Breaking the banks.

Bill clinton embraced at

least one Reaganesque idea at the Little Rock economic summit: banking deregulation. In a small way. Briefly. The tale of his retreat is instructive both about the depth of the banking system's problems and about the Clinton modus operandi.

The idea of banking deregulation came from William H. Brandon, the president and CEO of an Arkansas bank, and a longtime acquaintance of Bill Clinton. In Brandon's view, duplicative and contradictory regulations passed in the wake of the savings & loan crisis were the source of a major credit crunch. He estimated that these regulations were cutting lending by some 4 per cent despite generally low interest rates. Four per cent of the $2.15 trillion in total bank lending amounts to $86 billion--a not inconsiderable sum. A prudent streamlining of these regulations would, Brandon reasoned, repair banks' ability to lend to business and thus give the U.S. economy a significant stimulus without increasing the deficit--a factor that made the proposal particularly appealing to President-elect Clinton.

The chiefs of the country's six major banking 'associations followed up Brandon's foot in the White House door with a long letter to the President-elect in December advocating nine substantive reforms. The bankers told President-elect Clinton that the problem could not be solved without new legislation to undo the accumulated damage done by Congress since 1989. The Financial Institutions Reform and Regulatory Enforcement Act of 1989, the crime bill of 1990, and the FDIC Improvement Act of 1991 had, among them, imposed a formal and inflexible lending process on banks that has had dire effects on their ability to make loans to small business. Since small business is the main source of job creation, this would help explain why the recovery is producing so few jobs.

How exactly have the new regulations had this malign effect? First, explains Diane Casey, executive director of the Independent Bankers Association of America, old-fashioned "character" lending "has to a large extent disappeared." Bank examiners have interpreted the laws as requiring full and multiple appraisals of collateral, as opposed to allowing bankers, particularly at small local banks, to make risk assessment based on years of experience in the community. The cost of appraisals, and indirect costs of the time and paperwork, are proportionately greater for small loans, which are therefore less likely to be made.

The new regulations also wreak havoc with existing loans: because the rules concerning collateral are so strict, banks have been forced to declare loans non-performing even though no payments have been missed, simply because the market price of the asset securing the loan has temporarily dropped. Again, this affects small-business loans disproportionately, because they are disproportionately secured by homes and other real estate, whose value is depressed in today's economy.

Finally, the regulations have forced banks to increase their capital ratios drastically. This obviously reduces their ability to lend, and loans to small businesses are among the first areas bankers have cut back on, both because a banker must take care of his larger customers first and because it has become so hard to defend small-business loans to examiners.

Indeed, the new regulations and the change in the Washington Zeitgeist have turned bank examiners into unforgiving villains in the minds of bankers. "Every loan you make, you know the regulators are looking over your shoulder," says Kenneth Guenther, a lobbyist for the Independent Bankers Association of America. Bankers face fines at rates up to $1 million per day and the freezing of their personal and business assets if they are found to have violated an intricate set of rules and procedures.

Depressed Area

It should come as no surprise, then, that since last June bank lending to business, traditionally the profit center of the banking industry, has fallen below bank lending to the government. This gives America a Third World lending profile.

The trend has been under way since 1990, as bank lending to the government has grown at 25 per cent a year, while lending to business has stagnated. By last June, investment in government securities (at $610.7 billion) had surpassed loans to business, which then stood at $604.6 billion. As of this January, bank lending to business had slipped slightly, to $601.3 billion, while bank investment in U.S. Government securities had reached $657.4 billion, according to the Federal Reserve.

The current profile is also remarkably similar to that of the latter years of the Great Depression, according to Bert Ely, a banking consultant in Alexandria, Virginia. Then as now the banking industry was overcapitalized, loaded with excess liquidity, and not lending. In the late 1930s bankers were "scared stiff of bank runs," Ely says. Today they are scared stiff of bank examiners.

The reign of regulatory terror could have been halted almost as soon as it began: as of 1991, the Bush Administration and majorities in Congress favored true bank reform--the opposite of the regulations cited above. Three men have been standing in the way: House Banking Chairman Henry Gonzalez (D., Tex.), a populist throwback to the Thirties who believes bankers are by definition out to exploit the "little guy"; Senate Banking Chairman Don Riegle (D., Mich.), who has made a point of supporting regulators to the hilt ever since his role in the Keating Five  scandal became public; and House Energy and Commerce Chairman John Dingell (D., Mich.), who holds a quasi-religious belief that banks caused the Great Depression and must be tightly regulated. (Dingell's father was a principal author of the Glass-Steagall Act of 1933, which forcibly separated investment banking from commercial banking.)

