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r e l e a s e u p o n delivery-


at 9 : 0 0 A . M . ,

Friday, November


(Noon E . D . T . )

6, 1992

R e g u l a t o r y B u r d e n and B a n k C a p i t a l

S u s a n M. P h i l l i p s
M e m b e r , Board

of G o v e r n o r s of the F e d e r a l R e s e r v e S y s t e m

R e m a r k s P r e p a r e d for
the Fall Meeting

of t h e

A s s o c i a t i o n of B a n k H o l d i n g C o m p a n i e s

Tucson, Arizona

N o v e m b e r 6, 1992

I am pleased to have this opportunity to participate in your
meetings, and I thank you for inviting me.
I will be speaking today on the burden of bank regulation, a
topic which I suspect is being examined throughout your program.


remarks will focus on two issues, the first of which is the cost of
regulation and recent efforts to reduce this burden.

Second, I want

to discuss capital regulation; in particular, the prominent role of
capital in the various provisions flowing from last year's
legislation, the Federal Deposit Insurance Corporation Improvement Act
Reducing the Regulatory Burden
To begin, I know that the cost of bank regulation is a major
concern to the nation's bankers.

I can assure you that the regulatory

agencies are making a sustained effort to reduce this cost because I
have been directly involved in that effort.

While one always wishes

that more could be done, I am pleased with the progress that has been
made thus far.
Although we generally believe that the costs of supervision
and regulation have been increasing steadily in recent years, there
had been few studies estimating the total burden of bank regulation.
Now, there is some work on this topic, and I understand more cost
studies are underway.

The American Bankers Association estimated

regulatory costs to be $10.7 billion for the banking industry as a

As my colleague John LaWare points out, the true number may be

$15 billion or more when deposit insurance premium costs and the
opportunity costs of sterile reserves are included.

Put another way,

the true cost of the regulatory burden may well be a substantial 8 to
16 percent of noninterest operating costs.

The inability to pay interest on required reserves is a major
component of total regulatory cost.

Although reserve requirements

were established originally for safety and soundness purposes and to
provide clearing balances, they became a part of monetary policy.
Therefore, the desire to lower reserve requirements to reduce
regulatory burden becomes involved in the complex of monetary policy
The opportunity cost to the banking system of holding
nonearning reserves varies with interest rates.

In addition, the

opportunity cost is a function of both the level of reserves that
would be held absent a legal requirement, and the range of alternative
investment choices available to a given bank.

Required reserve

balances of depository institutions with the Federal Reserve Banks are
now about $22.5 billion.

At an opportunity cost of 3.1 percent, the

federal funds rate for October, the pre-tax cost of reserves would be
about $700 million per year.

I might note that the Federal Reserve

has reduced this opportunity cost appreciably on two different
occasions recently.

The Board eliminated required reserves on

nonpersonal time deposits in 1990 and reduced required reserves on net
transaction accounts this year.
Perhaps reserve requirements can again be reexamined over
time as transactions and clearing technology improve.

Likewise, some

day it may be possible to pay interest on required reserve balances
held at the Federal Reserve.

As you may know, the Federal Reserve

Board has recommended this change to Congress.
Bank deposit insurance premiums are the second major
component of regulatory cost.

Premiums have risen rapidly in recent

years and were over $5 billion in 1991.

Given the need to rebuild the

Bank Insurance Fund, it seems unlikely that there will be any

significant decrease in insurance premiums until the fund is fullyrecapitalized .
While the costs of deposit insurance premiums and the
foregone interest on reserves are high, these expenses have to be
viewed as part of the franchise cost of being in the banking business.
Reserves provide access to the Federal Reserve's payment services and
discount window.

These are very important to many banks.

premiums permit banks to offer insured deposit accounts.
government safety net has pluses and minuses.


On the positive side,

although banks suffer from certain competitive disadvantages -- such
as geographic and product restrictions - - none of their nonbank
competitors has the ability to offer government - insured deposit

On the negative side, there is the regulatory burden

designed to protect the taxpayer and the Bank Insurance Fund from the
so-called "moral hazard."
Beyond the costs of reserves and insurance, there are the
other costs associated with supervision and regulation.

These are the

costs that the American Bankers Association study estimated at $10.7
billion per year.
Since much of banking legislation is quite specific, there
are real constraints on the effort to reduce regulatory burden.


having said that, let me turn to the process of achieving some
regulatory relief.

I am new at the effort, but have had the

opportunity to learn much in recent months about bank regulation
generally and about the Federal Reserve Board's processes in

Since 1978, the Board has maintained a formal program of

regulatory review and simplification.

In addition, the Board

undertook a review of all its regulations earlier this year to

determine how its regulatory processes could be simplified and
streamlined within our statutory mandates.
What have these efforts achieved so far?

