Statements to the Congress.

Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, August 9, 1990.

I am pleased to be here on behalf of the Federal Reserve Board to discuss real estate lending by commercial banks and its effects on their financial condition. The committee is, I am sure, well aware of the many problems that banks and other depository lenders have had with real estate loans in the past five years or so and is understandably concerned about the prospects of these problems continuing. In my comments I shall provide a brief overview of the trends and developments of real estate lending over this decade and then discuss the evolution of conditions in the real estate markets and the dimensions of the problems they have presented to banks. I will also address some supervisory considerations and the effects that recent actions by banks are having on the availability of bank credit.

COMMERCIAL REAL ESTATE LENDING IN THE 1980s

Real estate markets were generally robust over the decade of the 1980s. Growing demand produced sizable increases in property values and prompted substantial growth in construction of new commercial and residential structures. Commercial banks, thrift institutions, insurance companies, and other major lenders, including foreign institutions, played important roles in this process, providing funds for the construction and sale of new properties and for the transfer of ownership of existing properties at rising values.

For the decade as a whole, real estate loans at all commercial banks almost tripled, reflecting a particularly sharp rise in commercial and construction loans, while total assets of commercial banks grew at a much slower pace. By the end of the decade, real estate loans made up about 23 percent of total bank assets compared with less than 15 percent at the end of 1980. Commercial property and construction loans now account for roughly one-half of the $778 billion of total real estate loans held by commercial banks.

States in which the energy sector was large, particularly Texas, Oklahoma, Colorado, and Louisiana, were in the vanguard of the strong real estate expansion of the early 1980s. These strong economies stimulated sharp increases in construction of commercial and residential properties. Once under way, the construction boom maintained momentum even as the energy sector lost strength. This continued construction was encouraged by the substantial optimism that prevailed in these Sun Belt states arising from their increases in population and general income levels.

The ready availability of credit bolstered this process. Savings and loan associations in the region, seeking to overcome weak capital positions and deficient earnings, aggressively extended credit for many projects. Commercial banks in the region were also active in real estate lending, as they sought to replace revenues previously earned on loans to firms in energy and related sectors. Major banks from other areas of the country and abroad also added to the supply of credit.

Other regions, as well, found real estate lending attractive areas for growth. Responding to the general expansion in economic activity and the favorable tax laws embodied in the Tax Reform Act of 1981, real estate markets gained strength. From year-end 1980 to the end of 1984, commercial real estate lending nationwide grew at a rate roughly twice the pace of total bank assets. By the mid-1980s when Southwest real estate markets were beginning to slow, markets in most other parts of the country were still growing at a brisk pace. Here again, the general economic expansion and the willingness and ability of financial institutions, both domestic and foreign, to finance real estate projects on favorable terms played an important role.

By the end of the decade the pace of expansion had slowed. In the past few years, the supply of real estate has exceeded demand, with consequent effects on vacancy rates, property values, and rental rates. To date, these developments have been most pronounced in the New England region, although weak market conditions exist along much of the East Coast as demonstrated by high and rising office vacancy rates. Market conditions in some midwestern cities have also begun to show a marked loss of strength, and even the western states of California, Oregon, and Washington, long the beneficiaries of strong real estate markets, have begun to report increased office vacancy rates in at least some areas.

These weakening market conditions are reflected in higher real estate losses for banks. During 1989, real estate charge-offs at commercial banks rose 54 percent from the prior year to almost 3 billion and totaled $1 billion in the first quarter of this year alone. The Northeast (excluding the large New York City banks) has replaced the Southwest as the latest area of concern and accounted for almost one-half of the industry's first-quarter real estate losses. Nonperforming real estate loans also continued to mount, increasing 37 percent last year and another 8 percent, to $32 billion, in the first quarter of this year. Nonperforming real estate loans now account for nearly one-half of all nonperforming loans held by U.S. commercial banks.

REASONS FOR THE ROBUST REAL ESTATE MARKETS

Given the problems that certain types of real estate loans have caused and the risk they still present, it is fair to ask why banks pursued this strategy and how some of the large real estate loan problems seem to have surfaced so suddenly. While there are no single or simple answers to these questions, several factors played important roles.

Disintermediation. During the 1980s, U.S. commercial banks-especially the larger ones-increasingly lost the business of their larger and stronger commercial borrowers to the commercial paper and securities markets. In the Southwest, as previously noted, this loss was compounded when demands by energy-related firms dropped as oil prices started to come down.

