View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Feder*iog33fe'i£a§gnk4 delivery
otOEJiQOLoura. e. , .

.....,.M — l r 1.2 2 -i
?-Y 2.

Statement by
Manuel H. Johnson
Vice Chairman
Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
United States Senate

May 21, 1987


am pleased to meet with this Committee to present

the views of the Board of Governors on the condition of the
banking system and to address the general areas covered in your
letter of invitation.

The Federal Reserve staff has worked with

the other depository institution regulatory agencies and members
of your staff to provide financial information and data on the
condition of U.S. banking organizations.

It is not my intent

here to review all of these data in detail; rather, I intend to
discuss our views on broad developments and conditions in the
banking system and what supervisory steps we have taken to
address these conditions.
In looking at the financial condition of the banking
system, it is important to consider the environment within which
banking organizations have been operating in recent years.
Without question, the environment has been a difficult one -characterized by considerable financial stress and volatility.
As a consequence, many institutions, many segments of the
industry, and, indeed, the industry as a whole have experienced
rising levels of loan charge-offs and classified assets and, of
course, the number of problem banks and failed banks has also
increased significantly.

- 2 -

These problems are rooted in several causes.


undoubtedly, is the transition to a less inflationary

As you know, inflation rates have drifted from

double-iigilevels in the late 1970s and early 1980s to low
single-digit levels in each of the last several years.
Unfortunately, inflationary expectations supported many farm,
energy, and real estate loans that, in hindsight, we now know
were not viable.

This situation was aggravated by steep

back-to-back recessions in the early 1980s that left a legacy of
troubled loans, even as the economy began to recover in late

A second type of economic transition--from a weak dollar

to a strong dollar--struck hard at another large segment of the
banking industry's customer base:
internationally traded goods.

manufacturers of

Finally, the transition from a

period of low or negative real interest rates and expanding
export markets to a period of high real interest rates and
declining export revenues, coupled with other factors, left many
borrowers in less developed countries in weakened positions.
During this period, banks also have been confronted
with competitive challenges from several directions.


foreign banks, and even nondepository financial institutions have
emerged as formidable competitors in many areas.

The direct

issuance of securities has proven to be a less expensive and more
efficient form of financing than bank loans for many of the
banking industry's prime customers.

And, the deregulation of

interest rates and the dismantling of geographic barriers have
placed pressure on the margins of some institutions, although

- 3 -

these developments should lead to a more sound and efficient
banking system over time.
All of this was compounded by the inclination on the
part of some depository institution managers to assume excessive
risks with federally-insured deposits in the hope that the
expected high rewards would accrue to investors.


far the majority of banking organizations are well-managed;
however, mismanagement, improper lending practices, and other
forms of excessive risk-taking have contributed to financial
problems and the failure of a number of institutions.
Yet, despite these economic dislocations, problems and
competitive challenges, most banking organizations remain
fundamentally sound, and it is important not to lose sight of the
important elements of strength that underlie our banking system.
To be sure, asset quality problems remain and segments of the
industry have been weakened by troubled farm, energy, real estate
and foreign loans.

On the other hand, many institutions continue

to record favorable operating results, and the industry as a
whole (and particularly the group of larger institutions)
continues to build its capital strength.

Indeed, I suspect that

many institutions that have withstood the recent pressures on the
industry may emerge in a much stronger competitive position.

Asset Quality
Asset quality difficulties have contributed to the
prevailing unease about the health of the banking system.
problems and loan losses have increased during the past few


- 4 -

years, despite more than four full years of economic expansion.
This experience is especially troublesome and contrary to that of
recent decades.

In past periods of recession and recovery, a

consistent pattern was observed: loan losses increased during the
recession and immediately afterwards, but then improved as
economic growth resumed.

The relatively high level of troubled

assets at some banks at this point in the recovery suggests that
any major unforeseen economic or financial shocks could test the
resiliency and solvency of the most vulnerable institutions.
The failure of asset quality to improve during the
current economic expansion is due to special national and
international economic conditions that have adversely affected
particular borrowing sectors.

The most obvious examples

domestically are the agricultural and energy sectors.

In the

late 1970s and early 1980s, borrowers in these sectors took on
large amounts of debt that could not be serviced when conditions
subsequently deteriorated.

While the wringing out of inflation

had an important positive impact on the economy as a whole, the
declines in the value of farm property and the price of oil led
to an increase in the level of delinquencies and defaults on bank
Depressed conditions in these two sectors have created
serious problems

in certain geographic areas.

