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For release upon delivery
Expected at 9:00 a.m. E.D.T.
Tuesday, June 23, 1992

Banking and the Economy

Susan M. Phillips
Member, Board of Governors of the Federal Reserve System

Remarks Prepared for
Virginia Bankers Association
Annual Convention

White Sulphur Springs, West Virginia

June 23, 1992

It is a pleasure to be here with you today.

In my

remarks this morning, I would like to discuss a number of topics:
the state of the banking system, recent developments in the
national economy, and important elements of the FDIC Improvement
Act (FDICIA) which was passed and signed late last year.

All of

these topics have significant implications for the banking
industry and hopefully will generate some healthy discussion in
the Q&A period following my remarks and for the remainder of your
conference.

Condition of Banking System
I do not need to tell you that recent years have been
difficult for the banking industry.

A series of asset quality

problems, weak economic conditions, and narrow margins have
introduced stresses to the domestic banking system that are
unmatched in recent decades.

Asset quality problems have almost

always been the principal risk to commercial banks, and the past
decade saw problems with developing country loans, then energy,
agriculture and finally real estate loans.

These problem assets

caused substantial damage to the profitability and capitalization
of many banks.
Also during the decade, technological and financial
market trends forced substantial changes in the nature and
activities of U.S. banks.

Many high quality commercial borrowers

sought funding directly in the capital markets, especially the
commercial paper market.

Expanded powers for thrifts and the

emergence of nonbank banks introduced much greater competition

2
for banks.
In response to these market pressures, many banks
expanded their lending to real estate developers and to other
less creditworthy borrowers, including those with exceptionally
high levels of debt.

While these loans provided attractive

yields and generated significant up-front fees, the initial
benefits proved short-lived as credit losses began to mount.

By

late 1989, it was clear that many banks faced significant
difficulties from highly leveraged borrowers and commercial real
estate exposures.
During 1990 and 1991, the volume of nonperforming
assets increased substantially, with commercial real estate loans
accounting for a large share of that increase.

Nonperforming

assets of the 50 largest holding companies increased by $22
billion, or nearly 50 percent, during the two-year period.
Smaller institutions were generally much less affected by real
estate conditions and had fewer problems.

Nevertheless, banks

with assets less than $1 billion incurred a still significant 17
percent increase in total nonperformings during the same time.
As a result, in recent years the industry's loss provisions and
chargeoffs have risen to the exceptionally high level of nearly 1
percent of assets.
These problems, in turn, have clearly weakened industry
earnings.

During each of the past three years, the industry's

average return on assets has been roughly 0.50 percent, a rate
that is 10-20 basis points below levels generally seen during the

past two decades.

Earnings have been weakest among the larger

institutions and in regions where commercial real estate markets
have declined sharply.
Since 1985, record numbers of banks have failed.

While

the number of failures has declined in the past few years, the
assets of the failed banks have been large.

Even more troubling,

the number of problem banks remains high, and their average size
has grown significantly.
At this point, however, there are indications that
conditions are beginning to improve.

Most encouraging is the

apparent turn in the pattern of nonaccruing loans, which have
been declining in recent quarters.

This apparent improvement

reflects the process of cleaning up and strengthening bank
balance sheets, with much commercial real estate having been
charged-off or written down to estimated market values and
foreclosed.
Lower interest rates have also helped strengthen the
condition of banks by permitting the industry to widen its net
interest margins to one of its highest levels in 20 years.

Lower

rates also contributed to a significant increase in unrealized
gains on investment securities during the last eighteen months.
My net assessment, then, is that while much further
improvement is needed, there is a basis for believing that the
industry's current problems have peaked.

We can expect the

number and costs of bank failures to remain high for some time,
but in many respects, the broader outlook for the U.S. banking

4
system seems brighter than it has in several years.
Even during the past few very difficult years, many
banks—including many large ones—have consistently performed
well.

In each of the past four years more than 40 percent of the

industry, holding a similar share of banking assets, earned a
highly respectable rate of 1.0 percent or more on assets.

These

strong performances do not represent only small community banks.
During each of the past four years, more of the banking system's
assets were in banks with ROAs exceeding 1.0 percent than was the
case in any of the prior years in the 1970s or 1980s.

That

improvement could not have been achieved without strong
performances by a number of large regionals and at least a few
money center banks.
Virginia banks appear to have generally reflected
national conditions and trends.

Regional commercial real estate

markets, like those in most other parts of the country, continue
to show historically high vacancy rates.

Nonetheless, asset

quality for Virginia banks appears to have stabilized and has
shown some improvement in recent quarters.

Earnings for the

first quarter of 1992 improved sharply due to both lower loan
loss provisions and better net interest margins.
Virginia banks reflect another pattern that has emerged
nationwide—that is, a growing separation between banks that are
doing well, and have done well consistently throughout this
troubled period, and those that are not doing well.

