YEAR.

T he

return

on

average

assets

for

banks

in

that

si ze

CATEGORY WAS LESS THAN 40 PERCENT OF WHAT IT WAS FOR ALL OTHER
COMMERCIAL BANKS.

UNTIL A FEW YEARS AGO, SMALLER BANKS CONSIS­

TENTLY OUTPERFORMED THEIR LARGE COMPETITORS.

THE BANKING INDUSTRY ALSO FACES SIGNIFICANT ASSET PROB­
LEMS.

T he LEVELS OF NONPERFORMING LOANS HAVE MODERATED SOMEWHAT

OVER THE PAST TWO YEARS —

BUT REMAIN HIGH.

THIS IS DESPITE

RISING NET CHARGE-OFF RATES, WHICH HAVE MORE THAN DOUBLED OVER
THE PAST FIVE YEARS, AND ARE TEN TIMES WHAT THEY WERE 30 TO
40 YEARS

AGO.

MOREOVER,

NONPERFORMING

LOT OF

INTERNATIONAL LOANS WHICH,

Mr . d e

Vries

CONCERN.




T he

point

out,

PROSPECTS

are

FOR

still

MAJOR

LOANS DON'T

INCLUDE

A

AS PROFESSOR DORNBUSCH AND
a

matter

DECLINES

of

considerable

IN NONPERFORMING

-

AND CHARGE-OFF

6-

LEVELS DO NOT APPEAR VERY BRIGHT "

AT LEAST

NOT IN THE SHORT RUN.

H istorically,

there

has

been

an

BETWEEN THE PERFORMANCE OF THE ECONOMY,

GNP,

AND BANK LOAN LOSSES.

inverse

relationship

AS MEASURED BY REAL

IN THE POST-WORLD WAR

II PERIOD

PRIOR TO 1982,

THE LEVEL OF CHARGE-OFFS AT COMMERCIAL BANKS

LAGGED

IN REAL

CHANGES

GNP

BY ABOUT THREE

QUARTERS.

WELL,

THREE QUARTERS HAS LONG SINCE PASSED SINCE WE CAME OUT OF THE
LAST RECESSION —
UP.

AND LOAN CHARGE-OFF RATES ARE STILL GOING

I'D SAY ONE MORE HISTORICAL RELATIONSHIP HAS PROVEN ITSELF

UNRELIABLE DURING THIS UNIQUE ECONOMIC PERIOD.

Lo o k i n g a t c h a r g e -o f f s b y l o a n t y p e

indicates

that

bank

ASSET PROBLEMS ARE NOT CONFINED TO JUST ONE OR TWO CATEGORIES.
Net c h a r g e -o f f r a t e s f o r r e a l e s t a t e l o a n s h a v e m o r e t h a n d o u b l e d
SINCE YEAR-END 1982.
TRIAL
AND

LOANS.

CONSUMER

In

LOANS

THE SAME IS TRUE FOR COMMERCIAL AND INDUS­

1985 a l o n e , n e t

c h a r g e -o f f

rates

for

farm

JUMPED BY OVER 50 PERCENT FROM THE YEAR

BEFORE.

R e a s o n s f o r D e c l i n e s in B a n k P e r f o r m a n c e

How

CAN WE EXPLAIN THIS DETERIORATION IN BANK PERFORMANCE!

A DETERIORATION THAT IS PARTICULARLY TROUBLING SINCE, IN GENERAL,
ECONOMIC CONDITIONS HAVE BEEN FAVORABLE OVER THE PAST SEVERAL




-7-

YEARS.

O ne

obvious

factor

is

that

economic

performance

HOT BEEN FAVORABLE FOR ALL SECTORS OF THE ECONOMY.
TURAL

AND

ENERGY

SECTORS

HAVE

BEEN

THE AGRICUL­

EXCEPTIONALLY

ARE IN THE MIDST OF A PAINFUL ADJUSTMENT PROCESS.

WEAK,

OF

SERVE

THESE

THESE

SECTORS ARE AFFECTED AS WELL.

SECTORAL

WEAKNESSES

ON

SOME

OF OUR

AND

THESE ADJUST­

MENTS ARE NOT CONFINED TO THE NONFINANCIAL FIRMS "
THAT

has

THE BANKS
THE

IMPACT

NATION S BANKS

HAS BEEN ACCENTUATED BY THE INADEQUATE LEVEL OF ASSET DIVERSIFI­
CATION.

Ba n k s , b o u n d e d b y g e o g r a p h i c a l o r p r o d u c t c o n s t r a i n t s ,

WERE UNABLE, AND PERHAPS NOT ANXIOUS, TO EXPAND THEIR BORROWER
scope.