Generally, the proportion of bank loans to commercial and industrial (C&I) borrowers declined over the decade, relative to other bank assets. During the last five years of the 1980s, for example, these loans fell from 20 percent of assets to 17.6 percent, with the New York money center banks much more severely affected. Increased real estate lending offered a way to offset revenue losses in other parts of their loan portfolios and to bolster overall earnings. Increased Fee Income. Banks were also attracted to real estate loans because of the substantial fee income they could earn on these loans. Fees on real estate loans are typically higher than those on other types of corporate credits, and before accounting standards changed in 1988, many of these fees could be recorded up-front," providing an immediate boost to earnings. In other cases, the fees provided, besides immediate income, an ongoing source of revenues. Strong Demand. Demand for residential structures and for additional office, retail, and industrial properties rose rapidly in various areas in the middle part of the decade. Office space in the early 1980s, for example, was far below that needed for the decade. Looking back to the 1970s, developers and many others, including lenders, had the view that inflation would work to make almost all projects profitable. In the face of the relative shortage, developers moved decisively to put in place added structures. Supply soon began to catch up with demand, and during the last half of the decade 40 percent more office space was built than absorbed. Tax law treatment introduced with the 1981 law and kept in place until the reform of 1986 also contributed to the building boom by subsidizing the cost of real property. Some analysts estimate that before the new law more than half of the return to taxable investors came from tax benefits rather than from higher economic values. Increased demand from abroad for U.S. real estate holdings also supported property values and helped to encourage new construction.

EFFECT OF STRONG LENDER COMPETITION ON CREDIT AVAILABILITY AND LENDING TERMS

The perceived need to find new business, the ability to generate real estate loans, and the appeal of larger fee income combined to encourage aggressive real estate lending. These factors, plus generally overly optimistic market assessments, produced favorable borrowing conditions for developers. It also led, in many cases, to more liberal underwriting standards. Some banks failed to assess realistically the economic soundness of specific projects and cash flow projections.

Construction loans that historically had been made on the basis of preleased space and prearranged permanent financing were now made without those features and largely on the basis of past relationships and on the appraised value of the underlying property. Borrower equity in projects was often minimal, and appraisals supporting the loans were sometimes based on revenue projections that did not materialize. With steady or, indeed, robust economic growth and rising real estate prices, lenders felt pressured to match "prevailing" market terms and unduly relied on the projected value of collateral as protection against loss. Some expanded nationwide, extending credit in markets in which they lacked experience.

Many lenders also seem to have focused on the strength of specific projects without giving appropriate consideration of total market conditions. Although the latest projects they were financing may have been successful, many were so only because they drew tenants from existing buildings and related problems elsewhere. Office gluts and generally lower operating costs in the Southwest and other regions of the country have enticed some companies to relocate from highcost areas, further weakening real estate markets that were already beginning to slow. Such a pattern may help cities like San Antonio and Houston revive, but only increases pressures on higher cost cities like Stamford, which already has the nation's highest metropolitan area office vacancy rate at 30 percent.

The expanded investment powers for thrift institutions may also have changed the nature, as well as the level, of competition. Besides simply increasing the supply of credit available for real estate construction, these changes introduced new competitors that at least initially were inexperienced in commercial real estate lending and unable to adequately evaluate the risks. Thrift institutions holding equity interests had different incentives than typical lenders and often focused on the potential gains from their ownership roles and extended credits they might otherwise have denied. As long as market conditions were favorable, these actions influenced market terms.

The result of these developments has been overbuilt real estate markets in which financial institutions have been forced to finance buildings beyond the time they originally envisioned, to accept significant concessions on rents, and to face vacancy rates much higher than planned. In these circumstances, the value of the banks's collateral-often only the real estate itself-has been reevaluated on the basis of existing market conditions and has led to significant write-downs of many loans.

BANK SUPERVISION

As bank supervisors, the Federal Reserve and the other federal and state banking agencies have the responsibility to review the activities of financial institutions and to enforce sound lending and operating procedures. Doing that requires sufficient resources to attract and retain qualified personnel and the institutional will to enforce the standards set. The atmosphere of deregulation in the early 1980s led to budgetary pressures at some agencies and, in some instances, to less supervisory oversight. These effects were most severe regarding the supervision of thrift institutions.

