Silas Keehn, President, Federal Reserve Bank of Chicago.

Statement by Silas Keehn, President, Federal Reserve Bank of Chicago, before the Subcommittee on Domestic Monetary Policy of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, May 8, 1991.

I am very pleased to have this opportunity to give you my views on the recent trends in credit availability. While perhaps I need not emphasize the point, as the representative of a Reserve Bank located in the heart of the Midwest, it is entirely possible that the tenor of my comments will be different from what you may hear from other parts of the country.

The Lending Slowdown

We have all heard a great deal about the "credit crunch" during the past year. Unquestionably, there has been a tightening in the extension of credit, particularly commercial credit, by banks during this recent period. Many banks have raised their credit standards, and to a significant extent they have reduced commitments when the use of unborrowed lines would result in large increases in outstanding credit. In addition, they have raised interest rate spreads and tightened covenants and collateral requirements. These price and nonprice changes have had the effect of restraining the extension of credit. While the impact of this has been particularly significant in certain categories of lending, such as commercial real estate and highly leveraged transactions, the effect of this restraint has extended to other parts of the loan portfolio as well.

Several forces have contributed to the restraint on the extension of bank credit. Because of intense competitive conditions in the banking markets, interest rate spreads on many commercial transactions have been driven to very low levels. Many industry observers (and I strongly agree with them) feel that there is a significant overcapacity in the banking business, which, along with other market factors, accounts for these highly competitive conditions. As a consequence, a commercial loan as a stand-alone transaction frequently does not return an adequate level of profit. Indeed, some institutions will decline a perfectly creditworthy loan unless ancillary business will increase the profitability of the overall transaction. This profitability issue is contributing to the current restraint.

It is important to remember that the shift in lending attitudes follows a phase of strong credit extension that took place during the 1980s. It is a logical response that was entirely reasonable to expect given some of the credit problems that have emerged as a consequence of this period of aggressive credit expansion. While the decline in economic activity with the resultant decline in the demand for credit has certainly had an important effect on loan volume, this tightening of credit standards, reflecting a change in attitudes by bank management, has had a major role as well. To emphasize the point, for a variety of reasons we are going through a period of significant credit restraint.

Having said that, I do not think that monetary policy has been the cause of this restraint. In a classic liquidity sense, it is my view that we are not experiencing a "crunch." In the most recent period, bank reserves have been adequate, and very frequently conditions in this segment of the money market have been described as "soft." Monetary policy has been eased rather aggressively and regularly over the past six months. Recognizing that it is a matter of judgment, I do not think that the recent and current credit restraint in the markets can be attributed to a shortage of liquidity that has been induced by an overly restrictive monetary policy.

Credit Restraint

What constitutes a credit "crunch," to my way of thinking, is when creditworthy borrowers, those that would normally find it possible to obtain credit even under adverse economic circumstances, cannot obtain financing. This is not currently the case, at least in the Midwest. A "crunch" is most likely to occur when all lenders serving a particular class of customers find their lending capacity contracting. As a classic example of this phenomenon, before Regulation Q, which imposed ceilings on interest rates, was removed, this is precisely what happened to mortgage borrowers when interest rates peaked dramatically--the good, the bad, and the indifferent as a class were unable to obtain credit.

What currently exists is credit restraint--not a "crunch." But irrespective of this definitional difference, when bank borrowers experience a restraint on the availability of credit, this restraint could have an impact on the performance of our economy. Firms may scale back on their plans and the projects for which the bank funds would have been used; if enough firms are affected, economic growth in the aggregate could suffer. Large firms, however, are less likely to be affected by this sort of problem. They operate in national or even international markets with many alternative suppliers of credit and therefore have greater flexibility. Moreover, credit intermediation outside the banking system may indeed be mitigating the impact of reduced credit extension by commercial banks. This involvement extends beyond the very large borrowers. Our senior loan officer opinion survey indicates that small and middle market firms are increasingly finding finance companies to be an attractive alternative to domestic banks.

This trend toward nonbank credit extension is apparent in the data for the nation as a whole. Business lending by finance companies grew at an annual rate of 12 percent in 1990 while lending by domestic banks was virtually unchanged. Finance companies represent only one of several alternative lenders that have stepped in to act as shock absorbers for the domestic banking system. Large commercial firms are increasingly turning to alternatives like finance companies, foreign banks, and the commercial paper market. Moreover, new credit-related activities like asset-backed commercial paper and prime rate funds have provided business with additional alternatives. Ignoring these new sources of credit can leave the observer with an overly pessimistic view of the state of the credit markets. Good data on many of these emerging alternatives are only now being assembled. However, some of the work done at the Federal Reserve Bank of Chicago suggests that the extension of business credit on a national basis could be growing significantly more rapidly than was thought earlier. The point is that focusing only on bank lending and not taking into account the broader recycling of credit within the financial markets may obscure the overall picture. While in the past some of these alternatives may have been feasible only for large corporations, increasingly more modest-sized companies are turning to these sources. While smaller firms do not yet have access to all these alternatives, the reduced reliance of large borrowers on bank credit has the potential benefit of freeing more bank resources for smaller borrowers.

The Effect of Regulatory Policies on Credit Extension

While various regulatory policies, individually and cumulatively, certainly are exercising a restraint on credit extension, in the main, I do not think that the restraint has been regulatorily driven. Rather, we are experiencing a self-corrective process. There has been a marketplace reaction, and, as I noted earlier, bank managements have taken steps to deal with deteriorating asset quality and the recessionary environment. Though difficult to quantify, recessions do have an effect on lending attitudes separate and apart from the credit qualifications of the borrower; the same loan applicant that might have been approved during a strong economic expansion will be declined in a recessionary environment--lending officers will exercise a higher degree of caution during adverse times.