As a result of our

comprehensive regulatory review begun earlier in the year, in April, I
reported to the Board on steps that the Federal Reserve could take to
reduce and simplify regulations.

The Board could initiate some

actions on its own, and others required the cooperation of other
banking regulatory agencies.

By September, we had taken action on

many of these proposals and other changes were out for public comment.
Although some of these ideas may not produce major, clearly
identifiable cost savings, even small improvements can help.
Many of these proposals dealt with the more efficient
processing of the nearly 3,000 applications that we receive each year.
The applications burden can be reduced, and paperwork savings
achieved, because many bank and bank holding company applications
present no significant regulatory issues.

Many times, when an

application must be filed, review and approval can be delegated to the
Reserve Banks.

This saves time at the Board level and, by eliminating

one layer in the regulatory process, speeds up the formal granting of
an approval.

In other cases, we are duplicating the regulatory review

done by the bank's primary regulator, and an application to the Board
can be waived if there are no significant regulatory issues.
Moreover, some issues have become less controversial over
time, and the need for extensive applications has diminished.


example, in the past, many branch office applications were

Other banks protested that there would be
Now, except for occasional CRA protests, there are

seldom any questions raised about branch applications.

Thus, these

applications should receive expedited treatment as long as the bank
meets standard regulatory requirements.
We are also working with the other financial regulatoryagencies to standardize and simplify both regulations and the
application and reporting forms associated with those regulations.
For example, when two or more regulators must review an application,
the same application form should be acceptable to both agencies.


bank should not have to fill out two different application forms to
obtain one approval.
The regulators can also reduce burden through the better
coordination of the bank examination process.

Disruption to normal

bank operations can be minimized if w e can avoid having multiple sets
of examiners going through a single bank.

We are working on this

problem in conjunction with the other regulatory agencies.
Standardizing the training of examiners and the interpretation of
regulations across agencies should also permit some savings and, by
reducing the level of regulatory confusion, lower the burden on banks.
As one other example, we have added a number of nonbank
activities to the "laundry list" of activities permissible for
subsidiaries of bank holding companies.

Once it is established that a

new activity is permissible according to the statutory criteria,
applications to engage in that business, as long as they are submitted
by sound banking organizations, should not require substantial
paperwork or lengthy regulatory review.
As most of you are aware, we are now participating
extensively in the Exam Council's review of regulatory burden, as
required by section 221 of FDICIA.
and is circulating for comments.

A draft report has been produced
We expect that the report will be

completed by the December 19th deadline.

While I cannot comment on

the specific contents of the report. I believe it will offer
guidelines for a substantial reduction of regulatory burden.

There is

a lot that can be done to reduce burden without endangering the safety
and soundness of the banking system or harming those who use its

I hope that all of you will read this report when it

becomes available and will react to it, both to your regulators and to
your representatives.
I am happy to report that the President signed the Housing
and Community Development Act of 1992 last week.

While many of the

proposed regulatory reforms that the Board supported did not make it
into this bill, there were some provisions that did.

For example, the

new law allows the regulators to adopt a $100,000 exemption for real
estate appraisals, and allows the regulators to establish thresholds
below which a licensed or certified appraisal is not required if there
is no threat to safety or soundness.
In another important area, the new law clarifies the FDICIA
provisions on executive compensation.

In particular, regulators are

instructed not to set a specific level or range of compensation for
bank officers, directors, or employees, as appeared to be called for

This clarification, however, does not affect the

regulators' authority to restrict the compensation of a senior
executive of an undercapitalized institution.
Other provisions in the new law delay compliance with Truthin-Savings for three months, exempt on-premise signs from the
advertising disclosure requirements, reduce the burden of regulations
on real estate settlement procedures, and increase regulatory
flexibility in the review of insider loans.

These are clearly

improvements, but broader reform in terms of regulatory burden or a

meaningful expansion of bank powers must await another legislative
Thus, we have seen some progress this year.

We have achieved

some burden reduction from the banking agencies' regulatory relief
effort, we expect regulatory savings to result from the FFIEC's study
of regulation, and we have won some gains from the recently signed

But, there is certainly a great amount of regulatory

burden remaining.
Indeed, the regulatory and legislative processes need to be
examined closely and continually in terms of cost/benefit analysis.
Sometimes, there are perceived problems that are not, in reality,
significant problems, or there are problems brought about by the
abuses of a few institutions.

In looking at new regulatory or

legislative proposals, we should all ask ourselves questions such as:
How many banks are guilty of a particular questionable practice?


is the cost to the system and society of allowing this practice to

What is the cost of attempting to control the practice by

regulation, rather than supervision?
duplicate other regulations?
be successful?