Particularly hard hit have been banks in the farmbelt states of
the midwest and the energy-dependent states in the southwest.
Asset quality measures of banks in these areas are generally
lower than those of banks in other parts of the country.

- 5 -

Nonetheless, there are some signs that conditions may
be stabilizing.

The price of oil has recovered somewhat from

very low levels, and in some areas the decline in farm asset
prices has leveled off.

while adverse effects on banks that lend

heavily to these sectors will continue, we have, I believe, begun
to work through these problems, and absent any unanticipated
shocks, the worst may be behind us in these sectors.
We need to maintain our vigilance, though, over these
and other areas of the loan portfolio.

In parts of our country

that witnessed the energy boom and bust, problems have spilled
over into the real estate industry.

New construction, especially

for downtown office buildings, has finally slowed and even come
to a virtual stop in some energy-area markets, such as Houston.
Nonetheless, these markets remain

depressed, vrith a large

supply of available office space.

Moreover, while

construction has slowed in these markets, it has not done so in
the aggregate.

In 1986, real estate construction loans held by

banks grew by nearly 20 percent, while total loans grew by less
than 8 percent.

Over the last three years, construction loan

growth averaged 21 percent, compared with a total loan growth
average of 10 percent.

Thus, the banking industry remains highly

exposed to conditions in the real estate market.

Although 1986

witnessed some improvement in real estate vacancy rates, they
remain relatively high by historical standards.
One additional area of the domestic loan portfolio
that bears continued attention in the future is that of credit
card loans.

In recent years, many banks have solicited new




accounts in a very aggressive fashion and have purchased existing

These methods of securing new accounts have resulted

in historically high charge-off rates.

Although there is

evidence that such rates may be peaking, losses are expected to
remain high and many credit card portfolios remain vulnerable to
narrowing margins and possible increased delinquencies.
An important determinant of asset quality at the major
money center banks and some regional institutions continues to be
the debt problems of the less developed countries.


adjustment process they have undergone has been painful and the
difficulties facing these borrowers remain serious; nonetheless,
some progress has been made in dealing with this situation.
Despite some significant exceptions, most countries have been
able to service their indebtedness over the last four and a half

During this period, banks have been able to significantly

improve their ability to absorb any losses from their loans to
countries with debt problems.

Since 1982, the capital of the 50

largest U.S. banking organizations has roughly doubled while
exposure to troubled LDC borrowers has actually declined

Thus, their exposure to the heavily indebted countries

relative to their capital bases has declined sharply.
At the same time, many borrowing countries have made
progress in strengthening their economies and their ability to
service their external obligations.

Most of these economies now

are experiencing real growth, reducing their combined current
account deficits considerably, and instituting many needed
economic reforms.

In the case of some countries, this has been

- 7

achieved despite a significant decline in commodity prices and
export revenues.

In my view, the international debt problem has

been managed through an extraordinary cooperative effort by
borrowing countries, the international banking community,
multilateral financial institutions and creditor governments.
Moreover, while banks have shown a willingness to work with
countries that undertake appropriate adjustment policies, this
has been done without an excessive build-up of additional debt.
The external debts of heavily indebted developing countries have
increased at only a 3-1/2 percent annual rate over the past four
years which, under normal circumstances, would imply declining
debt burdens.
While I believe we are on a track that offers a
reasonable prospect of long-run success, this is not to say, of
course, that individual countries will not experience renewed
problems from time to time.

For example, Brazil is now facing a

resumption of serious inflationary pressures which, with other
factors, has led to a curtailment of debt service.

It will take,

no doubt, the concerted effort of Brazil and all of its creditors
to manage this situation.

Nonetheless, despite the impact that

the international debt situation has had on bank earnings and
asset quality, U.S. banks to date have proved able to cope with
the effects of foreign debt problems and, in particular, with
Brazil's moratorium on interest rate payments.
It is important to note that events of recent days
underscore the prudence and wisdom of efforts, over the last
several years, to strengthen the capital bases of our larger





The support of Congress, as manifested in the

International Lending Supervision Act of 1983, together with
actions by both bankers and regulators in recent years, have
resulted in significantly higher capital levels at most of our
larger banking organizations.

This should enable banks to

withstand the pressures stemming from international lending
difficulties of the type being experienced by Brazil.

Indeed, it

is a fundamental function of capital to absorb losses stemming
from unanticipated shocks while maintaining confidence in the
banking system.