O ne

can

only

hope

the

painful

adjustment

OF SUCH BANKS WILL NOT BE LOST ON THOSE OF US
MAKER, REGULATOR —

experience

BANKER, LAW­

THAT DETERMINE THE SCOPE OF FUTURE BUSINESS

OPTIONS.
An o t h e r

factor

impacting

current

bank

performance

is

THE BUSINESS ENVIRONMENT HAS QUICKLY BECOME MUCH MORE COMPETI
TIVE.
NEW

The

deregulation

COMPETITORS,

AND

of

THE

interest

rates,

DISAPPEARANCE

OF

the

SOME

entrance

of

TRADITIONAL

BANKING MARKETS HAVE UNDOUBTEDLY TAKEN THEIR TOLL ON MANY BANKS.
Pr e s s u r e o n i n t e r e s t m a r g i n s h a s i n t e n s i f i e d a n d t h e r e
EVIDENCE

THAT

QUALITY

STANDARDS

HAVE

BEEN

RELAXED

is

so me

IN ORDER

TO PRESERVE SPREADS.
F in all y, bo rro we rs and lenders are ad jus ti ng t o drastical




-

LY LOWER

INFLATION —

8-

DEFLATION -IN SOME SECTORS.

MENT BECOMES MUCH MORE ONEROUS

DEBT REPAY­

IN MOVING FROM AN

ARY TO A NONINFLATIONARY ENVIRONMENT.

INFLATION­

THE VALUE OF THE DOLLARS

TO BE REPAID; RELATIVE TO THE ASSETS THEY BOUGHT, RISES SIGNIFI­
CANTLY.

Bu y i n g

now

and

paying

later

becomes

much

harder

to

DO.

How
TURE?

DOES THE INCREASE IN OVERALL DEBT FIT INTO THE PIC­

Cl e a r l y ,

it

makes

matters

worse.

Ec o n o m i c

weaknesses

ARE EXACERBATED WHEN HIGH LEVELS OF DEBT ARE PRESENT.

FDIC

A 1985

STUDY'INDICATED A RELATIONSHIP BETWEEN THE LEVELS OF CORPO­

RATE DEBT BURDEN (MEASURED BY THE RATIO OF AFTER-TAX NONFINAN”
CIAL

CORPORATE DEBT

SERVICE

CASH

FLOW)

LEVEL OF BANK FAILURES.

AND THE

HORIZON BEGINNING IN 1970,
LED

INCREASES

BURDEN TO NONFINANCIAL CORPORATE
OVER A 15~YEAR

INCREASES IN CORPORATE DEBT BURDEN

IN BANK FAILURES BY ROUGHLY FIVE QUARTERS AND

ACCOUNTED FOR ABOUT 62 PERCENT OF THE VARIATION IN BANK FAILURES.
W h i l e n o t c o m p l e t e l y e x p l a n a t o r y , t h e r e l a t i o n s h i p is s t a t i s t i ­
cally

SIGNIFICANT ~

AND APPEARS TO BE CONTINUING.

(SEE ALSO

THE ATTACHED CHART RELATING FAILURES TO GNP DEBT TOTALS.)

TO SUMMARIZE,

RECENT PERFORMANCE AND CONDITIONS

IN THE

BANKING INDUSTRY CAN BE EXPLAINED TO SOME DEGREE BY MORE COMPETI­
TION,

SECTORAL

LEVELS OF DEBT




WEAKNESSES

AND

DISINFLATION.

BUT,

INCREASED

IN THE NONFINANCIAL SECTOR ALSO CONTRIBUTE TO

-9-

INCREASING NUMBERS OF NONPERFORMING LOANS AND RESULTING INSTABIL­
ITY IN THE BANKING SYSTEM.

Po l i c y O p t i o n s
In t e r m s of d e v i s i n g l o n g -r a n g e r e g u l a t o r y a n d l e g i s l a t i v e

ACTIONS TO HELP MEET CURRENT BANKING PROBLEMS*

As

EASY ANSWERS.

THERE

ARE NO

PROFESSOR ElSENBEIS HAS POINTED OUT* THERE

ARE MANY OUTDATED PIECES OF BANK LEGISLATION THAT NEED REVISION.
IN THAT

REGARD* THE LIBERALIZATION OF GEOGRAPHIC RESTRICTIONS

ON BANKS

IS A POSITIVE

DEVELOPMENT.

THE

OF PRODUCT CONSTRAINTS ALSO IS DESIRABLE.

GRADUAL RELAXATION
BOTH WILL HELP BANKS

ACHIEVE GREATER ASSET DIVERSIFICATION.

Th e r e

are

also

certain

actions

that

can

be

taken

to

REDUCE THE INCENTIVE THAT THE FEDERAL DEPOSIT INSURANCE SYSTEM
CREATES

FOR

BANKS

IMPLEMENTATION

OF

TO
A

ENGAGE

RISK-RELATED

SYSTEM IS ONE SUCH MEASURE.
REDUCING
LEVELS

EXCESSIVE
OF

IN EXCESSIVE
DEPOSIT

"MARKET

INSURANCE

THE

PREMIUM

HOWEVER* THE ISSUES INVOLVED IN

BANK RISK-TAKING

SO-CALLED

RISK-TAKING.

BY MOVING TOWARD GREATER

DISCIPLINE"

ARE

COMPLICATED

AND

HAVE SIGNIFICANT IMPLICATIONS FOR THE STABILITY OF THE BANKING
SYSTEM.