Will the proposed regulation

Will attempts to control this behavior

And at what cost?

Would limited supervisory resources

be better deployed in investigating other banking practices?
the other side of the equation: What are the benefits?

And, on

What is the

value of the benefits, and how can they be measured against the cost?
These questions are difficult to answer, and often not enough
is known to make accurate assessments.

So, instead of making these

calculations, often a law is passed or a regulation is put in place
without adequate cost/benefit analysis.

Sometimes the law is detailed

and specifies precisely how the regulatory agencies are to deal with
the situation.

At other times, the law is vague and the regulators

have to try to determine the intent of the Congress and the best way
to carry out that intent.

In either case, however, the costs of

regulation are born by the stockholders of the banks that are
regulated, by the bank customers, who pay higher prices or receive
lower returns, and by the taxpayers who, at least partially, fund the
regulatory agencies.
To be quite fair, regulatory restrictions had their genesis
in attempts to correct a perceived problem or inequity, or to provide
certain types of benefits.

For example, based on the costs of the

savings and loan disaster, there were a number of incentives to take
actions to prevent the same type of collapse in the banking industry.
Many of the provisions of FDICIA were designed to make sure that banks
don't go the way of the savings and loans.
To take another specific example, Congress is now faced with
strong statistical evidence, presented in the Home Mortgage Disclosure

(HMDA) data and in the Federal Reserve Bank of Boston study,

that minorities are more likely to be denied credit.

The evidence may

not be statistically perfect, but the Boston study does correct for
some major flaws in past studies.

Most importantly, it makes it very

hard to imagine that Congress would repeal or weaken significantly the
Community Reinvestment Act

(CRA), the Equal Credit Opportunity Act, or

These laws certainly create some of the most burdensome, time-

consuming and costly regulations.

But, while there is convincing

statistical evidence of discrimination, can the burden be reduced?
In the short run, there may be ways to lessen the burden
of laws such as the CRA, especially on those banks with a good CRA

We continue to support legal and feasible methods of reducing

the law's burden on those banks.
responsibility is yours.

But, in the long run, the

The banking industry must devise loan

application systems and training programs to guarantee that all loan
applicants are treated equally.
For the Board's part and more generally with regard to
regulation, we are aware of the high and rising dollar cost of the
regulatory burden, and we are attempting to lower that cost by
reviewing and simplifying regulations.

We will continue to urge the

Congress to avoid unnecessarily adding to that burden.

At the same

time, however, the industry must exercise caution in its behavior so
as not to provide additional justification for the micro-management of
the banking industry.
Capital Regulation
Now I would like to switch from regulatory burden in general
to the more narrow issue of the role of capital regulation and its

I have chosen to focus on capital because it seems to be the

centerpiece of much of the current and proposed regulatory structure
coming out of FDICIA.

In fact, many argue that FDICIA served to

increase the burden of capital regulation.
view, but am not sure I agree with it.

I understand this point of

To analyze this argument, let

me talk for a few minutes about capital regulation and its role in
First, there are the capital based prompt corrective action
provisions which, I understand, the Board strongly supported.


bank is assigned a capital "zone" depending on its risk-based capital
and/or leverage ratios.

Once a bank falls into one of the three

"undercapitalized" categories, a host of mandatory and/or
discretionary sanctions may be imposed by the supervisory agency.
Among the mandatory provisions are: restrictions on dividends, a
required capital restoration plan, restrictions on asset growth,
restrictions on executives' bonuses and raises, and in the case of


critically undercapitalized banks, mandated conservatorship or

Chief among the discretionary sanctions available to

the regulator are removal of management, termination of activities,
and mandated recapitalization or merger.
These sanctions were designed to give banks powerful
incentives to maintain strong capital positions, and, more generally,
to prevent the Bank Insurance Fund from being exposed to excessive

However, it is important to remember that virtually all of

these options were available to the supervisors before the passage of
FDICIA, in the form of cease and desist powers.

FDICIA simply removed

some, but not all, of the supervisors' discretion.

In addition, the

four regulatory agencies must have common definitions of the capital
levels at which various prompt corrective action sanctions will be

This standardization approach may actually be desirable.

Since a prescribed capital level now results in a prescribed set of
sanctions regardless of which agency is the supervisor, banks now have
more certainty in their oversight.

At the same time the legislation

provides for enough supervisory discretion to allow for differences
across institutions that may not show up in the capital measures.
Second, FDICIA places new capital-based restrictions on
brokered deposits.

Only well capitalized banks may raise funds via

the brokered deposit market without restrictions.


capitalized banks must obtain a waiver from the FDIC.
Undercapitalized institutions cannot issue brokered deposits.
Third, the law provides new restrictions on deposit interest

Banks that are not well capitalized are subject to what

essentially amounts to a new version of Regulation Q.