Of course, adequate resources and resolve are not all that we need. Even under ideal conditions, concentrations in certain types of credits will occur because of the process we have. Bank regulatory agencies generally try to minimize their influence on credit allocation decisions and, as a general rule, do not impose limits on the different types of loans banks should make. We do, however, evaluate the policies and activities of individual banks but try to avoid substituting our credit judgments for theirs in lending decisions unless the need to intervene is clear. I would stress that we clearly recognize our role in protecting the federal safety net and minimizing risks that insured deposits present to taxpayers. Balancing those concerns with the objective of avoiding unnecessary interference in bank lending activities is a constant challenge to bank supervisors.

This supervisory approach recognizes that the long-term interests of the economy are best served when lending decisions are made by private institutions, not government agencies. As private institutions, their own capital is first at risk, and they are more familiar with and better able to determine the credit needs of their customers than are bank examiners and other supervisory personnel.

The Federal Reserve has long had the view that a strong supervisory process is built upon a program of frequent on-site examinations that, in turn, is centered on an evaluation of asset quality. Accordingly, a key function of the examiners is to evaluate credits and ensure that banks reflect assets at appropriate values in their financial statements. While we leave credit decisions to banks, the effects of their decisions must be promptly and accurately reflected so that management receives the information it needs to respond prudently.

Recently, there has been specific interest in the procedures that examiners use to evaluate real estate credits. I would say a few words about them. As with any loan, examiners first check to determine if the loan is current; that is, that the borrower has made all required payments. Examiners will then review the credit file, which should include financial statements of the borrower, a description of relevant terms of the loan, and full documentation on any collateral or guarantees that the bank holds to cover its risk. Real estate loans are typically collateralized, at least in part, by the project being financed, and a current appraisal of the value of that property should be included in the file or otherwise available at the bank. The file should also include information supporting the value of any other collateral the borrower has provided.

Examiners will criticize any loan for which documentation is outdated or incomplete or for which the borrower's ability to pay is otherwise uncertain. Real estate appraisals should be based on current market conditions and should demonstrate that the project is economically viable. Even current loans, or portions thereof, are subject to criticism if the current or likely cash flow provided by the project is insufficient to service the loan fully. That may happen, for example, if current payments are being made from an interest reserve created from proceeds of the bank loan and the assumptions on which the loan was made no longer reflect market conditions. Indeed, any appraisals that are not realistic are ordinarily discounted and could lead the examiner to criticize the loan.

While examiners urge adherence to sound banking practices, there are practical limits to the achievement of this objective. Maintaining diversification is a good case in point. To a greater or lesser extent, all financial institutions will be affected by local conditions that may broadly affect their activities. With roughly one-quarter of U.S. bank assets devoted to financing real estate, local conditions will almost certainly affect that part of their business.

Many of the real estate losses that banks have recently experienced have been identified by rigorous supervisory reviews, or of bank management's preparation for one. Some banks have been hit hard by these examinations; others have come through quite well. Most banks, though, are acknowledging that the real estate markets have changed and have reviewed and tightened their lending procedures. The effect is painful now, but it will be beneficial for the long term. It win also reduce the risk they present to the federal safety net.

AVAILABILITY OF BANK CREDIT

Under present conditions, the Federal Reserve has been concerned that creditworthy borrowers continue to have adequate access to bank credit and has monitored credit markets closely. In that connection, the Chairman of the Federal Reserve, along with the Chairman of the Federal Deposit Insurance Corporation and the Comptroller of the Currency, met in May with bank representatives to stress the importance to the economy of continued lending and to clarify that supervisory actions are not intended to prevent new loans.

In subsequent testimony Chairman Greenspan and I both indicated that while lenders had tightened their standards there did not appear to be a broad-based squeeze on credit but noted that the Federal Reserve was monitoring the situation closely. More recently, evidence is building that conditions have become weaker. It is difficult to determine what part of the slowdown derives from higher credit standards versus less loan demand. As the Chairman stated in his testimony of July 18, however, lending standards seem to have tightened too much. The Federal Reserve has recently taken some steps to offset the effect of these tighter lending standards.

SYNDICATIONS

Questions have been raised regarding the use of loan syndications in funding real estate assets. In this regard, it should be noted that banking organizations rarely syndicate real estate loans in the same sense as they do in other types of loans, including highly leveraged transactions. Real estate loans involving more than one lender typically involve participations in which one lender originates the loan and sells or assigns parts of it to one or more institutions. In true syndications, several institutions originate the loan, and any one of them can then participate out its own interest.

In either form, a lead lender generally has the responsibility to administer the loan and to ensure that the other lenders receive sufficient information to make independent credit decisions-both before the loan is brought and throughout the period that it is outstanding. Indeed, other borrowers have the responsibility to make independent decisions about the creditworthiness of the borrower and should not rely solely on the representations of the seller. Typically, the sales agreements include provisions that require participating lenders to attest to having made such independent reviews.

