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For release on delivery
March 11, 1986

Statement by

Preston Martin

Vice Chairman, Board of Governors

of the Federal Reserve System

before the

Senate Committee on Banking, Housing and Urban Affairs

March 11, 1986

I am pleased to appear before this Committee today to review the
problems being experienced by banks in our agricultural communities and to
discuss various proposals that have been advanced to ease the strains
resulting from these problems.

As you know Mr. Chairman, Chairman Volcker

recently sent you a letter that presented the Federal Reserve Board's views
on these matters and in conjunction with that letter a rather extensive
study by our staff of farm credit conditions and their impact on farm banks
was forwarded to the staff of your Committee.

Accordingly, I intend to

structure my remarks this morning to highlight the main points made in
those documents.
The problems currently afflicting the agricultural sector of our
economy are more serious than any encountered since the Great Depression of
the 1930's.

Farm incomes and farm asset values have declined sharply

over the current decade as crop prices —

responding to a major increase

in world supplies of farm products relative to demand —
from boom-time levels of the late 1970's.

have dropped substantially

All of our farmers have been adversely

affected by these developments but not to the same degree.

Farmers that

are relatively debt-free generally continue to have strong financial positions
although significantly less so than a few years back.

In contrast, farmers

who entered the 1980's substantially in debt have experienced an erosion in
their financial health that generally is the more serious the greater the
degree of their leveraging.
Our staff estimates suggest that perhaps a third of the full-time
producers on commercial-sized family farms are experiencing moderate to
severe financial stress.

This group owes about one-half of the farm debt


of all such operators.



The problems of these farmers, of course, have been

compounded by the relatively high interest rates that have prevailed over
the current decade.

In addition, their efforts to restructure debt, or to

reduce it by selling some of their assets, have been hampered greatly by
the decline in farm asset values.
The great, proportion of farm debt is owed to the Farm Credit
System, the Farmers Home Administration and individuals.

But about one-quarter

of the total is provided by commercial banks, and the banks that have concentrations
of such loans have been experiencing increasing strains in recent years.


example, loans delinquent 30 days or more at agricultural banks amounted to
7 1/4 percent of total loans at the end of last year, up from 6 1/4 percent
a year earlier.

This increase took place even as these banks charged off

more than 2 percent of their total loans over 1985.

These loan losses and

the need to add to loan loss reserves because of the increasing volume of
poor performing and nonperforming loans have substantially reduced the
earnings of many farm banks.

Indeed, in all too many cases earnings have

turned negative and capital has been eroded, sometimes substantially so.
The result has been that an increasing number of farm banks have failed (68
last year) and the number of seriously troubled banks has risen substantially.
It is important to keep the present situation in proper perspective,

Over 95 percent of the total loans at all agricultural banks are

performing, and one-half of these banks reported earnings equal to at least
10 percent of their equity.

Also agricultural banks generally have a

substantial capital cushion to absorb loan losses.

The capital asset ratio

- 3 for all agricultural banks averaged 9 3/4 percent in September of last
year, higher than it was at the start of the decade and well above the
7 1/2 percent ratio for the entire banking system.
There are a number of recent developments that should work to
assist the farm economy, including the recent dramatic fall in energy
prices and the substantial declines in interest rates and in the exchange
value of the dollar that have occurred over the past year or so.


recently enacted farm bill also offers an additional source of support for
farm incomes.

At the same time, however, prospective supply conditions for

farm products both at home and internationally, suggest that a substantial
rebound in crop prices, and thus in farm incomes, is not likely to take place
over the foreseeable future.

Certainly it would appear unwise to base public

policy on the assumption such a rebound will take place.

Accordingly, while

farmers that are now financially healthy should be able to avoid serious
problems and many borderline farm operators may be able to work out of
their current difficulties, many other farmers with relatively heavy debt
loads face a continuation of serious difficulties.

That means, of course,

that a sizable number of farm banks will also continue to experience severe
Mr. Chairman, it is altogether understandable, that the Congress
is seeking to identify approaches by which appropriate assistance can be
provided to troubled farm banks to aid them and their farmer customers to
get through this period.

