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TESTIMONY OF
PAUL G. FRITTS
DIRECTOR, DIVISION OF SUPERVISION
FEDERAL DEPOSIT INSURANCE CORPORATION
ON
AVAILABILITY OF CREDIT TO SMALL BUSINESSES
BEFORE THE
COMMITTEE ON SMALL BUSINESS
UNITED STATES HOUSE OF REPRESENTATIVES
10:00 A.M.
Wednesday, June 6, 1990
Room 2359A, Rayburn House Office Building
Good morning, Mr. Chairman and Members of the Committee.
I
appreciate the opportunity to address the Committee on behalf of
the Federal Deposit Insurance Corporation on the timely topic of
the availability of credit to small business.
Our remarks will focus on the so called "credit crunch" debate.
Specifically, we will address the region receiving the most
attention - New England.
Our testimony also will review the
supervisory policies and practices followed at the FDIC, and
will attempt to clear up the misconceptions surrounding the term
"performing non-performing loans."
CREDIT CRUNCH
To discuss the subject of a "credit crunch," we first need to
know what is meant by this term.
We define credit crunch as the
general unavailability of credit to creditworthy borrowers for
legitimate and viable purposes.
This is in contrast to the term
"credit contraction," which is generally defined as a phase in a
normal market driven down-cycle.
What we see are mixed signals.
a credit crunch.
We have no empirical evidence of
If there is one, it is a recent phenomena not
reflected in either the banking industries' year-end 1989 or
first quarter 1990 Reports of Condition and Income ("call
report").
About all we can surmise from year-end 1989 data is
that the banking system, in the aggregate, has suffered some
capital erosion and has less capacity to lend than previously.
However, this dampening effect in itself is not enough to cause
a credit crunch or even a significant credit contraction.
March
1990 call report figures are undergoing a final edit, but these
statistics will not prove or disprove a systemic credit
availability problem.
On a nationwide basis, it is reported that a survey of small
business conducted by the National Federation of Independent
Business found no evidence of a credit crunch and no
expectations of a contraction.
The Federation's most recent
monthly credit survey of 2,500 businesses found that borrowers
are having no problems finding credit.
We acknowledge that loan
volume has dropped in certain sectors and regions, such as real
estate in New England and the Southwest, but this a normal
economic response to overbuilt markets.
To quote William
Dunkelberg, Chief Economist at the Federation and a Professor of
economics at Temple University, "Small businesses are borrowing
at low levels, but that's because they don't need it or don't
want it."
NEW ENGLAND BANKING ENVIRONMENT
The New England region is undergoing a strong credit contraction
as a result of declining economic conditions, particularly in
the real estate industry.
The decline appears to be a normal
market correction caused by several years of a strong regional
economic boom fueled in part by overcapacity in banking.
Banking capital expanded significantly with the conversion of a
sizable number of institutions from mutual to stock ownership.
Concomitant with the capital increase was pressure from
shareholders to lend in order to achieve an acceptable market
return.
The boom unfortunately was too often aided by liberalized
lending terms and relaxed credit standards.
These policies led
to high loan demand, primarily in real estate development, which
was funded by a combination of high cost purchased funds and
consumer funds.
The easy, though costly, availability of credit
to both established and marginal borrowers led to severe
overbuilding and a general overpricing of goods and services
throughout the region, a common occurrence during boom periods.
Other market forces —
such as severe setbacks in the financial
services industry in the aftermath of the 1987 stock market
crash, a maturing of the high tech industry, and slowdowns in
defense spending —
have caused a severe market correction in
the region's economy.
4
Much of the asset quality problems in New England are lodged in
jthe banks which underwent the strongest growth during the boom
years.
Many of these banks are among the region's largest.
The
asset quality problems have caused significant decreases in
banking profits and asset valuations.
Whether the losses have
been recognized voluntarily by the industry or regulator-induced
through the examination process is really irrelevant.
The asset
devaluations, with rare exceptions, are proving to be valid and
could in fact be understated if the region's economy continues
to erode.
In order to maintain compliance with capital requirements, many
affected banks have found it necessary to retrench through a
shrinkage in size.
circumstances.
This is not an uncommon scenario under the
As a result, there has been a general
contraction in the availability of credit funds in these
institutions.
Statistics bear this out.
Loan volume in New England fell by $7
billion in the first quarter, but $5 billion of that amount was
due to loan sales and chargeoffs.
loan volume was $2 billion.
Thus, the net contraction in
This is not an alarming
contraction, especially since loan demand also has slackened
significantly throughout the region, reducing the overall need
for credit.
Creditworthy borrowers in many instances, in the
face of an economic slowdown, are unwilling to borrow funds and
risk capital.
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The New England banking industry has tightened credit standards
in a normal reaction to the general downturn in economic
conditions, the overhang of properties held by the Resolution
Trust Corporation and the rising level of loan problems.
These
^^-^htened standards are not new, but a return to the prevalent
credit standards in place before the boom years.
A number of
annual and quarterly financial reports being issued by these
banks use the term "back to basics" in the management discussion
section of the reports.
A more conservative lending posture has no doubt resulted in
many marginal borrowers, particularly real estate developers,
finding credit availability curtailed.
This may have helped
create a general perception of a credit crunch rather than what
is in reality a normal credit contraction during a period of
economic downturn.
