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For release upon d e l ivery Thursday, September 5, 1974 1:00 P M E.D.T. (3 p.m. E .D.T .) PROGRESS A N D PRUDENCE IN BANKING Remarks of Robert C. Holland Member Board of Governors of the Federal Reserve System To Members and Guests of the Boards of Directors of the F e deral Reserve Bank of San Francisco and Its Salt Lake City Branch Salt Lake City, Utah September 5, 1974 I a m pleased to be w i t h you and your guests today. I w o uld like to take this opportunity to share w i t h you some of m y thoughts about tension in b a n k i n g — at least, about one fundamental kind of tension that is being accentuated in banking today. This audience, I know, is k e enly aware of the importance to our nation's economy of a progressive and healthy banking industry. What I w o uld like to do this a fternoon is first to highlight some of the progress that we have seen banking make over the past decade or so. Then, I w o u l d like to turn your attention to some of the present and potential adverse situations facing banking. Such adverse developments have in certain instances been un w a n t e d side effects of some of the progressive activities we have seen banks undertake. These, and other obstacles to further healthy progress in banking, appear now to require all of us to place renewed emphasis on a quality that historically has always been closely associated w i t h healthy b a n k i n g - - p r u d e n c e . For assistance in the preparation of this paper, I am indebted particularly to Mr. Paul M e tzger of the Board's staff. The views expressed herein, however, are my personal responsibility. - 2 B anking Progress Over the last ten to fifteen years progress in banking has virtually transformed the industry. When compared with the business of banking as it was practiced historically, at least through the Depression era, these recent changes have been sufficiently m a r ked to warrant being called "revolutionary." Consider, for example: the mushrooming reliance of larger banks on "liability management," namely, the issuance of large certificates of deposit and other mone y market instruments in order to raise loanable f u n d s ; the increased use of charges for services by banks to offset the growing reluctance of their customers to maintain any more than minimal demand deposit balances; the expansion a nd diversification of bank holding companies both here and overseas; the rise of the Eurodollar market; the almost universal employment of computers bot h w i thin and b etween financial institutions; and the increasing i n t e r a ction of the world's financial systems, especially among the. more industrialized nations. - 3 The s e changes I regard as by and large progressive ones. Th e y benefit broad segments of the public, both in the United States and overseas, and are indicative of the greatly enhanced capacity of A m e rican banking to r espond to continuing demands for change. Our banks have been spurred by heig h t e n e d c o m petition, coming not only from w i t h i n the banking industry but also from thrift institutions, insurance companies, d i versified financial corporations and even nonfinaneial firms that e x tend consumer credit. In turn, the competitive climate of our entire economy has broadly b e n e f i t t e d from banking's response to the challenges of rising competition. Wha t we have witnessed, in short, is the o n going transformation of banking. Our nati o n has been an ultimate beneficiary of the increased resourcefulness and s o phistication of the banking community. It is a record of progress of which bankers can be justifiably proud. Banking Prudence Progress, however, is not enough. more is needed. Something - 4 Banking has traditionally been treated--with justification--not just as a business but as a profession. W h e n asked wh y they have v i e w e d their occupation in this light, bankers more often than not w o u l d respond that theirs was no ordinary business, but one vested w i t h the public interest. T h e y dealt in other peoples' money. Funds were entrusted to them by broad segments of the public. This established, in a v e r y real sense, a public trust that compelled them to act w i t h greater care than individuals engaged in commerce and industry. In significant measure, it was because of this attitude on the part of bankers that the public came to have a high regard for, and confidence in, the banking system. Over time, bo t h legislation and watchful r e g u l a tion of the banking industry have served to buttress the public's confidence in the safety and soundness of our b anking system. Nonetheless, this attitude of bankers themselves continues, I believe, to be a substantial element in maintaining the public's trust. - 5 - If prudence and the promotion of public c o n fidence have been basic ingredients of good banking, then surely an extra measure of these indispensable ingredients is called for today. attendant evils Double-digit inflation and its (not only in the United States but in most other highly industrialized nations) have produced a situation w h i c h has led to ver y considerable pressure being placed on banks. M o netary policy has assumed a major role in the fight to reduce the rate of inflation. Accordingly, the Federal Reserve has had to supply new bank reserves m u c h less generously. Meanwhile, credit demands from would-be borrowers have been v e r y strong. In this atmosphere, banks could and have charged high interest rates on loans, but they have also been pinched by sharp increases in the interest rates they have had to offer to attract funds. These conflicting pressures have been so e x t r a ordinary as to generate a certain amount of market anxiety concerning the ability of some banks to bear them. Con cerned customers are closely scrutinizing their banks' - 6 - financial condition, and some u n e a s y m o n e y could decide to seek haven elsewhere if signs of weakness should multiply. To minimize such troubles, one simple slogan commends itself to each bank management today: HU S BAND YOUR BANKING RESOURCES. Tr y to preserve the bank's liquidity. the average m a t urity of its purchased money. Length e n Buttress its capital position whenever the opportunity affords. Place a tight leash on officers in charge of n e w business d e v e l o p m e n t s , and tell them to concentrate on arrangements w h i c h will not place drains on bank liquidity or capital for a year or two. Tell loan officers to screen out non-essential loans. At the same time, good bankers will not dodge their responsibility to lend to creditworthy regular customers, whether large or small, the m i n i m u m amounts n e eded to keep those