Although the difficulties facing many foreign

borrowers are significant, the problems in Brazil should not
obscure the progress made with other debtors.

During 1987, new

lending agreements have been signed or tentatively agreed to with
Mexico, Chile, Venezuela, Argentina and the Philippines.
Having generally reviewed those segments of the loan
portfolio that have been cause for concern in recent years, I
would now like to address briefly recent trends in certain broad
indicators of loan quality.
Overall, loan losses trended upward for most of this

For all insured commercial banks, the ratio of net

charge-offs to average total loans has increased steadily since
1981; by year-end 1986, it had reached nearly one percent, an
unusually high level for the industry as a whole.
Looking at specific size classes of banks, we find
that the overall trend describes accurately each size group.


size class has fully escaped the general deterioration in asset
quality, although some have done better than others.

In general, banks with assets of less than $100 million have the
highest relative level of loan losses.

The problems experienced

by smaller banks largely reflects the relatively high
concentration of agricultural credits in many of these

The smaller regional banks, those with assets of

between $1 billion and $5 billion dollars, have had the best
performance, relatively speaking.
Nonperforming assets give some general idea of the
level of problems in the loan portfolio.

Nonperforming assets

have increased or remained at relatively high levels in the last
several years despite the extraordinarily high level of loan
charge-offs over this same period.

Among the various size groups

of banks, nonperforming asset ratios are generally highest at the
largest and the smallest banks.

At year end 1986, for example,

nonperforming assets averaged 2.34 percent of total assets for
the 25 largest banks, up from 2.25 percent a year earlier.1


the smaller banks, those with assets of less than $300 million,
the nonperforming ratio stood at 2.09 percent, unchanged from the
prior year-end level.

As I have already suggested, nonperforming

assets are higher than we would like at this point in the
economic cycle.
In general, the difficult period of asset quality
problems through which we are passing firmly underscores, for

1The figures for year-end 1986 do not include the effects of
placing Brazilian debt in nonperforming status, which occurred in
the first quarter of 1987.

- 10 -

both bankers and supervisors alike, the need for renewed
attention to sound and prudent lending standards and practices,
as well as the need for continued efforts to strengthen capital
You have asked that we address the effect of
"securization" on asset quality.

Simply stated, a securitized

loan is one in which the originator is not the ultimate investor.
In a typical loan securitization, the originator sells a bundle
of loans, rather than individual loans, and the loans are
converted to securities backed by the loans.

Of course,

depository institutions can act as both buyers and sellers of
securitized loans.

Until now, loan securitization has occurred

mainly in the residential mortgage market, where over half of all
loans that are originated are subsequently securitized.


assets that have been securitized on a much smaller scale include
automobile loans, credit card receivables, lease receivables, and
commercial real estate.
Securitization offers the potential benefits of
diversification of credit risk, improved control over interest
rate exposure, enhanced liquidity, and increased efficiency.


question of how securitization will affect asset quality,
however, is difficult to answer with precision.

The answer will

no doubt lie ultimately in the quality of underwriting performed
by those originating the loans to be securitized.

The quality of

lending could improve if securitization results in greater
specialization and standardization in lending and if it is
performed by the industry's most capable lenders.

On the other




hand, there is always the danger that too many institutions will
attempt to participate in the securitization process and that
credit underwriting standards will be compromised in the battle
for market share.

From a supervisory standpoint, we expect

banking organizations that purchase securitized assets to conduct
proper credit analyses and to assure themselves of the quality of
the assets they are taking into their portfolios.
We sometimes hear that if banks securitize and sell
their highest quality assets, the overall quality of bank assets
will decline as relatively weaker assets that cannot be sold are
retained on the balance sheet.

While I see no necessary reason

that banks that engage in this activity should relax their credit
standards in general, examiners will, of course, continue to
evaluate the condition of assets retained in selling bank
portfolios, and supervisors have the latitude to require
additional capital if an institution's credit profile changes as
a result of such transactions.
One supervisory concern regarding securitization
relates to whether the selling institution achieves a complete
transfer of risk to the buyer before removing the "sold" assets
from its books.

Obviously, if the seller retains an explicit or

implicit obligation to repurchase the securities with the aim of
providing a credit guarantee or liquidity support, then the
transaction has not reduced the risk to the selling institution.
Moreover, if such obligations were, in fact, retained in
connection with a large number of such "sales," risk could be
significantly increased.

