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Statement by Richard F. Syron, President, Federal Reserve Bank of Boston, Before the Committee on Small Business, U.S. House of Representatives, July 2, 1992.

Statement by Richard F. Syron, President, Federal Reserve Bank of Boston, before the Committee on Small Business, U.S. House of Representatives, July 2, 1992

I appreciate this opportunity to appear before you to discuss questions about the current availability of credit and bank capital standards. I would like to emphasize at the outset that these views are my own and not necessarily those of the Federal Reserve System. In the interest of your time, I propose making a fairly brief statement and request that our Annual Report, which focuses on this issue in more detail, be included in the record. (1)

The past recession and the ongoing recovery have been unusual because of the financial difficulties in the banking sector. These difficulties may also have constricted the lending critical to a successful recovery. Bank lending policies during much of the 1980s were too lax, undoubtedly contributing to a real estate bubble in several regions of the United States. Reversing past laxity is both desirable and prudent. However, it is essential that in addressing this past laxity we avoid overreacting in a way that may dampen economic growth.

Today I will outline what I believe should be the appropriate use of bank capital, that is, to cushion economic shocks during periods of economic distress. However, I will argue that in some cases capital regulation has penalized banks for bad loans, that is, for bets lost, rather than for increased risk in the portfolio, that is, for bets taken.

Undeniably, many banks built up too little capital during the 1980s, and I am in favor of generally improved capital positions. My concern, however, is that this be done in a way that is consistent with the needs of the economy. I will conclude on a positive note. We are seeing some improvements in the ability of banks to raise new capital, as well as greater appreciation of the macroeconomic impact of capital regulations.

THE ROLE OF CAPITAL

Bank capital should be a financial shock absorber, drawn down during periods of economic distress and replenished when economic circumstances improve. In the past, when large loan losses occurred, the majority of banks drew down their capital while continuing to finance projects that would improve their future earnings. This role for capital is currently in danger, however, because of economic and political forces evolving from the savings and loan debacle.

The extent of the taxpayer bailout of the Savings and Loan Insurance Fund, coupled with the financial condition of many commercial banks, has changed the perception of the appropriate role of capital. Increasingly, bank capital is seen primarily as providing a cushion for the deposit insurance fund rather than a buffer for the economy. In this environment it is attractive to require substantially more capital per dollar of assets to reduce taxpayers' potential future exposure to problems in the banking industry. I agree that higher target capital ratios should be implemented for many banks, but how and when capital standards are raised has important implications for the economy.

Regulation of bank capital has undergone many changes recently. The Basle Accord, which I consider a significant step forward, provided international standards for commercial banks. It promoted a more even playing field among banks, whose operations increasingly cross national boundaries, and it explicitly recognized the large risks to banks that could arise from off-balance-sheet items. The objective of these new regulations was to better match bank capital with the risks inherent in the bank's assets. Because banks with riskier portfolios have a greater probability of large losses, requiring higher capital for riskier institutions is a substantial improvement.

Because asset classifications under the Basle Accord were not sufficiently precise to adjust for all types of risk, and in particular because interest rate risk was not incorporated into the original ratios, regulators adopted an additional requirement for U.S. banks, the "leverage ratio." This ratio sets a minimum capital-to-asset ratio of 3 percent for institutions with the best supervisory rating but does not weight the assets of the bank according to risk. The leverage ratio was intended to provide a floor for bank capital that all banks were expected to satisfy, regardless of risk. Unfortunately, implementation of the leverage ratio requirement has caused some unforeseen problems.

First, higher leverage ratios have been required for banks that have been downgraded on the basis of loan losses. Although this would seem to be common sense, the raising of capital standards to reflect current and past problems rather than prospective problems related to asset risk may well have caused bank lending to become procyclical.

Second, for many institutions, particularly for those in New England, this leverage ratio adjusted for the condition of the bank has become the most binding capital ratio, making the risk-weighted capital ratios irrelevant. New England was the first region that experienced both a dramatic decrease in bank capital and the effects of the new bank capital regulations. Its experience suggests some ways in which the new approach should be modified.

In my view, the better approach would be to determine the appropriate risk-based capital ratios for an institution ahead of time and then stick to them. Reducing these ratios to allow for losses would be forbearance that I would object to. However, increasing the ratios in response to actual losses creates a procyclical problem. In short, I believe the target should be based on future risks rather than on realized losses.

THE EFFECTS OF CHANGING CAPITAL RATIOS IN NEW ENGLAND

The New England economy would be experiencing problems even if no difficulties had occurred in the banking sector. Slower defense spending, regional concentrations in shrinking sectors of the computer industry, and the restructuring of the financial services industry made New England more sensitive to an economic downturn than the rest of the United States. Nonetheless, the regional recession clearly has been compounded by problems in banking and real estate.