As I indicated at the beginning of my remarks,

the Board, at the request of the Congress, has reviewed a number of proposals
that are under consideration by Congress to accomplish this goal.

In my

remaining time I will summarize the Board's assessment of these proposals




and review certain supervisory policies the Board intends to employ to
provide assistance to basically sound, well-managed farm banks.

Debt Restructuring
One approach that can be taken to deal with the present debt
problems of farm banks and their farmer customers is to restructure that

Traditionally, when borrowers have been unable to meet their debt

service obligations but appeared to have a reasonably good prospect of
eventually repaying a loan, lenders have been willing to practice forbearance
by changing the terms of loan agreements to make them more compatible with
the altered economic circumstances of the borrower.

In addition, in some

cases, lenders have extended additional credit to troubled borrowers when
it appeared that that might significantly improve their prospects of
ultimately returning to economic health and repaying all their indebtedness.
In considering voluntarily arranged loan restructurings, the
treatment of such restructurings by Generally Accepted Accounting Principles
deserves special emphasis.

In particular, Financial Accounting Standards

No. 15 specifies that in cases in which the total of cash receipts that can
reasonably be expected to be received under the terms of a restructured loan
are at least equal to the original principal value of the loan, a lender
need not change the value of the loan shown on its books.
Given the seriousness of the exiting problems in the agricultural
sector, the Federal Reserve believes that regulatory policies followed by
examiners in classifying loans should give full consideration to GAAP
accounting procedures.

In addition to debt restructurings that are undertaken voluntarily
by both lender and borrower without governmental assistance, there are, of
course, a number of proposals for restructuring the terms of farm debt that
would involve the government in a decidedly more active way.

Some have

proposed that a moratorium be imposed on loan foreclosures (by either the
Federal or state governments).

This amounts to a kind of forced restructuring

of debt because over the moratorium period farmers would retain title to
and use of their land while being relieved of the drain that interest and
principal payments place on cash flow.

Such a restructuring would clearly

assist farm borrowers, at least in the short-run.

But such help would come

at the expense of farm lenders and could prove particularly detrimental to
the financial health of already weakened farm lenders.

The imposition of

such arrangements, moreover, would cast a long shadow over future credit
Other proposals for government assisted debt restructuring arrangements
would induce voluntary participation by both borrowers and lenders through
the provision of government subsidies or guarantees.
arrangements —

Such governmental

as for example those offered by the Farmers Home Administration

have the quality of generally assisting both farmers and farm banks.


the same time, such assistance does not come free; its provision would add
to government costs either immediately or in the future and thus present
yet another obstacle to achieving a much required reduction of the Federal

- 6 -

Net Worth Certificates and Loan Loss Write-Off Deferrals

Other proposals under consideration by the Congress —

the stretch­

out of loan loss write-offs and issuance of net worth certificates —


not result in an immediate expenditure of public funds, althouyh both likely
would add to the FDIC's costs over the longer run.

Both these devices

would boost regulatory capital without injecting real capital

the basic

objective being to buy time to enable a bank to restore its real capital.
This end would be accomplished with the net worth certificate approach
through an exchange of promissory notes between the troubled bank and the
FDIC (or possibly its primary regulator) and with the loan loss deferral
approach by permitting a write-off of loan losses over an extended period
of time.
One important difference between the two approaches, as they have
generally been proposed, is that loan loss stretch outs would be available
to all banks meeting specified qualifications while net worth certificates
could be issued to selected institutions on a more discretionary basis.
While in theory a loan loss deferral program could be structured to provide
more targeted assistance, in practice this might be difficult.
In its letter to this Committee, the Board expressed strong reservations
about the use of either net worth certificates or loan loss stretchouts.


particular, the Board noted that they raise the question of whether regulatory
accounting practices should differ significantly from Generally Accepted
Accounting Principles.

Since under these proposals regulatory accounting

statements would show levels of capital that substantially exceeded that

- 7 -

reported on financial statements prepared under GAAP, this would tend to
cause public confusion and impair the usefulness and credibility of regulatory
financial statements.
In addition, the Board noted that such techniques do not address
a bank's fundamental financial situation.

While they buy time for a bank

to improve its condition, they do not in themselves provide a direct means
for achieving that end.