To deal with this concern, we have

- 12 -

generally recognized transactions as true sales only if the
seller retains no risk of loss to its capital base.

In general,

if the holder of the securities has recourse to the bank, that
is, if the bank is at risk, the transaction must be kept on the
bank's balance sheet and the risk of loss must be backed by

Earnings and Profitability
The economic difficulties and imbalances that have
marked the 1980s inevitably have placed downward pressure on the
earnings and profitability of the banking industry.


after tax earnings growth slowed from about an 11 percent annual
rate in the 1970s to about a five percent annual rate in the
first half of the 1980s, and earnings actually declined about one
percent last year.

Over this same period, asset and equity

growth also have slowed, but more moderately.

Consequently, key

measures of aggregate industry profitability--return on assets
and return on equity--last year fell to the lowest levels since
at least 1970.
The deterioration in asset quality that I have
described has been the dominant factor underlying declining
industry profitability.

U.S. banks' loan loss expenses, measured

as a percent of average assets, have tripled since 1981.


this development accounts for much of the decline in
profitability during this period.

Declining interest rates have

allowed banks to offset a substantial portion of their credit
losses with gains from the sale of investment securities.

- 13 -

Profits from the sale of investment securities accounted for
about one-sixth of total pre-tax income for the banking industry
last year.

Some of the very largest banking organizations have

cushioned the impact of credit quality problems on profitability
by achieving a very robust growth in other noninterest income,
reflecting their increased emphasis on fee-based services, such
as investment banking, securities processing, and cash

It is not clear, however, how much these activities

have contributed to the net income of these banks since data
necessary to allocate certain expenses is not available.

It is

known that expansion of fee-based services has required
substantial noninterest expenses in the form of investments in
technology and the hiring of highly-paid staff.

Indeed, at some

of the largest banks, the growth of noninterest expense has
outstripped that of noninterest income.
It is extremely important to realize, however, that
much of the U.S. banking industry remains profitable.
Earnings difficulties have been concentrated in the western half
of the country, where the problems in the energy and agricultural
sectors have loomed large and at the major multinational banks,
which have been hurt by foreign loans and, in some cases, by
concentrations of energy, real estate, and shipping loans.


largest banks also have been adversely affected by the loss of
many of their most creditworthy customers to the securities
markets and to foreign banks.
Those banks that have avoided the most serious asset quality
problems generally have fared quite well.

Indeed, the return on assets

- 14 -

was at or near peak levels last year for many regional banks
located in Federal Reserve Districts in the eastern half of the

The resiliency of the banking industry is evident in

data on net interest margins, that is, net interest income as a
percentage of assets.

Although the margins dipped somewhat last

year, they remained well above the average for the 1970s.


deregulation of deposit interest rates does appear to have
contributed to a narrowing of margins at smaller banks from the
very high levels recorded early in this decade, but even at these
banks margins generally compare favorably with historical levels.
What is not clear, however, is the extent to which the
attempt to earn

high margins has induced

banks to hold riskier

loan portfolios.

While trends in banking conditions over the last few
years may give rise to some uneasiness, our nation's banks,
fortunately, have made considerable progress in strengthening
their capital positions.

This development is particularly

noteworthy because capital plays a central role in fortifying the
banking system. It acts as the buffer that provides protection to
depositors, other creditors, and the deposit insurance fund when
an institution reports negative earnings.

The protection capital

offers also serves to maintain confidence in the banking system
as a whole.
It was only a few years ago that capital levels in the
banking industry caused considerable apprehension about the

- 15 -

ability of some banks to weather a difficult economic and
financial environment.

This apprehension was accentuated by the

buildup in problem loans and off-balance sheet exposures that in
many instances accompanied the thinning of capital cushions.
Against this background, in December, 1981, the three federal
bank regulatory agencies adopted formal minimum capital standards
for banks and bank holding companies in order to halt the secular
decline in

capital ratios that had occurred and to

counterbalance the increase in risk-taking that became evident
during the 1970s.

It is therefore comforting to note that since

the adoption of the guidelines, the industry's capital base has
been bolstered steadily by the issuance of common and preferred
stock and long-term debt, and by the buildup of loan loss
Currently, all banks and bank holding companies must
meet a minimum primary capital requirement of 5.5 percent and a
minimum total capital requirement of 6.0 percent.


As these

levels are minimums, banks normally are expected to, and in fact
do, operate above them.
From our perspective, the capital guidelines have
worked reasonably well. The long secular decline in bank capital
ratios has been reversed.