Interest rates

on their deposits cannot be more than 75 basis points above prevailing


local rates, or prevailing national rates in the case of wholesale
Fourth, interbank risk exposures are to be regulated.


requires the Federal Reserve Board to prescribe standards that limit a
bank's risk from its exposure to other banks.

These risks of loss

result from correspondent balances, swaps, and other interbank

The Board has proposed such a regulation which would

require all banks to track their exposure to other banks.


proposal would set up benchmark standards for limiting exposure to a
bank's correspondents that are not well capitalized.

Our staff is in

the process of reviewing the public comments that were received.
Fifth, FDICIA removes insurance coverage on a pass-through
basis to certain deposit accounts held in conjunction with employee
benefit plans if the bank in question may not accept brokered

Thus, as a practical matter, only well capitalized banks,

or those with an FDIC waiver for brokered deposits, can continuously
raise funds in the employee benefit plan deposit market.
Sixth, access to the discount window is curtailed for
undercapitalized banks, and access to the window may be eliminated for
critically undercapitalized banks.
Finally, FDICIA requires that the capital standards be
reviewed biennially by each of the agencies.

Moreover, the agencies

are to revise the risk-based capital standards to "take adequate
account of" interest rate risk, concentration of credit risk, and the
risks of nontraditional activities.
As you can tell from my recitation of the capital "burden"
associated with FDICIA, I am skeptical of using capital standards to
deal with every nuance of the supervisory process or to dictate
prudent business practices.

There is also some amount of duplication


inherent in the FDICIA provisions.

For example, certain potential

abuses covered by FDICIA are also treated within the examination

The growth of undercapitalized banks is controlled by the

new interest rate caps on deposits, by the new pass-through insurance
coverage provisions, by the prompt corrective action sanctions,
and by the growth restrictions in the banks' approved capital
restoration plans.
Nevertheless, I believe capital standards are an appropriate
centerpiece for some regulatory programs.

After all, we do not want

to see a repeat of the troubles of the past.

Also, I think capital

standards can be used to reward less risky banks with a reduced
regulatory burden, and more tangible benefits such as lower risk-based
deposit insurance premiums.

Perhaps, some expanded powers can be tied

to whether a bank is well capitalized.

But, capital should not be

seen as a panacea -- there are many other aspects of banking which
contribute to a bank's success, not the least of which is management.
As I've indicated earlier, the banking system has a safety
net stretched beneath it consisting of the full faith and credit of
the government on insured deposits, and direct access to the Federal
Reserve's discount window and payments system guarantees.

This safety

net, if it were not accompanied by prudential regulation, including
tough capital standards, would expose the taxpayer to significant
How burdensome are the capital standards?

Our data show that

more than 11,000 banks, comprising more than 93% of institutions, meet
the definition of well capitalized banks under the standards recently
promulgated by the agencies.

To a large extent, these banks are not

burdened by the capital standards, although individual members of this
group may have asset or other weaknesses that subject them to


supervisory actions, prompt corrective action sanctions, and other
provisions of FDICIA.

Indeed, historically, a large portion of the

industry's institutions have maintained capital well in excess of
standards set by the regulators, recognizing the need for strong
The significant capital burden will be imposed mainly on the
233 banks in the three undercapitalized categories.


institutions fortunately hold less than 2 percent of the total assets
in the banking system.

There is also a capital constraint imposed on

the 520 banks that are "adequately capitalized."

These institutions

constitute less than 5 percent of the banks, but hold more than 30
percent of the system's assets.

This group of banks will have to

maintain or improve their performance in order to ensure they do not
fall into the ranks of the undercapitalized.
Given the data just presented, capital regulation currently
does not appear to be overly burdensome.

Moreover, the burden is

distributed where it should be -- on the banks that, left to their own
devices, have not maintained adequate capital, thereby exposing the
Bank Insurance Fund, other banks, and the taxpayer to unnecessary
In conclusion, I hope my comments have demonstrated my acute
interest in studying and attempting to reduce unnecessary regulatory

I hasten to add that total regulatory burden can never be

eliminated, nor should it be.

But the regulatory burden can be

subjected to more stringent cost/benefit analysis.

Such analysis

should be on a continuing basis, reflective of changing economic and
technological conditions.

Just because "we've always done something

this way" or because "it ain't broke" doesn't mean it can't be made to


work better.

On the other side of the cost/benefit equation, we

should not ignore the benefits.

As difficult to quantify as costs

are, benefits may be even more difficult to measure.

Yet it is often

the benefit side which drove the passage of the law or establishment
of the regulatory program.

Thus, proposals for change must

concentrate on both costs and benefits.
I thank you for your attention, and will be interested in
your reactions to my remarks.