CONCLUSION

Unfortunately, real estate loans are only one of the significant risks that banks in this country face. Loans to highly leveraged borrowers and to developing countries cannot be ignored. The current slowdown in real estate markets will have a dampening effect on economic activity that will be felt unevenly nationwide.

The problems that financial institutions are experiencing at this time merely illustrate the risks and uncertainties inherent in lending funds. Strong bank management and an active and sound supervisory process will help prevent many problems. Many others, however, will still exist. It is critical that banks have sufficient equity capital to support the risks they take-both to ensure their own survival and to protect the federal safety net. Ensuring adequate bank capital is an important objective of supervision and remains an important priority of the Federal Reserve.

Statement by Henry Terrell, Senior Economist, Division of International Finance, Board of Governors of the Federal Reserve System, before the Task Force on the International Competitiveness of U.S. Financial Institutions, Subcommittee on Financial Institutions Supervision, Regulation and Insurance of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, August 2, 1990.

I appreciate the opportunity to appear before this Task Force on the International Competitiveness of U.S. Financial Institutions to discuss the results of some of the research that my colleagues and I have conducted on the activities of the U.S. agencies and branches of Japanese banks. I want to stress that my statement is as a research economist employed at the Federal Reserve; my conclusions do not represent policy positions that have been endorsed by the Board.

U.S. agencies and branches of Japanese banks had total assets of about $360 billion as of year-end 1989, or about 10 percent of the assets of all banking institutions domiciled in the United States, and somewhat more than one-half of the total assets of $580 billion of all U.S. agencies and branches of foreign banks. Agencies and branches of foreign banks are integral parts of their parent banking organizations with lending limits based on the worldwide capital of their parent. Agencies differ from branches in that their deposit-taking powers are more limited. While my remarks cover only the activities of the agencies and branches of Japanese banks, as of year-end 1989 U.S.-chartered banks that were majority-owned by Japanese banks had an additional $60 billion in total assets. These subsidiary banks differ from the agencies and branches in having lending limits based on their own capital and tend to be more heavily oriented toward retail banking activities. I will suggest this morning that the growth of the activities of the Japanese agencies and branches in the United States has, in large part, been affected by economic and financial factors in the United States and Japan. Until recently, restrictions on the ability of Japanese banks to offer their domestic Japanese customers market-determined interest rates on deposits appear to have had the effect of inducing Japanese banks in the aggregate to shift some domestically oriented business to their U.S. offices because the low regulated interest rates in Japan caused funding difficulties, and Japanese banks actually relied on their overseas branches for funds for use at their domestic offices. This fact suggests that Japanese banks were not on balance borrowing low-cost funds in Japan and relending them in the United States at low rates. Table 1, derived from the regular U.S. Call Report for the U.S. agencies and branches of foreign banks, reviews the growth of the major asset categories of the agencies and branches of Japanese banks in the nine-year period from year-end 1980 through year-end 1989.1 During that nine-year period, the assets of these agencies and branches increased fivefold. Besides rapid growth of their balance sheet assets, in more recent years there has also been a rapid increase in the off-balance-sheet activities of these institutions, as shown by the increase in the amount of their standby letters of credit since 1985. Loans, totaling nearly $160 billion, constitute the largest single asset item, with cash and due from banks, largely reflecting clearings and other interbank transactions, representing another $100 billion. Examining more detail on the loan portfolio of the U.S. agencies and branches of Japanese banks shows that commercial and industrial loans, largely to borrowers identified as U.S. residents, were $90 billion, with loans to financial institutions of about $30 billion being the second largest loan category, again reflecting the important interbank activities of these institutions. Some of these commercial and industrial loans were originated by U.S. banks and were purchased by the Japanese agencies and branches, including loans for highly leveraged financial restructurings. U.S. banks, of course, earned fees on these transactions. In recent years Japanese agencies and branches have expanded their loans secured by real estate to about $20 billion, but our data sources do not permit a distinction in these loans between loans for U.S. real estate (including loans financing Japanese purchases of U.S. real estate) or loans secured by real estate in other countries including Japan. Loans to foreign governments constitute a small and declining share of total loans. Japanese banks booked many of their loans to developing countries in the early 1980s at their U.S. offices and, like banks from other countries, many of these loans have been sold, written off, or repaid. For data showing the major funding sources for the U.S. offices of Japanese banks, interbank transactions are reported on a net basis, with a positive number for net liabilities indicating a net source of funds to the agencies and branches and a negative number representing a net use of funds. This distinction is important to separate funding sources from interbank trading activities that gross up both sides of balance sheets. The reporting of some important categories on a net basis means that the totals will be less than the asset totals, which include interbank activities on a gross basis. The largest single source of funds for the Japanese banks is net borrowing from banking offices in the United States of about $55 billion, with net borrowing from banks outside the United States of about $25 billion being another important source of funds. Deposits from nonbank U.S. and foreign sources amounted to only about $35 billion, equivalent to only about one-fourth of their total loans to nonbank parties.