Nationwide,

roughly 45 percent of all commercial banks have earned more than

one percent on assets in each of the past four years, while
another 10-15 percent each year reported losses.

So there

clearly are differences among and between banks, but the
industry's prospects are more positive than at any time in the
recent past.
Progress, however, may come slowly, and will depend
heavily on local and national economic conditions.

Economic outlook
Let me turn briefly to a discussion of the current
national economic situation and the longer-run prospects for the
economy.

As I am sure you know, real GDP rose at a 2.4 percent

annual rate in the first quarter, and economic tea leaves so far
in the second quarter seem to be consistent with continued—
albeit moderate—growth.

The most favorable news comes from the

industrial sector, where production has been rising at a 6.3
percent annual rate since its recent low in January.
labor market, the news has been more mixed.

In the

In particular, as

has been widely reported in the press, the unemployment rate
jumped from 7.2 percent in April to 7.5 percent in May.

At the

same time, however, the number of workers on nonfarm payrolls
advanced another 68,000 in May, continuing the expansion of
employment that resumed in February.

In addition, work schedules

lengthened and overtime hours increased in a number of
industries.

Thus, seen from the demand side of the labor market-

-that is, employment and h o u r s — i t appears that income and

6
economic activity have continued to expand at a moderate pace.
Let me now turn from employment and production to
indicators of aggregate demand, starting with housing.
course, is a bellwether sector of the business cycle.

This, of
Encouraged

by declines in mortgage interest rates, construction picked up in
the fourth quarter of last year and increased further in the
first quarter of this year.

The data on housing starts in April

were somewhat disappointing, but the May figures showed a bounce
back.

More importantly, the fundamentals—such as mortgage rates

and real incomes—point to further solid gains in activity in
this sector.

Favorable spillover from the strengthening of new

construction that now is under w a y — i f sustained—should affect a
much broader circle of industries in coming months.
Recent data on consumer spending also have had their
ups and downs from month to month.

Retail sales, after rising

smartly in the first quarter showed little improvement in April
and May.

In contrast, sales of domestically produced autos and

light trucks have continued to advance through the early part of
June.

Looking ahead, real incomes and consumer confidence have

been rising, which suggests the likelihood of a revival of the
uptrend in overall household spending sometime soon.
Business spending for new equipment remains somewhat
lackluster, perhaps reflecting an abundance of caution in the
business sector.
in train.

But a modest recovery in coming months may be

New orders for nondefense capital goods have traced an

uneven, but generally upward, path since reaching their trough

early last year.

For computers, new orders have been rising, on

balance, in recent months.

With prices continuing to fall,

demand is likely to expand further.
the outlook is relatively weak.

For aircraft, by contrast,

In short, business investment is

an area which bears watching in coming months to see whether
recovery is sustained.
A discussion of the current economic situation would
not be complete without reference to inflation.

Over the twelve

months ending in May, the overall consumer price index rose 3
percent, down from a 5 percent increase during the preceding
twelve-month period.
oil prices.

Granted, some of the slowing reflects lower

But even excluding the volatile energy and food

categories, price increases have slowed from about 5 percent last
year to slightly less than 4 percent this year.

And, with

nominal wage increases gradually easing, I think the odds of
seeing a further gradual reduction in the core rate of inflation
are quite favorable.
In summary, no one can forecast with confidence exactly
when the positives in the outlook will completely outweigh the
remaining negatives.

In the fine tradition of a two-armed

economist, I cannot discount the risk of a temporary setback.
But, that said, there are clearly reasons to be encouraged about
both the near-term and the longer-run prospects for the economy.

Recent Legislation
I am sure that nearly all of you are familiar with

8
FDICIA —
year.

the FDIC Improvement Act —

that was passed late last

While I do not want to attempt a detailed summary, I would

like to discuss some of its important features.

The Act

contains a number of measures designed to prevent some of the
many problems depository institutions have encountered in recent
years.

The Act calls for enhanced regulations regarding capital

standards and safety and soundness issues.
Among the more striking aspects of the legislation is
its emphasis on capital.

This emphasis is brought out strongly

in numerous provisions of the law.

For example, the FDIC's

recent proposal on deposit insurance premiums would tie premiums
to a bank's capital ratios, tempered by supervisory assessments
about the overall condition of the bank.

The FDIC has also

issued a rule to limit the unrestricted use of brokered deposits
to "well capitalized" institutions, which are defined as those
banks with total risk-based capital ratios of at least 10
percent, Tier 1 ratios of at least 6 percent, and leverage ratios
exceeding 5 percent.
Prompt corrective action, another provision of FDICIA,
requires the bank regulatory agencies to take specific and
increasingly onerous actions as a bank's capital ratios decline.
This provision largely reflects the supervisory actions
regulators have generally pursued in the past.

Now, however,

those practices are codified into law, reducing some of the
flexibility that was used, or some might argue, abused, in recent
years.