The larger banking institutions have

The principal components of primary capital are common
stockholders' equity, perpetual preferred stock, loan loss
reserves and certain debt instruments that must convert to stock.
Total capital consists of primary capital plus secondary capital
instruments— such as limited-life preferred stock and certain
qualifying long-term debt securities.




made especially noteworthy improvement in their capital positions
since the end of 1981.

Over this period, the average primary

capital ratio of the nation's 50 largest bank holding companies
jumped from 4.7 percent to 7.1 percent —
minimum guideline level of 5.5 percent.

which is well above the
Of course, a complete

assessment of capital adequacy must take account of both the
quality of a banking organization's assets and the amount of any
off-balance sheet exposure.
With regard to the latter, financial innovation has
given birth to a wide variety of financing instruments which carry
varying degrees of risk and serve different purposes but which do
not find their way onto banks' balance sheets.

Interest rate

swaps, financial futures and options, forward rate agreements,
and foreign exchange contracts are among the off balance sheet
instruments banks use either to capitalize on or to hedge against
interest rate and foreign exchange risks.

Another group of off

balance sheet items, often referred to as "direct credit substitutes,"
includes financial guarantees and standby letters of credit that
back financial claims of third parties.

A bank issuing such

instruments bears essentially the same credit risk that it would
have if it made a direct extension of credit to the customer.
Commitments form yet another broad group of off balance sheet
The total volume of the industry's off balance sheet
business is considerable.

At year-end 1986, standby letters of

credit issued by insured commercial banks amounted to $170
billion, foreign exchange commitments came to $893 billion, loan




commitments were $571 billion, and interest rate and cross
currency swaps totaled $376 billion.
staggering, as indeed they are.

The numbers appear

However, it clearly would be

inappropriate and misleading to relate the total volume of
off-balance sheet exposures to the capital requirements of the
banking industry.

This is because in many cases the principal or

face value of the instruments is not an indicator of the amount
that is at risk, and because many of the assorted off balance
sheet activities are used by banking institutions to reduce their
exposure to risk.

Therefore, it is important to look at these

activities on a risk-adjusted basis.
In an attempt to provide some insight into the effect
of the growth of off balance sheet items on capital trends, we
have looked at a number of capital ratios adjusted for
off-balance sheet risks.

Based on our analysis, the capital

ratios of the largest banking institutions appear to have
improved over the last several years— even when off balance sheet
activity is taken into consideration.

For example, the ratio of

primary capital to total assets including adjustments for
off-balance sheet items for the 10 largest bank holding companies
has climbed from 4.0 percent in December 1981 to 6.2 percent by
year-end 1986.

These results are not surprising given the huge

amounts of new capital banks have raised over the last several

These trends clearly demonstrate why capital, which long

has been a sore point for the banking industry is becoming an
important selling point for major U.S. banking institutions,
which now are among the most strongly capitalized in the world.




As you may know, we have recently proposed, in
conjunction with the other federal banking agencies and the Bank
of England, a risk-based capital framework.

In addition to

factoring off-balance sheet risks into our analysis, other
important objectives of this proposal are to recognize that
certain liquid, low-risk assets require less capital backing than
standard loans and to achieve greater convergence in the
assessment of capital adequacy among countries with major
financial centers.

We currently do not collect all of the data

necessary to calculate precisely the ratio as proposed.


estimates for the 10 largest banking holding companies averaged
approximately 6.3 percent as of June 30, 1986; by year end this
figure had increased to 6.6 percent.
Capital ratios are, of course, lower if adjustment is
made for problem assets.

This is not surprising

since one of the major functions of capital is to absorb losses
resulting from problem loans.

Yet, even if capital is reduced by

a percentage of classified loans, we find that there has been an
improvement over the 1982-1986 interval.

For the 25 largest

banks, for example, the average ratio of primary capital,
adjusted for problem assets, to total assets increased from 4.0
percent at year-end 1982 and to 5.6 percent by year-end 1986.
Some improvement in this ratio, albeit on a more modest scale,
was also reported for other banks with assets of $1 billion or

On the other hand, we noted some deterioration in this

ratio for banks in the less than $300 million size category.


average for this group declined from 8.0 percent in 1982 to 7.7



percent by the end of 1986.


This decline was in large part due

to the disproportionate share of problem farm loans held by small
An important goal of the recent joint proposal of the
U.S. federal banking agencies and the Bank of England for the
establishment of a risk-based capital framework was to reduce the
competitive inequities that can arise when supervisory
authorities in countries around the world introduce different
capital requirements.