Consequently, in the Board's view, these approaches

are likely to be largely ineffective for most seriously troubled institutions
whose real capital has been wiped out or greatly depleted by loan losses
and whose earnings prospects are poor.

In these cases the Board believes

it would be far better to seek a permanent solution to the bank's problem
by having it obtain new capital or, if its problems are too severe, by
inerginy it with a stronger institution.
There are, of course, less extreme situations in which a bank has
suffered set-backs but retains a sizable amount of capital —


considerably less than normally maintained or perhaps even less than required
to meet minimum regulatory standards -- and has reasonably good prospects
for recovery over time.

In these situations, however, a more straight­

forward way of buying time for institutions would be simply for supervisors
to permit them to operate for some interval with capital at levels below
supervisory standards.

The Federal Reserve already follows this capital

forbearance approach in applying its capital guidelines.

We recognize that

an important function of capital is to absorb unexpected losses, and that a
bank that has recently utilized its capital for this purpose may not be in
a position to replenish its capital resources immediately, although its
long-run prospects may be quite favorable.

- 8 One problem that does arise when a bank's capital is temporarily
depleted is that its single borrower loan limit is reduced commensurately
because this limit is based on a percentage of capital
case of national banks).

(15 percent in the

Thus, although a loan may have been within the single

borrower limit at inception, a reduction in capital that results from loan
losses will lower the bank's loan limit, thereby precluding the restructuring
of loans that are above the reduced single borrower limit.

This would occur

even though the absolute amount of the loan would not be increased.

It is our

view that if this problem could be dealt with and if the agencies would agree
to utilize the provisions of existing generally accepted accounting standards
as set out in FASB #15, it would not be necessary nor would there be any
advantage to issuing net worth certificates or endorsing the deferral of
loan losses.
Mr. Chairman, in your letter to Chairman Volcker you also asked
for comment on the March 6 testimony of Charles Sethness, Assistant Secretary
of the Treasury, and that of the ABA and IBAA.

First, regarding Mr. Sethness's

testimony, I believe it clear from my remarks that his views on the various
proposals for assisting farm banks reviewed here today parallel those of
the Board.

On the other hand, the ABA and IBAA have endorsed the stretching

out of loan losses over a number of years.

The Board, as I reviewed earlier,

has reservations regarding this approach, for the reasons I stated.
To sum up, it is clear that a substantial number of farm families
and farm banks are experiencing difficulty of greater or lesser degree at
the present time.

In light of this situation, the Board believes that the

Congress and the banking agencies should take actions that will provide
assistance to the agricultural sector while, at the same time, not undercutting

- 9 -

effective and appropriate supervision of and accounting for the activities
of farm banks.

In particular, the Congress and state legislators could

make a much needed contribution by helping to maintain the provision of
banking services to small communities.

The Garn-St Germain Act of 1982

presently prohibits acquisitions of troubled banks across state lines
before they have failed and acquisitions of failed banks with assets under
$500 million.

The banking agencies believe that these two constraints

should be eased by allowing failing bank acquisitions across state lines
and by reducing the size criterion so as to maintain the banking services in
farm communities.

An easing of state restrictions on branchings could also

help maintain banking services in small towns in cases when a separately
organized and capitalized bank might not be viable.
There are also important things that can and should be done by the
banking regulators in these difficult times.

Reaffirm the policy of not discouraging banks from exercising

forbearance on farm loans that are being restructured when there is a reasonable
prospect that this will work to the mutual benefit of the bank as well as
the borrower.

Consistent with this general policy on forbearance the agencies

should be forthcoming in applying the principles of FASB #15.

That is, the

agencies should not require that a loss be recognized on a farm loan unless
the anticipated cash receipts of the restructured debt are insufficient to
cover the principal amount of the loan.

- 10 -


Also, in keeping with the spirit of that approach the agencies

should modify regulatory reporting requirements so that loans appropriately
restructured, no longer need be classified as nonperforming loans.

The single borrower limit should be changed or interpreted

to prevent restructured loans from being held in violation of the limit
based solely on the temporary decline in the bank's capital.

The agencies should offer a clear statement of their

intention to employ a simple policy of capital forbearance.