Risk, Regulation, & Responsibility

The U.S. banking industry is beset by a crisis that parallels in many respects the one faced by the S&L industry during the mid-1980s, before its spectacular collapse. A rising tide of bank failures has all but depleted the reserves of the Bank Insurance Fund (BIF), the federal deposit insurance fund for commercial banks and many savings banks. The need for a large taxpayer bailout--following in the footsteps of the on-going $150 billion bailout of the S&L deposit insurance fund--looms as a real possibility on the near-term horizon.

The Bush administration has devised a three-pronged response to the banking crisis. First, it would authorize the Federal Deposit Insurance Corporation (FDIC) to borrow $25 billion from the federal government in order to provide BIF with additional funds to handle bank failures. Second, it would modify the federal deposit insurance statute to provide a very modest rollback in the scope of federal deposit insurance coverage. Third, it would uproot the long-standing federal laws that control the framework of the banking system to unleash sweeping structural deregulation of the banking industry--authorization for large banks to operate branch office networks on a nationwide basis; repeal of the Glass-Steagall Act to enable banks to exercise full securities powers; and elimination of the prohibition against combinations between banks and industrial firms.

Congress has begun serious deliberations on the banking reform issue and is likely to enact some form of legislation by the end of the year. The legislation under consideration by the House and Senate banking committees includes a variety of measures to strengthen prudential (safety and soundness) regulation of banks, as well as the administration's proposals.

Recapitalization of the Bank Insurance Fund

The mounting bank failures of the late 1980s and early 1990s have inexorably eroded BIF's reserves. These reserves have dwindled from $18.3 billion at year-end 1987 to roughly $5 billion by the end of 1990. The General Accounting Office (GAO) recently projected that by the end of 1991 BIF would most likely have reserves of only $1 billion, and the fund could be as much as $5 billion in the red.

To enable BIF to deal with the cost of projected bank failures over the next several years, the administration has proposed that the FDIC be authorized to borrow $25 billion from the federal government. Observers, however, are questioning BIF's ability to collect enough deposit insurance premium revenue from insured banks in the future to cover the cost of projected bank failures, pay back this $25 billion loan and recapitalize itself. In April, the GAO urged that insured banks be subject to a special one-time assessment of 40 cents per $100 of assets in order to raise $15 billion for BIF. This assessment would supplement the regular deposit insurance premium, which has already been boosted from a rate of 8 cents per $100 of deposits--in effect from the 1930s until 1990--to a current rate of 23 cents per $100 of deposits.

The GAO has testified that without a major increase in deposit insurance premiums or a special assessment, BIF is not likely to be able to pay back its borrowing from the government and recapitalize itself adequately. Yet, many financial experts contend that profit margins in the banking industry are so low that banks are already over-burdened by the current deposit insurance premium rate of 23 cents per $100. In 1989, U.S. commercial banks as a group earned only 49 cents per $100 of assets (return on assets, or ROA), and the comparable rate for 1990 was only 50 cents per $100.

Moreover, the burden of high deposit insurance premium rates has implications for the international competitiveness of U.S. banks. A recent Congressional Budget Office report shows that Japanese banks pay deposit insurance premiums of only 2.5 cents per $100 of deposits, while German banks face a premium rate of only 6 cents per $100. Reflecting concern about the profitability of U.S. banks, Bush's banking legislation would set a statutory cap of 30 cents per $100 on the maximum permissible deposit insurance premium or assessment rate.

The administration has somewhat euphemistically labelled its proposal to allow the FDIC to borrow $25 billion from the federal government as a "BIF recapitalization" plan. Yet, such borrowing increases BIF's liabilities, not its capital. Rather than recapitalizing BIF, Bush appears to be setting the stage for another taxpayer bailout of depository institutions.