I cannot emphasize strongly enough our

interest in the competitiveness of U.S. banks.

Only a strong,

competitive and profitable banking system can remain healthy in
the long run and fulfill the strategic role banks play in our
economic and financial system.

Thus, the Federal Reserve is

committed to working with supervisors from other countries to
encourage the development and adoption of more consistent and
broadly accepted international capital standards of the type set
forth in the U.S./U.K. proposal.
Another dimension of the issue is the competition from
nonbank financial institutions, including thrifts institutions.
Again, as a matter of both competitive equity and prudential
concerns, it would seem desirable to bring the capital
requirements of competing institutions into closer alignment.
For this reason, we strongly support the efforts of the Federal
Home Loan Bank Board to encourage thrift institutions to
strengthen their capital positions.
You specifically asked that we address the issue of
"double leveraging".

Double leveraging refers to the practice of




a parent company transforming debt it issues into equity at the
subsidiary level.

A bank holding company can leverage itself by

issuing long-term debt and can then channel, or "downstream", the
proceeds of the offering to its bank or nonbank subsidiaries by
purchasing their equity securities.

Double leveraging is often

used to increase the capital of a subsidiary bank in order to
satisfy regulatory capital requirements.

By using the parent as

a centralized conduit for the capital financing of subsidiaries,
an organization can reduce its cost of raising funds.
An organization using double leveraging runs the risk
that its subsidiaries will not be able to "upstream" the cash
flow needed to service the parent's debt.

A bank subsidiary, for

example, may fail to earn sufficient income to pay dividends, the
principal source of funds parent companies use to service their

The risks of double leveraging are borne by a parent

organization's shareholders and uninsured creditors.
A commonly used measure of double leverage is the
ratio of the parent company's equity investments in its
subsidiaries to total parent company equity.

Last year there was

a significant decline in levels of double leveraging in the
banking industry.

The decline was particularly pronounced among

the largest holding companies, where as a group, the ratio for
the 25 largest dropped from 158 percent at year-end 1985 to 125
percent by year-end 1986.

The decline in double leveraging can

be attributed, in part, to a heightened awareness on the part of
holding company creditors that the flow of funds from bank
subsidiaries to the parent company cannot be assured, and in




part, to increased supervisory scrutiny of parent company cash
flow and its potential impact on the capital of subsidiary banks.
In addition, since we apply our capital standards to consolidated
holding companies as well as their subsidiary banks, there is a
limit on the potential incentive for excessive double leveraging.

Liquidity is a difficult concept to define with
precision and judgments on liquidity require consideration of a
number of factors pertaining to both the asset and liability side
of the balance sheet, as well as to off-balance sheet

However, one helpful measure of liquidity is the

degree of reliance on volatile, purchased liabilities to fund

Reliance on such liabilities has decreased in recent

years, primarily because of the deregulation of interest rates
which has enabled banks to compete more effectively for retail accounts.
This trend has been offset to some degree by a decline in the holding of certain

liquid assets by banking institutions; nonetheless, on net,
liquidity appears generally to have improved over the last
several years.

Although dependence on managed liabilities has

changed little in recent years at smaller banks, deregulation has
removed the threat of deposit disintermediation, which was
perhaps the most serious threat to their liquidity.
Brokered deposits generally have remained a very small
share of total deposits of banks, and thus, for the most part.

- 22 -

have not had a significant impact on liquidity.


brokered funds have been abused in some specific cases,
supervisors monitor the use of such funds closely, particularly
in connection with our review of the overall use of purchased

Problem and Failed Institutions
It is a widely known fact that the number of problem
and failed banking organizations has risen at an uncomfortably
rapid pace over the last several years.

It is our expectation

that, absent unforeseen adverse economic or financial
developments, these numbers many begin to level off.

However, we

do not expect these numbers to decline in a significant way in
the near term.
In data submitted to the Committee staff, the banking
agencies have provided information on the total number of problem
and failed commercial banks, and their aggregate deposits, in
some detail.

Therefore, I will touch briefly on the situation

with respect to institutions under the jurisdiction of the
Federal Reserve System.
At the end of March, 1987, there were 85 problem state
member banks and 510 problem bank holding companies. These 85
state member banks represented 7.7 percent of all state member
banks, while the 510 bank holding companies represented 7.9
percent of all bank holding companies and controlled
approximately 8.5 percent of total banking assets.