In 1991, Dingell almost single-handedly transformed the BushBrady bank reform into the FDIC Improvement Act. Gonzalez and Riegle, meanwhile, are responsible for the ascendancy of Charles A. Bowsher, chief of the General Accounting Office (an arm of Congress), as an unofficial super bank regulator. Over the last year Bowsher's influence on bank examiners has probably become greater than that of the four banking and thrift regulatory agencies (the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) put together.

Indeed, so far from deregulation, what the Terror Trio of Gonzalez, Riegle, and Bowsher want is micromanagement of banking from Washington. This year, for example, Congress is likely to reconsider allegations of racial bias in lending. These allegations are based on the flawed studies of Alicia Munnell [see box, page 42], the left-wing former research director of the Boston Fed who has been appointed under secretary for economic policy at the Treasury Department. It is not beyond the realm of possibility that Congress will decide to force banks to make risky loans to alleged victims of discrimination.

In any case, when the trio heard that their new President was considering deregulation, they went into action. First, on January 18, Gonzalez asked the Congressional Budget Office to prepare a study on bank lending to small business with the scarcely hidden agenda of proving that there was no problem. Within three weeks, the lapdogs at CBO, which is still straightfacedly referred to in press accounts as "non-partisan," released a hastily written staff memorandum, "Regional Analysis of Bank Lending." The CBO memo dutifully offered evidence that severe new regulation actually could be improving bank lending to business. The central evidence was a finding that healthy banks-ones that had managed to meet the new, higher capitalization requirements--had increased overall lending in the last year by 3 per cent. Sadly, no one read the fine print. In fact, CBO reported a 1.4 per cent decrease in commercial and industrial lending, the main business category. The 3 per cent figure includes all other lending, including a 9.9 per cent growth in real estate lending. Moreover, the CBO simply ignored the overall low level of lending to business-- which normally rises sharply during a recovery--and discounted the disturbing shift of lending from business to government. The memo was technically correct in remarking on recent improvements in bank earnings, but this is unquestionably a result of the decline in the interest rates that banks must pay their depositors, which has allowed most banks to profit off a larger spread. (The improvement is also not permanent: if interest rates begin to rise, banks could suffer a sharp reversal of fortune as their huge holdings in government bonds decline in real value.)

The next step came February 17, when Gonzalez brought Bowsher before his committee to deliver an attack on the laxity of bank examiners. Bowsher criticized examiners' use of discretion and their resulting wide variety of responses to apparently similar problems and faulted regulatory agencies' use of guidelines rather than mandatory minimum standards. Terming the present system "a weak regulatory system," he suggested Congress consider legislation to increase the level of regulatory oversight. The testimony, and Gonzalez's friendly response to the witness, was a signal that the Banking Committee would not tolerate a loosening of regulations.

The final blow came in a closed-door meeting between the staffs of the House and Senate Banking Committees and the nominees for U.S. comptroller and under secretary of the Treasury for domestic affairs, Eugene A. Ludwig and Frank N. Newman. According to a source close to the Treasury Department, the staffers told the nominees in no uncertain terms that legislative regulatory relief "is not going to happen." After the meeting, Treasury officials leaked the news that President Clinton had backed off the idea of seeking new legislation. A week later Clinton began telling businessmen simply that he would pressure regulators to allow banks to do more character lending.

The Unveiling

Having considered bank reform for months, however, Clinton would have been too embarrassed not to come up with something. Accordingly, on March 10 he unveiled a "plan" in which the four federal banking agencies would loosen regulation and thereby generate "a flow of billions of dollars of economic stimulus that doesn't cost the American taxpayer one red cent." Senator Riegle attended the announcement; Representative Gonzalez declined the President's invitation.

In classic Clinton style, the package acknowledges the concerns of virtually every party involved but doesn't propose any real change. In a joint statement released at Clinton's press conference, the four agencies admitted the need for "a program directed at dealing with problems of credit availability, especially for small and medium-sized businesses." The policy statement recognized many of the problems with the current system, including its bias against character loans, foolish treatment of real-estate collateral, and an ineffective appeal process-but it also sent signals of concern about "discriminatory lending practices" and "uniform examination policies." The main initiative is a plan to allow banks to reduce documentation on an as yet unspecified amount of loans, the ceiling on each loan also to follow.

This may create a small window for some small-business lending. But the initiative does not--and, as an administrative rather than a legislative approach, cannot--remove the accumulated regulation that has led banks to avoid character lending. Bank examiners will continue to follow the clear intent of the FDIC Improvement Act, which at bottom prohibits such lending. Though top regulators can urge discretion on bank examiners, "It's easier to unleash the dogs than to call them off," in the words of Kenneth Guenther. Diane Casey views it as "an excellent first step," since it urges bank examiners to be more reasonable, but adds that it will not generate a surge in lending to small businesses: that would require new legislation. Forget about that $86-billion stimulus.

Mr. England is a Washington-area writer on financial and political matters.