Deposit insurance reform

The administration has proposed a very limited rollback in the scope of federal deposit insurance coverage with the goal of subjecting banks to more scrutiny from uninsured depositors. One proposed change would limit deposit insurance coverage to $100,000 per person per bank, rather than allowing a depositor to protect multiple accounts (individual, joint, trust) in the same bank. Another reform would eliminate deposit insurance coverage for brokered deposits--the large deposits placed by securities brokers that pool accounts of individual customers. A third change would restrict pass-through deposit insurance coverage for large pension fund deposits; current practice permits pension funds placing large deposits to count each pension beneficiary as a separate insured depositor for purposes of the $100,000 deposit insurance ceiling.

The overall impact of such changes is likely to be quite modest, especially when one considers the fact that the federal banking regulators have generally protected all the deposits at large or medium-sized banks that fail--uninsured deposits, as well as deposits formally covered by statutory deposit insurance. The regulators contend that it is less costly and less disruptive to pay another institution to take over a failing bank and thereby assume all the failing bank's deposit liabilities than to liquidate the bank and pay off only its insured depositors. Because this failure resolution technique is invariably adopted in the case of large bank failures, it has become known as the "too-large-to-fail" syndrome, although it might more aptly be described as a "too-large-to-default-on-deposits" policy. When failing banks of any size are disposed of through acquisitions arranged and assisted by the regulators, their stockholders are generally wiped out. Interestingly, the Bush administration has not proposed ending the "too-large-to-default" policy.

Structural deregulation: Bush's cure for banking ills

In the administration's view, the underlying problem of the banking industry is excessive regulation which has prevented the industry from adapting to technological change and taking advantage of new profit opportunities. This lack of profit opportunity is seen as the root cause of excessive risk-taking by banks. As bank profit margins and market shares have declined, many banks have sought to recoup by entering into high-yield, high-risk lending activities. Proponents of this theory hold that structural deregulation is a cure-all that will both improve bank profitability and reduce the need for banks to engage in high-risk lending.

Advocates of structural deregulation argue that if banks are allowed to establish interstate branch systems--rather than requiring banking organizations to establish a separate subsidiary bank within each state--they will become much larger, more efficient, more diversified and less risky. Deregulation proponents also contend that granting full securities and insurance powers to banks will enable them to earn added profit by offering a broader range of financial service products to their consumer and corporate customers. And this view also asserts that allowing combinations between banks and non- financial firms will bring well-capitalized industrial firms into banking, adding risk-reducing diversification for the banking sector.

Yet, the prescription of structural deregulation as the panacea for the ills of the banking industry doesn't jibe with the reality of the problems afflicting banking. U.S. banks now operate in an environment characterized by increasing competition within financial service markets and increasing instability in the economy at large. Increased competition reduces profits and induces banks to chase after the higher yields associated with riskier loans. Yet, increased economic instability means that loan customers are more likely to default and indicates a need for more prudence in banking. The underlying cause of the current surge in bank failures, deposit insurance losses and profitability problems within the banking sector lies in the federal government's failure during the 1980s to strengthen prudential regulation in order to cope with this riskier environment.

Increased competition leads to greater risk-taking

During the 1980s, a host of factors combined to make banking a much riskier business. Controls on the interest rates paid by banks on their deposit accounts were phased out, making it possible for high-roller S&Ls and banks bent on rapid expansion to bid aggressively for additional deposits. The fall of barriers prohibiting bank acquisitions across state lines made many larger banks more vulnerable to takeover bids. Such banks often became more concerned with boosting their short-term earnings and stock prices in order to discourage takeover bids, than with focusing on long-term profitability. Development of the capacity to convert mortgage loans (and, more recently, auto loans and credit cards) into securities readily traded in broad capital markets brought many new, non-bank competitors into bank credit markets. More and more large corporations began to borrow short-term funds directly from the capital markets by issuing commercial paper, rather than relying on bank loans for short-term funding, and many large depositors shifted large deposit balances into money market mutual funds. The upshot of these changes was to foster much greater competition in banking markets and much greater instability in market shares for individual banks and various bank products.