As of May 8, 1987, 74 commercial banks had failed,
compared with 41 over the same period in 1986.

Of the 74 banks

that failed, 5 were state member banks with total assets of $24 3
million; in all of 1986, 11 state member banks with total assets
of $147 million failed.

Over the five-year period of 1982

through 1986, the assets of failed state member banks represented
5 percent of total failed bank assets.

To put this figure into

perspective, state member banks comprised 18 percent of total
bank assets at year end 1986.

Supervisory Actions
Over the last several years, the Federal Reserve has
addressed the trends and conditions I have just described with a
number of important actions designed to strengthen our
supervisory policies, practices and procedures.
have been threefold:

Our objectives

first, to implement supervisory policies

that would improve the ability of

banking organizations to

withstand financial stress and adversity; second, to enhance our
ability to identify in a timely manner financial and operating
deficiencies that could weaken an organization's financial
condition; and third, to strengthen our follow-up procedures,
particularly by improving our techniques for communicating with
boards of directors and, where appropriate, broadening our use of
formal enforcement actions.
In carrying out our supervisory responsibilities, we
attempt to balance the need to maintain a fully adequate
supervisory framework with our desire to avoid impinging on the

- 24 -

legitimate prerogatives of management or undercutting the
benefits from greater competition in our banking and financial

While views may differ on the best way to strike this

balance, the crucial public interest in the maintenance of a
sound and stable banking system, and the existence of the federal
"safety-net," underscore the critical importance of a strong and
effective supervisory and regulatory framework.
I have already noted the efforts the Federal Reserve,
together with the other federal banking agencies, has made over
time to encourage banking organizations to strengthen their
capital positions.

The imposition of minimum capital standards

in 1981, and the strengthening of these standards in 1983 and
1985, have played an important role in helping banking
institutions to withstand the strains of the last several years.
In carrying out its day-to-day supervisory activities,
the Federal Reserve has encouraged banks to operate above the
minimum capital ratios established by regulatory rules.


organizations undertaking significant expansion are expected to
maintain particularly strong capital positions that are well
above minimum supervisory standards.

In addition, within the

last two years, we have reiterated and strengthened our policy on
the payment of cash dividends to shareholders when a banking
organization is experiencing financial problems.

Accordingly, we

have intensified our review of dividend payments by banking
organizations and, when appropriate, have encouraged them to
conserve their capital by adopting more prudent dividend levels.




As I have stated, we are in the process of further
improving our capital adequacy policies through adoption of
risk-based capital standards.

A major objective of our

risk-based capital proposal, as I have indicated, is to ensure
that capital is adequate to support off-balance sheet exposures.
In addition, our adoption of a risk-based capital framework will
help to more accurately match an organization's capital
requirements with its level of risk-taking and will contribute to
broader international efforts to enhance capital standards for
large multinational banking institutions.

Such efforts are aimed

at achieving stronger, more stable international banking
institutions and markets, and at reducing the competitive
inequities and distortions that can result from vastly different
prudential rules among countries with important financial
We have, as you may be aware, taken other prudential

Over the last several years, much time and effort has

been devoted to heightening banking organizations' awareness of
the potential risks associated with daylight overdrafts in large
dollar payments systems and to giving bankers and examiners alike
improved analytical and supervisory tools to monitor and control
these risks.

More recently, we have reiterated as clearly as

possible our longstanding policy that bank holding companies
should serve as a source of financial and managerial strength to
their subsidiary banks.

This is particularly important since

banks benefit from the ability to issue federally-insured
deposits and borrow from the Federal Reserve discount window.





light of subsidiary bank access to these "safety-net"
protections, we expect their holding companies to stand ready to
use available resources to support their banks during periods of
financial stress or adversity, and we have underscored our policy
to use our enforcement authority, when warranted and appropriate,
to see that this is done.
In addition, we have taken actions to improve our
ability to monitor the emergence of supervisory problems in
banking organizations.

In 1986, we increased the frequency of

examinations to provide for at least an annual examination of
state member banks and most large bank holding companies and
semiannual examinations or on-site reviews for very large
institutions and problem companies.

This program has been

supported by a significant boost in budgetary resources devoted
to supervision and regulation and by an increase in the number of
examiners from 835 in 1985 to 914 at the end of 1986.

This more

frequent on-site examination program has also has been made
possible, in part, through increased cooperation with state
banking departments in the form of greater reliance on state
examinations of certain institutions, and through increased
operating efficiencies.