The details are forthcoming in proposed regulations, but

9
the basic framework has now been decided by law.
I should note that the importance of capital ratios in
this regulatory framework will lead to more emphasis on the
adequacy of a bank's loan loss reserves by regulatory agencies.
Examiners will be looking even more carefully at reserve levels
in order to prevent banks from ignoring or minimizing loss
provisions and thereby overstating their capital positions.
Both FDICIA and the risk-based capital framework have
acknowledged the need to incorporate a measure of interest rate
risk into U.S. capital requirements.
August 1993.

FDICIA calls for this by

Staff of the Federal Reserve and the other banking

agencies have developed an approach to measuring interest rate
risk that could apply to all U.S. banks —

not only the

internationally active banks that would be covered by the
international risk-based capital agreements.

This domestic

approach would be compatible with international efforts but would
generally be less complex and burdensome and would increase
capital requirements only for those institutions that appear to
be taking the greatest risk.

The Federal Reserve Board expects

to issue a proposal on this topic for public comment next month.
FDICIA contains a number of other provisions designed
to promote a safer and more prudent banking system including
0

limits on loans to directors and other inside interests and more
stringent standards for real estate lending.

The Act also

requires that the regulatory agencies publish standards for loan
documentation, credit underwriting, asset growth, compensation,

10

and a variety of internal controls and operating systems.
Proposals related to each of these areas either have been issued
for public comment or will be in the very near future.

I can

report to you that with the exception of interest rate capital
proposals, most of the FDICIA implementation initiatives are
being jointly undertaken by the bank and thrift regulators.

This

has entailed a great deal of consultation and cooperation, but
hopefully will result in eliminating the possibility of
conflicting requirements or interpretations.

Regulatory Burden
Federally insured depository institutions are
necessarily highly regulated simply because of the special role
they serve in the economy and the huge volume of federally
insured deposits they hold.

The collapse of the thrift industry

and the recent problems of commercial banks have only made the
industry's regulatory burden problems worse, as the Congress
reacted with new legislation.

Through FDICIA, lawmakers have

imposed restrictions intended to stem losses and limit the
financial exposure of the government, and thereby the taxpayers.
However, the banking agencies, the Administration, and
the Congress are receiving the message that this latest round of
legislation may have gone too far, at least in some areas.
Delegation after delegation of bankers has visited Washington to
protest.

I understand that a group from your organization (the

Virginia Bankers Association) visited Washington in early May and

11
met with regulators and Congressmen to voice your concerns and
views.
The Federal Reserve did not support many elements of
FDICIA, particularly those provisions that propel both the
regulator and lawmaker into the micro-management of a bank.

A

somewhat different approach to banking legislation, one that
strikes a more equitable balance between the costs and potential
benefits of regulation, might go farther toward achieving more
effective legislation.
FDICIA itself calls for a study of regulatory burden in
order to identify revisions of policies and regulations that
could reduce unnecessary burdens without compromising the safety
and soundness of insured institutions.
taken very seriously.

This mandate has been

A series of "town meetings" is being held

across the country in order to collect more information on these
issues and problems and to supplement the review currently under
way.

In addition, Governor LaWare is testifying today on behalf

of the Federal Reserve regarding ways regulatory burden could be
reduced.
The issue of regulatory burden must be considered in
perspective.

A certain amount of "burden" on the banking

industry is justifiable on a cost-benefit basis.

However, it

seems clear that many aspects of the existing regulatory burden
should and are being reconsidered.

Regulators should continually

monitor the burdens associated with oversight programs.

Changes

may be appropriate as economic or competitive conditions change

12

or as the effects of new regulatory programs are more fully
understood.

Such a reexamination has led "Luu Federal Reserve

Board to participate in the Regulatory Uniformity Project (RUP)
with other bank regulators and to undertake a number of
initiatives to streamline application procedures, eliminate
duplicate application and approval processes and re-examine
certain exemptive levels or criteria.

The fruits of these

efforts should be evident in the Federal Register in the coming
weeks.

But even more broadly, a reconsideration of regulatory

burden is likely to lead to additional legislative efforts —

not

only to reduce immediate costs and reporting burden but to
provide relief from outdated restrictions that prevent the U.S.
banking industry from competing most efficiently.
Fundamental reforms to eliminate barriers to interstate
branching and to allow expanded insurance and securities powers
should be revisited.

The structure and activities of the U.S.

banking system are changing at a rapid pace.

Allowing the

industry to operate more efficiently and to compete more
effectively with foreign banks and with various nonbank entities
is the best approach to take in maintaining a safe and sound
banking system.

Conclusion
At this time, the condition of the banking system
appears to be improving, although many problem situations remain
to be resolved.

More active supervision should help deter future

13

problems, but supervisory and regulatory oversight can be taken
too far.

The need for fundamental banking reform remains.

The

banking and financial services industries have changed markedly
in recent decades.

Broad reform must be undertaken if the U.S.

financial system is to be strong and healthy and fully capable of
meeting the long-term financial needs of the country.