Faced with these increased competitive pressures, it was only natural for depository institutions in general, and the high- rollers in particular, to gravitate toward higher-yielding loans, which inherently entail greater risk. But the banking regulators failed to anticipate the problems this would cause and did not devise more rigorous supervisory procedures which could have curbed such risk-taking. With the federal deposit insurance system effectively guaranteeing most bank liabilities, the losses resulting from such increased risk-taking are inevitably shifted to the deposit insurance funds and, in all likelihood, will ultimately be borne by taxpayers (as they are now in the case of the S&L industry). In fact, a recent Securities and Exchange Commission study of the federal deposit insurance system estimates that during the 1980s the failure to control bank risk-taking--or conversely, the underpricing of deposit insurance--has resulted in a government subsidy of roughly $20 billion per year that passes through the deposit insurance system to high-risk banking institutions.

Risk-taking by the largest banks

An important aspect of the current instability within the banking sector is the fact that much of the systemic profitability and risk-taking problem is concentrated within larger banking institutions. The large money center banks have been hardest hit by the shift of blue-chip corporate borrowers from bank loans to capital market securities. For example, at Chase Manhattan Corporation, commercial and industrial loans as a percentage of total loans had fallen from 62 percent in 1978 to only 28 percent by 1990. Faced with a shrinking market for high-quality loans to major industrial corporations, many of the largest banks lent recklessly to Third World countries during the late 1970s and early 1980s and subsequently plunged into speculative commercial real estate and highly leveraged takeover financing in the mid-to-late 1980s.

In recent years, small and medium-sized banks have achieved a return on assets that falls well within the trend range of the last thirty years (0.60 percent to 0.90 percent), but earnings at larger banks have been deeply eroded. (This performance data is shown in the accompanying table - omitted here.) The poor performance of the larger banks relative to the smaller banks is the result of both a higher loss rate on the large banks' loan portfolios and the fact that they purchase a large share of their funds in money markets and thus have higher cost funds.

As shown in the table, during the 1989-1990 period, the charge-off rate for loans at the largest banks was twice as high as the rate for small and medium-sized banks. The percentage of total assets that are noncurrent (loans in default and property acquired through foreclosure) is now twice as high at the largest banks as at small and medium-sized banks. The cost of funds is currently 3 1/3 percentage points higher for the largest banks than for small and medium-sized banks. On the other hand, larger banks have lower operating costs, reflecting the fact that wholesale banking activities generally involve transactions with large dollar amounts.

The performance data for commercial banks suggests that the nation's 12,000 commercial banks with assets of less than $1 billion--a group with combined assets of 51 trillion--are not the source of the systemic problems of the banking industry. The trouble lies with the nation's 374 commercial banks with assets greater than $1 billion--a group with combined assets of $2.4 trillion--where there is evidence of systemic profitability weakness and excessive risk-taking. Unwilling to accept a reduced role as lenders to blue-chip industrial firms, many of these larger banks are pushing aggressively into high-risk areas.

Consumers pay for mistakes in wholesale banking

Most larger banks engage in both consumer (retail) banking and wholesale (corporate, interbank and international) banking. Their consumer banking activities are generally quite profitable, while their wholesale banking activities often incur large losses. For example, Citicorp reports that for 1990 its consumer banking activities produced a net income of $979 million, while its wholesale banking activities resulted in a loss of $423 million. Similarly, Chase Manhattan Corporation states that for 1990 its retail banking operations (consumer and smaller business) provided net income of approximately $400 million, while its wholesale banking activities produced a loss of $734 million. For 1990, Security Pacific had net income of approximately $420 million on its consumer banking business but lost approximately $260 million on its wholesale banking business.

The performance of banks that straddle both consumer and wholesale banking markets suggests that profits from consumer banking activities are used to cover losses resulting from aggressive expansion into high-risk, wholesale banking activities, such as lending to Third World countries, commercial real estate and takeover financing. Surveys of consumer banking products, which show that the largest banks tend to charge consumers the highest fees on deposit accounts and the highest rates on consumer loans, provide additional evidence of such cross-subsidization.