We also have revised our reporting

requirements for bank holding companies to place greater emphasis
on such indicators as the level of non-performing loans and
off-balance sheet activities.
Taken together, those actions have strengthened our
ability to monitor risk-taking and improved our capacity to take
enforcement actions.

Indeed, since 1982, we have greatly




increased the number of enforcement actions such as cease and
desist orders, written agreements and removal actions aimed at
officers and directors.

In the period 1980-82, the Federal

Reserve System averaged 42 enforcement actions per year; from
1984-86, the average number of enforcement actions had increased
to 177.

Such actions are employed to require banks to improve

their lending policies and procedures, strengthen management,
terminate unsafe and unsound practices, and adopt more prudent
funding, dividend and capital strategies.
Enforcement actions are but one form of supervision.
Equally, or perhaps more, important are preventative actions such
as our efforts to improve communications with directors who, of
course, have primary responsibility to see that their
institutions are operated safely and in compliance with banking
laws and regulations.

Toward this end, we have implemented a

directors' summary report to spell out more clearly and
effectively our supervisory assessment of an organization's
problems and have broadened the involvement of senior Reserve
Bank officials in meetings with directors of large institutions
and those with significant problems.
Actions of the type I have just reviewed, of course,
cannot deal with all of the problems facing our depository

Thus, the Board continues to support legislation

to recapitalize the FSLIC fund at an appropriate level.
Moreover, while we are gratified by the actions taken by some
state legislatures to permit out-of-state acquisitions of failed
or failing banks, we do not believe these have alleviated the




problem of finding buyers for troubled institutions in certain

Thus, the Board continues to urge Congress to provide

federal regulators with authority to arrange interstate
acquis'tions of failing and failed institutions.
As you are aware, the Board has recently approved the
applications of certain bank holding companies to engage in
underwriting commercial paper, 1-4 family mortgage-backed
securities and municipal revenue bonds.

We have approved these

applications subject to conditions to assure that the activity
will be consistent with safe and sound banking practices and
avoid conflicts of interest, concentration of resources, and
other possible adverse effects.

It is our hope that this action

will provide banking organizations with additional sources of
income and enhance in a meaningful way their ability to compete
effectively with other nonbank financial institutions.
In the long run, of course, these activities should
result in real benefits to banking organizations by promoting
greater efficiencies, more competitive equity and more
diversified sources of income.

These will also, I believe,

contribute to a stronger and more resilient banking system.


addition, a prudent expansion of bank holding company powers
should provide significant benefits to customers in the form of
greater convenience and competition and additional alternatives
for obtaining important financial services.
In approving these applications, the Board acted undej
existing authority, applying a statute adopted over 50 years ago
in very different circumstances, to a financial market place thai




technology and competitive forces have altered in ways that the
enacting Congress could not have envisioned.

Thus, we continue

to urge Congress to recognize the competitive, technological, and
international forces at work in banking and financial markets by
providing a clear legislative framework for expanding the
authority of bank holding companies to provide financial
services, consistent with the need to maintain a safe and sound
banking system and safeguards against conflicts of interest and

We also believe Congress should address

the need for change in the current prohibitions on corporate
underwriting, recognizing that bank holding companies conduct
such activities abroad in substantial volume.

As part of more

comprehensive legislation in the future, we feel that it would
also be desirable to consider ways of encouraging more
consistency in accounting, supervisory, and capital standards
among various types of depository institutions.

The recent trends in the performance and condition of
our nation's banks, notably, the deterioration in asset quality,
the slide in earnings and profitability, and the growth in off
balance sheet exposures, explain much of the current unease about

But the industry has been working to reverse these

trends and much progress is evident.

Many banks have put in

place cost cutting programs, strengthened their capital
positions, adopted more conservative lending practices, and
generated new sources of income.

The supervisory agencies, for

- 30 -

their part, have implemented programs to help ensure that the
banking system remains on a sound footing and that adequate
safeguards are in place.

All of these efforts should have the

effect of putting banking organizations in a better position to
withstand any additional unanticipated pressures and strains
within our economy or financial markets.
While there is some justification for the prevailing
sense of unease over banking, I believe that, on balance, much
more is right in banking today than is wrong.

The problems,

while significant, are manageable, and I can assure this
Committee that the Board will do its utmost to see that
supervisory efforts will continue to be directed toward
maintaining the soundness of the banking system.