Data on funding relations between the U.S. agencies and branches of Japanese banks and their related offices outside the United States show that, on balance, as of year-end 1989, U.S. agencies and branches of Japanese banks were receiving about $25 billion net from their related offices outside the United States. However, that $25 billion in funding from related offices was accounted for by nearly $60 billion in net liabilities to related offices outside Japan, largely in offshore centers and in London, and a net claims position of almost $35 billion with their parent bank in Japan. Stated slightly differently, the U.S. agencies and branches of Japanese banks borrowed (net) about $60 billion from their related offices in non-Japanese markets, retained about $25 billion for use in their U.S. business, and onlent the remaining $35 billion to their parent bank in Japan. Since the source of funding to the offshore branches of Japanese banks is largely the Eurodollar market, including the issuance of Eurodollar CDs, these net borrowings by U.S. agencies and branches of Japanese banks from their related offices would appear to represent a market-based source of funding for both their U.S. office lending and their home country activities. Having briefly described the activities of these institutions, it is useful to try to analyze the factors over time that have motivated Japanese banks to expand their U.S. activities rapidly during this past decade. In our statistical research we used an approach that considered both the "pulls" of opportunities in the domestic U.S. banking market as well as "pushes" from Japanese economic variables. In the former case our research found a statistical correlation between faster economic growth in the United States and faster asset growth of the U.S. offices of Japanese banks.

Our research also found a very strong relationship between Japanese economic variables and the asset growth of U.S. agencies and branches of Japanese banks. The important influence of Japanese economic variables on the activities of the U.S. agencies and branches of Japanese banks was expected because of the heavy concentration of Japanese risk in their asset portfolios. As of year-end 1989, about one-third of the total assets of U.S. agencies and branches of Japanese banks were direct claims on residents of Japan. However, when the country risk of the portfolio is reallocated to the country of the ultimate obligor, rather than to the country of the nominal borrower, the share of Japan risk in the portfolio of the agencies and branches of the Japanese banks increases to about two-thirds. This reallocation of risk occurs primarily in two ways: First, a large proportion of Japanese bank lending in the United States to nonbank borrowers is to U.S. affiliates of Japanese companies; and second, a significant amount of the large interbank activities of Japanese banks in the United States is with other Japanese banks.

In our work two principal domestic Japanese variables were found to be important determinants of the U.S. activities of Japanese banks: (1) the aggregate level of Japanese international trade, measured as the sum of Japanese exports plus Japanese imports, and (2) the degree of restraint on interest rates in the domestic Japanese banking market. The impact of international trade is rather straightforward; a large proportion of all Japanese international trade is financed in U.S. dollars at the U.S. offices of Japanese banks. The degree of restraint on banking in Japan captures the extent to which domestic Japanese restraints on the payment of competitive rates of interest on bank deposits have provided incentives for Japanese banks to shift banking business that might otherwise have been conducted in Japan to offshore (non-Japanese) centers.

The impact of restraints on banks' ability to pay full market interest rates on deposits can be twofold. First, to the extent that banks are able to obtain funds at lower interest rates than otherwise in the regulated market, their overall cost of funding will be reduced, and the banks will enjoy a competitive advantage if they are able to lend these low-cost funds at market-determined rates. Since lending rates in Japan have not been fully market determined, some of the subsidy of low-cost deposits was passed through to local Japanese borrowers and did not accrue to the banks. A second, and offsetting, effect of restraints on interest rates on deposits is that, from the point of view of investors, regulated deposits at banks carry inferior returns relative to unregulated financial instruments offered by other intermediaries, including insurance companies, and pension funds, as well as deposits offshore and other foreign financial investments. To the extent that investors elect to place their funds with other intermediaries offering higher yields, banks will actually suffer a competitive loss of business.