Ce r t a i n l y *
WHOM

AND




WHEN

discipline

ARE THE

is

RELEVANT

necessary*

QUESTIONS.

but

A

how

much*

BALANCE

on

NEEDS

-

TO

BE

DRAWN.

TOO

LITTLE

10

-

DISCIPLINE

MAY

CAUSE. INSTABILITY,

BUT THE RISKS OF TOO MUCH DISCIPLINE ARE FAR MORE THREATENING.
I AM A STRONG BELIEVER THAT WHERE FRAUD OR INSIDER ABUSE
DETECTED,

PUNISHMENT

SHOULD

BE

SWIFT AND SEVERE.

THOSE WHO TAKE EXCESSIVE RISKS WITH DEPOSITORS'
PAY FOR THEIR MISTAKES.

HOWEVER,

IS

SIMILARLY,
MONEY SHOULD

I AM EQUALLY CONVINCED THAT

WE SHOULD NOT BE INSENSITIVE TO THE PROBLEMS OF INNOCENT VICTIMS.

AS THIS RELATES TO THE STABILITY OF THE BANKING SYSTEM
AND THE
WILL

HANDLING

CONTINUE

OF

TO

BANK

MAKE,

FAILURES,

EVERY

THE FDIC

EFFORT

TO

IS MAKING,

ARRANGE

AND

MERGER-TYPE

PURCHASE AND ASSUMPTION TRANSACTIONS AS OPPOSED TO LIQUIDATIONS
THROUGH

DEPOSIT

PAYOFFS.

On

SUCH

TRANSACTIONS,

ARE PROTECTED BUT STOCKHOLDERS AND MANAGEMENT “
TO THE BANK'S PROBLEMS —
OTHERS

IS REDUCED.

PAY A HEAVY PRICE.

DEPOSITORS

THOSE CLOSEST
THE IMPACT ON

BANKING SERVICES ARE CONTINUED.

THE RISK

OF PANIC AND UNCONTROLLABLE INSTABILITY IS LESSENED.

R e g a r d i n g t h e h a n d l i n g of p r o b l e m i n s t i t u t i o n s , I b e l i e v e
IT IS INCORRECT TO VIEW THE CONCEPT OF FOREBEARANCE AS SOMETHING
WHICH ALWAYS
long r u n .

CONDITIONS
POINT

AND EVERYWHERE MAY LEAD TO HIGHER COSTS

IN THE

W h e r e p r o b l e m s a r e m o r e t h e r e s u l t of a d v e r s e e c o n o m i c
THAN

MISMANAGEMENT

IN TRYING TO "TEACH THE

OR

INSIDER

ABUSE,

THERE

INDUSTRY A LESSON."

IS NO

THE NEED

IS TO HELP FIND A WAY ACROSS THE LOW POINT, WITH MINIMUM DAMAGE
TO THE SYSTEM.




-

T h u s , we at t h e

FDIC

BANK MANAGEMENT APPEARS

11

-

"c a p i t a l f o r e b e a r a n c e ,"

favor

CAPABLE AND THERE

FOR A RETURN TO VIABILITY.

where

IS REASONABLE HOPE

THIS WILL PROVE TO BE MORE COST

EFFECTIVE THAN LIQUIDATING BANKS IN A FIRE“SALE ENVIRONMENT.

Has

the

level

of

debt

compromised

FDIC's

the

ability

TO MAKE GOOD ON ITS ANNOUNCED INTENTION TO PROTECT DEPOSITORS
WHENEVER
HEALTHY

POSSIBLE?
($18

So

BILLION

FAR,
NET

THE ANSWER

WORTH)

AND

IS NO. ' THE FUND

CONTINUES

TO

GROW.

IS
It

HAS NOT JOINED THE CURRENT TREND TO BORROW ITS WAY TO HEAVEN.
Ev e n a t c u r r e n t l e v e l s of b a n k f a i l u r e s , t h e f u n d s h o u l d s h o w
A MODEST

ONE-HALF

BILLION

GAIN THIS YEAR.

BUT,

THERE

IS A

LEVEL OF DEFAULTING DEBT THAT WOULD JEOPARDIZE THAT ABILITY.
One t h i n g

is

certain, the

current

trend

line

in

bank

failures

CAN NOT BE EXTENDED FOR MANY MORE YEARS WITHOUT TROUBLE; THE
CLIMB IT EVIDENCES IS TOO STEEP.

Pe r h a p s
THE

TREND

LINE

i t 's

TO

SAY

DEBT TO

GNP;

REASONABLE

DEPICTING

THE

IT c a n 't

GO UP AT THIS RATE FOR MANY MORE YEARS —
TOO STEEP.




SAME

THING

ABOUT

CONTINUE TO

THE CLIMB IS WAY

Insured Commercial Bank Failures
and the Ratio of Total Debt to GNP. 1955 - 1986
To t a l De b t -t o -GNP Ra t i o

A n n u a l B a n k Fa i l u r e s
150

-

120

-

90

-

60

30

Note: Midyear debt levels were used to compute
debt ratios.