Capital requirements are certainly playing a role. In the early 1980s the Congress, regulators, and bankers began to be concerned that the banking industry did not possess a capital cushion that was adequate for the risks being taken. Regulators began pushing banks, particularly large banks, to increase their capital positions. The Congress registered its concern in 1983 when for the first time you gave regulators explicit statutory authority to set minimum capital requirements for banks. These efforts have had a positive result, and today, capital in the largest banking organizations is nearly twice the level of the early 1980s. As a result of this higher level of capital, the banking industry, which has undergone, and is continuing to undergo, a period of significant adjustment has, in the main, withstood some serious shocks better than anyone could have imagined only a few years ago. But in an environment in which it has been very difficult to raise capital in the markets and in which, because of intense competitive pressures and the need to provide reserves for loan losses, profitability has been reduced, the only other way of improving relative capital positions is to limit asset growth. Clearly this drive to increase capital is having an effect on the willingness of the banks to extend credit. But this is a constructive reaction and one that probably would have occurred without regulatory pressure. It is clear from the data that the better capitalized institutions have the ability to achieve greater asset growth and higher levels of profitability. To reiterate the point, improved capital positions will be absolutely critical to the health and well-being of the industry, and until capital has been increased to a point that bank managements and regulators alike feel is appropriate, this issue will have an inhibiting effect on the extension of credit.

Characteristics of the District

I noted at the outset that coming from the Midwest I might provide a different response to the thrust of your hearings than is the case in other parts of the county. The early 1980s was a particularly difficult period for our region. Our economy relies very heavily on manufacturing, and because of that we have always been highly cyclical. Economic recessions that affected the national economy had a considerably greater impact on our area. Our manufacturing sector bore the brunt of the 1980-82 recession; during this period the region's employment declined at roughly twice the national rate. Even after the recession ended, employment did not bounce back, largely because the sharp run-up in the value of the dollar in the exchange markets limited the export of the region's manufactured products into the global markets. Adding to the stress experienced by the manufacturing sector, the region's agricultural sector also underwent a major structural adjustment as the virulent inflation of the late 1970s and early 1980s was brought down to more moderate levels. These adjustments, and it would be hard to overemphasize the magnitude of the adjustments that we experienced during this period, had a major effect on the banks in the region. We experienced a very high level of bank failures during this period as the undercapitalized or weakly managed institutions were unable to adjust their positions. But our banking system came out of this period stronger and better capitalized, learned the risks associated with asset value lending and the importance of adequate cash flows for loan repayment, and is now able to deal with the recessionary environment with less stress than was the case before. Some observers suggest that banks in the District, having been conditioned by the region's adverse experiences, are better prepared to deal with the current recession. Nonetheless, if the recession is longer and deeper than is generally anticipated, our banks will not escape the difficulties that have emerged in other areas.

In our District, smaller banks are a primary source of credit for small and medium-sized businesses. As a consequence, their lending experiences are most likely to reflect conditions in the District as they pertain to this segment of the market. In the Seventh Federal Reserve District, commercial and industrial lending by smaller banks grew a little less than 3 percent in 1990, down from 4.7 percent during 1989. This slowdown in lending appears to have been driven largely by the weakness in key manufacturing sectors like the automotive industry, not by tighter credit standards. To support that point, commercial lending at small Michigan banks was virtually flat during 1990 after having grown 4 percent in 1989. In general, these smaller Michigan banks are well capitalized with a relatively lower level of criticized assets suggesting that, to a very great extent, the reduced level of credit extension is a reflection of reduced activity in the automotive industry. In states such as Wisconsin and Indiana, where the economy has remained relatively strong, business lending continued to grow at a healthy rate in 1990. This pattern of commercial lending suggests that credit extension to small business in the Midwest is being driven by a slowdown in manufacturing activity in the area and not by restrictive credit terms, and we are not likely to see a significant increase in bank lending until the economy moves into the recovery phase. This conclusion has been reinforced by recent interviews with a number of small businesses.

Historically, the states in our District have had a unit banking orientation, which is to say that branching or at least extensive branching was not permitted. This meant that some local markets, on occasion, may have experienced greater credit restraint than others because funds did not flow freely across the region from surplus to deficit areas. This has been changing, but still it is a feature of our market that differentiates the region from others where statewide branching has been permitted for quite some while. I might say, however, that there is an interesting alternative argument to this point. Some of our smaller markets are served mainly by the banks in their particular areas. Many of these banks have been a "source of strength" to their markets because they have not been adversely affected by some of the problems that have had an impact on the larger institutions, and therefore they have not had to restrain the extension of credit. Adding to this, the smaller banks in our area quite frequently have had better capital positions and therefore have not had to restrain asset growth as a way of improving their capital positions--simply put, unit banking cuts two ways.

Conclusion

To conclude, it is my opinion that the credit restraint that we are experiencing in the Midwest reflects an adjustment in the marketplace, and it is entirely possible that we are coming to the end of this phase. Barring a more adverse economic experience than is generally anticipated, I would expect to see a stabilization in asset quality, and that at some reasonably near-term point, and as the market process continues we will see an improvement in bank earnings. Capital positions, already significantly better than they were at the beginning of the last decade, will continue to show improvement, and as we go through this period the safety and soundness of the banking sector will be enhanced. This is absolutely fundamental to the economy of this country. A well-functioning economy experiencing good rates of sustained economic growth is dependent on a sound banking system. While in the short run the credit restraint that we have been experiencing has been difficult, particularly for those who have been denied credit, in the long term the overall economy will benefit from this significant transition. In the interim, while legislation to deal with the broad question of restructuring the financial system has become absolutely compelling, any specific legislative initiatives to deal with the credit restraint in an attempt to override the market process would seem ill-advised and would probably result in unintended distortions.