customers' activities viable. It is ha r d work to pursue all these objectives at once, but being able to do so is the mark of a successful banker Ln 1974. - 7 - Progress versus Prudence There is a kind of dynamic tension bet w e e n the forces impelling the progressive activities of banks and the compelling need for prudent conduct of the nation's banking business. For example, when bank holding companies expand and diversify, they seek to enter b a n k - r e l a t e d businesses partly to reach new sources of earnings by performing various services for a fee as an offset to declining demand deposit balances. In so doing, holding companies have sometimes sought permission from the Board of Governors to go beyond the fairly extensive list of activities n o w permissible to bank holding company subsidiaries, in order to engage in significant n e w activities either in the U n ited States or overseas. Such applications often represent a progressive step that will benefit both the bank holding company and the public. Occasionally, however, they can stretch the bounds of prudence. T h e y sometimes involve the management of risks qualitatively different from those likely to be familiar tc bank management. Sometimes, too, the proposed activity - 8 - m ay require a sizable amount of capital a n d specialized m a nagerial r e s o u r c e s . It may therefore divert capital and management talent away from the banking subsidiary w here they might in fact have been helpful in shoring up a thin capital position or a shallow layer of management. This question of the adequacy of capital is, of course, a major issue in banking today. It is a part of the underlying tension between progress and prudence. As yo u know, this issue has become one of particular c o n cern to the Board, for many of our leading banking institutions have tended to pursue a poli c y of rapid e xpansion in both domestic and foreign markets. Prudence w o u l d dictate that such expansion be supported by a strong capital base and an adequate liquidity position. The t ension of which I have spoken is h e ightened when a bank's m anagement must make the hard choice between continuing e x pansion into possibly highly profitable fields or slowing that expansion to permit augmentation of capital a nd to ensure appropriate liquidity. - 9 W h i l e I am well aware of the pressure bankers are under to show a record of profitable performance to current and potential stockholders, I believe that the wiser choice for bankers today is to go slow on expansion plans, and to emphasize instead actions to bolster the long-run strength of their institutions. The capa c i t y to sacrifice short-term gains to protect a l o n g er-term position has always been a mark of the prudent banker. Whi le a m e a sure of entrepreneurial aggressiveness by bank managements has helped make our banking s y s t e m a progressive one, in the final analysis only a prudent management can assure that system's continued well-being. In the ultimate test of banking, of course, public confidence is the key. It cannot be otherwise for institutions that have promised to pay a major part of their liabilities on demand. Bankers have a h e a v y responsibility to avoid actions that w o uld result in w eakening the public's confidence in our banking system, particularly in difficult times like these. Tha t k ind - 10 - of banker prudence is more important than Federal Reserve w illingness to serve as l e n d e r - o f -last-resort or FDIC insurance of deposits in reassuring the public of the fundamental soundness of our banking, system. Having spoken at some length now about b a n k e r s : responsibilities, let me say something about how I see bank regulators' responsibilities for attempting to achieve that same difficult balance between progress and prudence. You can be assured that I and my colleagues on the Board are sensitive to banks' needs to seek new sources of funds and to engage in profitable undertakings b oth at home and abroad. For it is only in this fashion in today's highly competitive environment that banks can hope to perform adequately their intermediating function of marshalling funds from savers and investors and dispensing them to meet growing public and private needs. T he importance of this function may be made even more a pparent in the future as rising world-wide demands for capital make their full weight felt. - 11 - We are also sensitive, however, to the even more vital need to preserve the basic h e alth of this country's banking system. For if prudence is the h a l l mark of sound banking, it is even more the necessity of sound banking regulation. We realize, I might add, that we are imposing a heavy burden on bankers by sometimes urging t h e m to increase their equity capital and improve their liquidity positions at a time whe n tight monetary policy has made these more difficult to accomplish. But w h e n we see some banks u n dertaking costly expansionary activities without providing commensurate capital and liquidity bases, we cannot help but think that the time has come, b y denying certain applications, to urge such institutions to reconsider the balance they have struck between the dictates of progress and those of prudence. In such cases, a slowing of too-rapid expansion by holding companies has seemed to us to be the wisest course. r e sponsibility as regulators of banking in the public Our interest has impelled us to act in these instances to tip the balance in favor of prudence. C o nelusion What I have been speaking about this afternoon has ostensibly been the tension between the need for a progressive, forward-looking and responsive banking system on the one hand, and the need for prudent conduct to assure the continued health and safety of our banking institutions, on the other. I have also been talking about the responsibilities of bankers and bank regulators to achieve a balance between these two sometimes c o n flicting needs. But actually, I have been discussing s o mething that both underlies and encompasses these subjects. My topic today has really been the nature of the public interest in our banking system and how bankers and ba n k regulators alike can better help to promote that interest. This is a joint undertaking, one made particularly difficult--and all the more important--by the troubling economic circumstances of our time. It requires that we strive together to see that the public's interest in banking is both thoroughly protected by a ppropriately wise and prudent conduct a n d well served by soundly progressive and innovative undertakings. Our nation's economic and financial well - b e i n g is significantly dependent on maintaining a proper balance between these two g o a l s .