Structural deregulation won't end excessive risk-taking

The overall pattern of relatively stable profits at smaller banks and aggressive risk-taking by larger banks casts serious doubt on the wisdom of the Bush administration's strategy of addressing the banking crisis with structural deregulation policies. This strategy would encourage consolidation within the banking industry and the formation of mega-banking institutions. Yet, the predilection toward risk-taking already evidenced by the largest banks is definitely reinforced by their "too-large-to-default" status--a key structural factor that is ignored by the administration. In addition, FDIC research into the causes of bank failures has shown that rapid expansion through mergers and acquisitions is one of the principal causes of bank failures. Finally, even if there is some theoretical risk-reduction benefit from geographic and product-line diversification, the evidence suggests that large bank managements will be likely to offset any such gain by taking even greater risks. They appear inclined to pursue risk to the brink, unless restrained by regulation or perhaps very short-lived memories of recent debacles.

The consolidation of the banking sector into megabanks is likely to have a major downside for consumers and small businesses, as well. Operating with a much broader retail banking base, mega- banks will have a greater capacity to squeeze profit from consumers and small businesses to cover the cost of mistakes in wholesale banking markets. Even if this enhanced capacity for cross-subsidization were to reduce the likelihood of bank failures, it is an extremely regressive way to pay for the cost of bank management mistakes in wholesale banking markets.

Granting broad securities powers to banking institutions raises serious conflict of interest concerns and would impose additional demands on the supervisory resources of the banking regulators, which are already overburdened [see "Repealing the Glass-Steagall Act," Multinational Monitor, October 1988]. Allowing combinations between banks and industrial firms would open the door to widespread misuse of bank resources to support industrial affiliates, a serious concern both from bank safety and soundness and antitrust perspectives. Gerald Corrigan, president of the Federal Reserve Bank of New York, who staunchly opposes the combination of banks and industrial firms, recently told Congress that the potential for credit misallocation inherent in such combinations constitutes a threat to "the impartiality of the credit decision-making process" that goes "right to the heart of one of the most important functions of banking in a market economy."

The need for stronger supervision ant regulation

The chairmen of the Senate and House banking committees, Senator Riegle, D-Mich., and Representative Gonzalez, D-Texas,have introduced banking reform legislation that is more on target than the Bush administration's structural deregulation proposals. The bills sponsored by the respective chairmen emphasize prompt and aggressive intervention by the regulators when the capital level of a banking institution falls below regulatory standards.

There is definitely a need for early intervention, but an approach that focuses on the level of a bank's capital as the trigger for intervention sidesteps the real issue. Under conventional accounting standards, the risk embedded in a bank's loan portfolio is only recognized when loan losses begin to mount and loans are written down. Consequently, the level of capital in a bank merely reflects losses that have already occurred, not those that are a real possibility in the near future.

The essential ingredient for successful bank reform is to develop bank examination procedures and standards that seek to measure the level of risk inherent in a bank's loans when they are first booked. Once this risk assessment is made, the bank should be required to set aside loan loss reserves that adequately reflect the potential risk embedded in its loan portfolio. In other words, bank supervision should use loan loss reserve requirements as a tool to force bank managements to recognize risk on a prospective basis.

Such an approach would contrast sharply with the current procedures of the federal banking regulators. Under these procedures, federal bank examiners do not require loan loss reserves in any significant amount unless loans are noncurrent or otherwise troubled. In essence, the regulators take action only after the damage has been done. Unless bank examination procedures are shifted from an ex post facto to a prospective evaluation of risk, the early intervention reforms proposed by Chairmen Riegle and Gonzalez are not likely to prove any more successful than the numerous so-called "safe banking reform" measures that have been enacted by Congress over the last 25 years.

The chief obstacle to strengthening the bank examination process and using it as a brake on bank risktaking is that such emphasis on supervision and regulation runs directly counter to the deregulation ideology that has guided the Reagan and Bush administrations' approach to banking policy. The necessary reforms would require an upgrading of the skills and stature of bank examiners and would entail granting bank examiners and their supervisors considerable discretion to override key operating decisions made by bank managements. This is a hard sell to officials who believe they have an underlying mission to get the government off the back of banks and other businesses.