The Boston District has suffered a much more severe decline in employment in the recent recession than any of the other Federal Reserve Districts. In addition, those other regions that experienced banking problems and a slowdown in real estate prices, such as the Mid-Atlantic states, have also shown significant declines in employment.

The current problems in New England actually began in the 1980s. New England commercial banks expanded rapidly, doubling assets between 1984 and 1989. Much of the growth was due to real estate loans, which grew 370 percent in New England over this period, much faster than in the nation as a whole. Bank financing of the real estate boom in New England significantly increased bank exposure to risk. Although the boom in New England enabled the region's commercial banks to increase their capital, their assets grew so fast that they achieved only modest increases in their capital-to-asset ratios.

In retrospect, this was an significant missed opportunity. Had institutions chosen to improve their capital-to-asset ratios by growing more slowly, they would likely have expanded less aggressively in construction and commercial real estate loans, whose value eventually declined significantly. If, in addition, they had chosen to raise new capital while their prospects were good and their stock prices high, they would have had a much larger buffer when the real estate bubble burst. It should be recognized, however, that real estate was seen in the 1980s as a much more secure investment than it is today.

Because their capital had not risen enough during the good times, banks were inadequately prepared for the bad times. Ideally, banks set loan-loss reserves to anticipate any expected loan losses and maintain equity capital as a reserve against anticipated loan losses. Unfortunately, in retrospect, neither reserve was raised sufficiently during the real estate boom. Futhermore, during the ensuing bust, as banks depleted their capital by writing off bad real estate loans, we began to require troubled banks to achieve higher leverage ratios than banks that had yet to experience difficulties.

Ideally, poorly capitalized banks would raise new equity quickly to replenish their capital. Because most troubled banks have small or negative earnings, restoring capital by retaining profits is not feasible. Similarly, new equity issues may not be a feasible alternative because potential investors cannot make accurate assessments of troubled banks without an indepth appraisal of the loan portfolio. Thus, banks that have recently lost capital but are still viable have difficulty convincing investors that prospects for the future, rather than problems of the past, motivate the new equity issue. When new equity issues are not feasible for capital-depleted banks, they are forced to shrink. (Although the capital-to-asset ratio of New England banks has been increasing in the past two years, this improvement is primarily the result of shrinking assets rather than of capital growth.)

Recently, efforts to shrink have caused some banks to downsize in ways that can impair the long-run prospects of the institution and the local economy it serves. Banks not only reduce their new lending but also cut back on current lending, either by demanding repayment of outstanding loans or by refusing to renew credit. This is a greater problem for small businesses, which are more dependent on local bank financing, than for larger businesses, which have better access to national credit markets.

Research conducted at the Federal Reserve Bank of Boston has found that poorly capitalized institutions have shrunk more than their better capitalized competitors. This research also reveals that banks that are required to increase capital levels over a very short period reduce their lending activity more than would be expected at this stage of the business cycle, even after controlling for mergers, loan sales, and loan reclassifications.

With so many institutions short of capital, some banks have begun to examine "gimmicks" as possible ways to satisfy the leverage ratio. For example, a bank can shrink artificially by moving securitized assets into nonbank subsidiaries. This practice has perverse results for the Federal Deposit Insurance Corporation (FDIC). The least liquid and most risky assets remain in the bank under the FDIC insurance umbrella, while the more liquid and less risky assets are removed from the bank. Should this strategy be adopted by many institutions, eventually the FDIC will be insuring much riskier institutions than it has in the past.

CONCLUSION

In my judgment, bank capital should return to its historical role of serving as a shock absorber. This can best be achieved by allowing risk-weighted capital ratios to return to center stage. All banks should be required to satisfy the risk-weighted capital ratios agreed upon in the Basle Accord, and in addition a flat 3 percent or 4 percent leverage ratio. If the leverage ratio were no longer adjusted upward for bets lost and were restored to its original role of providing a floor for bank capital regardless of risk, most institutions could focus once again on the risk-weighted capital ratios. Once interest rate risk has been incorporated into the risk-weighted ratios, the leverage ratio could be eliminated.

I am hopeful that the situation is now improving. All of us are coming to recognize the macroeconomic impact of regulatory policy. This is most essential if banks are to help finance the economic recovery.

The financial condition of New England banks is also improving. Several large banks in the region have recently announced new stock issues. The higher stock prices of many New England banks should provide an opportunity for more banks to raise capital with new equity issues. Improved capital positions will not only reduce the FDIC's possible exposure but should also enable banks to return to the business of making loans to creditworthy borrowers.

1. See Federal Reserve Bank of Boston, Annual Report 1991 (FRB Boston, n.d.).
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Title Annotation:Statements to the Congress
Publication:Federal Reserve Bulletin
Article Type:Transcript
Date:Sep 1, 1992
Words:1941
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