Some proof of this is from the credit
hotline program established in March of this year by the
Massachusetts Governor's office.
To date some 200 calls for
help in finding credit have been received, which is a relatively
small number considering the economic base of the state.
Even though there is unquestionable weakness in banking
conditions in New England, we do not see a repeat of what
occurred in the Southwest.
There are fewer than 50 problem
institutions among the 714 banks and savings associations in our
Boston region.
This is below the national average of problem
institutions to total institutions.
BANK LENDING PRACTICES
In my view, banks are to be applauded for tightening lending
standards.
A recent Washington Post article titled "Credit
Crunch Threatens Small Business" gives some examples of the kind
of borrowers who are experiencing difficulty in obtaining,
expanding or renewing credit lines.
These include small,
troubled and unestablished businesses, companies that are
suddenly unprofitable, and "the ones that are shaky."
Applying
traditional prudent lending standards to this kind of borrower
is a sound practice.
Tightening standards does not mean that marginal borrowers are
perfunctorily denied loans.
It does mean that bankers are
requiring borrowers to provide support for the loans.
Bankers
are asking for a demonstrated payment record, profitability,
owner's equity and collateral.
Most of us find it unpleasant to
break bad news to someone and bankers are no exception.
Placing
blame on the examiners or regulators for rejecting loan requests
or insisting on better collateral, documentation and other
support before advancing funds is one way to mollify an
important past and future customer.
FDIC SUPERVISORY POLICIES AND PRACTICES
We recognize that some bankers are concerned that vigorous
examinations, especially in weak markets like New England, are a
signal to cut back on lending.
If this is the signal received,
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it is a false one.
We recently took unprecedented action to
dispel any misconceptions or misunderstandings that may exist.
FDIC Chairman Seidman, Federal Reserve Board Chairman Greenspan
and Comptroller of the Currency Clarke met with the Directors of
the American Bankers Association.
They told the group that we
expect bankers to closely scrutinize real estate loans but did
not tell bankers to stop making loans.
There are good loans
available and those loans should be made.
But we are
encouraging bankers to carefully screen their loans and pay
close attention to market conditions.
"PERFORMING NON-PERFORMING LOANS"
The press has reported that examiners are adversely classifying
performing loans.
The terminology used is "performing
non-performing loans."
The term "performing non-performing
loans" is a misnomer and is not used officially at the banking
agencies.
We are even removing the word "nonperforming" from
official FDIC literature to alleviate semantic problems.
Instead, the terms "overdue," "nonaccrual," and "adversely
classified" are the more common modifiers of troubled debt.
Historic definitions of overdue and adversely classified have
been developed as part of the examination process.
Definitions
of nonaccrual loans have been formalized in accounting
instructions.
A bank is not to accrue interest on (1) any asset
which is maintained on a cash basis because of deterioration in
the financial position of the borrower,
(2) any asset upon which
principal or interest has been in default for a period of 90
days or more unless it is both well secured and in the process
of collection, or (3) any asset for which payment in full of
interest or principal is not expected.
The third definition is
important in understanding the agencies' historic handling of
loans which are performing but which may not be paid in full.
"Performing non-performing loans" are best described by
outlining a typical loan which may fit the category.
Assume 100
percent financing of the construction of an income producing
property for which no secondary source of repayment is offered.
The initial advances provide for the interest payments during
the construction period and possibly for a short-term bridge
loan after construction is completed.
During the life of the
loan, it is found that the assumptions used to make the initial
appraisal of the property are no longer correct.
For instance,
rental rates may be lower than expected, operating expenses may
be higher than projected, or initial occupancy is lower or
slower than anticipated.
These or other adverse changes in
assumptions mean that a more realistic appraised value of the
collateral may be less than the amount of the loan outstanding.
In the meantime, the interest reserves included as part of the
initial loan are used to keep the loan current or performing.
In the absence of a source of payment separate from the project,
the full repayment of the principal is unlikely.
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Therefore, based on the instructions, this loan would be placed
on a nonaccrual status and all payments received would be
applied as a principal reduction.
The supervisory response to
this type of loan has been constant for a number of years.
loan would be considered to be in a nonaccrual status.
The
The
shortfall between the loan amount and the current collateral
value, assuming no other source of payment, would be recommended
for charge-off and the balance would be listed as having more
than ordinary risk.
A loan of this type is speculative in nature.
When assumptions
used in this type of venture prove to be incorrect, the most
prudent course of action is to recognize the losses inherent in
the asset.
This does not represent a toughening of supervisory
standards but the continuation of a traditional supervisory
stance.
CONCLUSION
We have no evidence of a credit crunch on either a nationwide or
regional basis.
However, credit contractions are occurring in
areas of economic downturn.
A credit contraction is occurring
in the New England region —
but this is after several years of
rapid growth, particularly in real estate development.
A normal
business cycle downturn has resulted in a real devaluation of
asset values, which has turned the banking industry cautious.
Credit may be difficult to obtain for marginal borrowers,
10
leading some to the false perception of a credit crunch.
However, there appears to be ample credit sources available to
meet legitimate and viable credit needs.
We are in favor of the
banking industry tightening lending standards, and returning to
basics.
However, this tightening does not mean banks should
stop making loans.
Instead we expect and urge banks to continue
making loans to creditworthy borrowers.
@FedFRASER