A major rollback in deposit insurance

The only real alternative to a rigorous strengthening of the bank examination and supervision process is a dramatic rollback in the scope of federal deposit insurance. Without question, federal deposit insurance, by shielding depositors from the risk of bank failures, makes it easier for bank managements to build up loan portfolios that contain considerable risk. A deep cutback in the scope of federal deposit insurance would not only reduce taxpayer liability for bank failures but, more broadly, would force banks to confine their portfolios to top-grade loans and investment securities, which carry minimal risk of default.

However, in order to reduce the overall level of risk greatly in the banking system, a deposit insurance rollback would have to be of major proportions, not the modest tinkering with deposit insurance coverage contemplated by the Bush administration. A modest rollback is not likely to curb bank risk-taking, unless depositors are somehow able and willing to make complex judgments about the quality of assets held by different banks. Unfortunately, the record of the financial analysts who rate bank securities in predicting bank performance is not very impressive, and there is no reason to assume that depositors-- who are generally less sophisticated, have less information and are able to withdraw deposit funds on short notice--would be any more successful.

Narrow banks: Wall Street's solution

The more serious proposals designed to achieve a major rollback in federal deposit insurance would require banks operating with federal deposit insurance to become "narrow banks," confining their activities to accepting checking accounts, managing the payments system and investing their funds in Treasury securities, other government guaranteed securities and commercial paper issued by blue-chip corporations. Although consistent with the goal of reducing the exposure of the federal deposit insurance funds and, more generally, with deregulation ideology itself, such a dramatic contraction of deposit insurance raises a number of troubling questions.

Credit Access   If banks were permitted to invest only in high-grade, tradeable securities, this would pose serious credit access problems for many important credit uses, including small businesses, community development activities, multi-family housing, emergency borrowing by firms of all sizes and certain international lending. In particular, small businesses, which by definition lack direct access to capital markets, and borrowers, seeking non-standardized mortgage loans which cannot be pooled and converted into tradeable securities, are heavily dependent on banking institutions for financing.

Broad-based deposit insurance has enabled banks to transform the short-term, liquid deposits desired by most depositors into non- tradeable or illiquid loans, thereby expanding the overall supply of credit available to the non-financial sector of the economy. From the Wall Street perspective--that of the large money center banks that have witnessed a decline in their market share of corporate financing and the big securities firms that have pioneered the securitization of certain types of bank loans--this traditional credit intermediation function of banks may appear to be somewhat obsolete. Yet, from the perspective of the small businesses, housing developers and many other borrowers on Main Street, it is still vital.

Government Exposure and Concentration   Advocates of the narrow bank approach to rolling back deposit insurance generally envision that larger banks would set up non- insured finance company affiliates to undertake much of the lending activity that is currently performed by banking institutions. However, the assertion that shifting lending activity from insured banks to such finance company affiliates would stabilize credit markets generally and reduce the exposure of the federal safety net established for banks--deposit insurance and the Federal Reserve System's lender of last resort facility--is a highly debatable proposition. On one hand, these finance company affiliates would be virtually unregulated, and thus there would be no supervisory discipline to curb their risk-taking. On the other hand, the federal government is not likely to allow a large finance company affiliate of a mega-bank to fail out of fear that its collapse could destabilize credit markets and weaken the affiliated bank. The net result is likely to be much greater concentration and continued instability in credit markets and no overall reduction in government exposure.

Social Contract   Broad-based deposit insurance represents one side of an implicit social contract under which a banking institution, in return for the government's guarantee of its deposit liabilities, is subject to an obligation to serve its entire community. This underlying obligation has been made explicit by the federal Community Reinvestment Act, which requires federally insured banks to serve the banking needs of individuals and businesses whose access to banking services tends to be restricted, in particular, low- and moderate-income and minority persons and certain small businesses. Adoption of the narrow bank model or any other approach incorporating a major rollback in federal deposit insurance would undermine the social contract theory of banking. The clear outcome would be the elimination of virtually all countervailing pressure against the current trend of banking institutions to expand services targeted to upscale customers and reduce services in less affluent markets.

1. Net charge-offs to loans and leases
2. Noncurrent loans and leases plusother real estate owned to assets
3. Cost of funding earning assets
4. Net noninterest expense to earning assets

Jonathan Brown is the director of Essential Information's bank research project.