Restraints on interest rates that Japanese banks were permitted to pay appear to have affected their ability to fund their domestic loan portfolio in the Japanese domestic deposit market during a period when investors were being offered increasingly attractive alternatives to domestic bank deposits. At year-end 1982, deposits at Japanese banks' domestic offices exceeded their total loans. During the subsequent five years, through year-end 1987, interest rates that banks in Japan were permitted to offer lagged behind market clearing rates. Correspondingly, growth of deposits at banks in Japan lagged behind the growth of demand for loans at Japanese banks' home offices. Japanese banks appear to have responded to this excess of loan demand above their ability to acquire deposits at their offices in Japan in two ways. Their first response appears to have been to use their offshore offices, including their offices in the United States, to book some of the loans that otherwise would have been booked at the banks' domestic offices but which the domestic offices were unable to fund because of the restraints on deposit interest rates. Their second response appears to have been to use borrowings from their offshore branches, located in London as well as in other offshore centers, to supplement their domestic deposit sources.

During most of the 1980s there has been a correspondence between the excess of loans over deposits at banking offices in Japan and net borrowings by domestic offices of Japanese banks from their foreign branches. The correspondence is only approximate and not perfect, since other asset items, such as securities, and other sources of funds, such as borrowings in interbank markets or from the Bank of Japan, can balance the difference between bank deposits and loans.

At year-end 1987, the net liabilities of domestic offices of Japanese banks to their foreign branches peaked at slightly more than $130 billion, which was roughly equal to the difference between loans and deposits at the domestic offices of Japanese banks. In the two-year period since year-end 1987 there have been several liberalizations of the restraints on interest rates payable in the domestic Japanese market, which have increased the share of bank deposits with unregulated rates. Moreover, there have also been improvements in the competitiveness of the interbank call money market in Japan in which auction rates are more freely quoted. In this two-year period of liberalization of domestic interest rates, both net borrowings by Japanese banks from their foreign branches and the excess of domestic office loans over deposits have declined.

In summary, during the 1980s, the evidence does not suggest that the growth of Japanese banks in the United States was financed by low-cost deposits raised in their home market. While lower-cost domestic office funding may, to some extent, have aided the profitability of Japanese banks in their domestic business, the impact of the regulated interest rates for banks in Japan in this period appears to have provided incentives to Japanese banks to shift some of their lending and interbank business, including transactions with Japan-based entities, to the United States, because of regulations on interest paid on deposits. The U.S. activities of agencies and branches of Japanese banks are, in fact, largely funded by large net interbank borrowings in the United States and abroad, and by advances from their related offices in London and in other offshore centers, neither of which is a low-cost source of funding.

Having discussed the factors that appear until now to have motivated Japanese banks to expand their U.S. activities, it may be useful to note several potential factors that might influence the future growth of their activities in the United States.

First, the continued deregulation of interest rates in the Japanese domestic banking system should make it more efficient for Japanese banks to conduct a greater proportion of their domestic banking business, including interbank trading, in Japan.

Second, under pressure to meet the capital standards of the Bank for International Settlements, Japanese banks may decide to reorient their business practices away from growth toward higher profitability to attract capital. Some of their U.S. activities reportedly carry relatively low profit margins and could be candidates for restructuring.

Third, recent research suggests that the largest Japanese corporations are increasingly choosing to finance themselves through capital market issues, and, thus, are becoming less reliant on their main banks for funding. This shift in Japanese corporate funding patterns is similar to what has happened in the United States, which resulted in some reduction in bank intermediation and slowed the growth of U.S. banks; it could affect Japanese banks, including growth in lending at their U.S. offices because, in the past, large Japanese companies have been major borrowers from the U.S. offices of Japanese banks.

Fourth, the market for consumer banking in Japan, including credit cards and other types of consumer loans, has been relatively underdeveloped, and some Japanese banks may choose to redirect their growth toward this relatively higher margin activity. from their related offices in London and in other offshore centers, neither of which is a low-cost source of funding.

Having discussed the factors that appear until now to have motivated Japanese banks to expand their U.S. activities, it may be useful to note several potential factors that might influence the future growth of their activities in the United States.

First, the continued deregulation of interest rates in the Japanese domestic banking system should make it more efficient for Japanese banks to conduct a greater proportion of their domestic banking business, including interbank trading, in Japan.

Second, under pressure to meet the capital standards of the Bank for International Settlements, Japanese banks may decide to reorient their business practices away from growth toward higher profitability to attract capital. Some of their U.S. activities reportedly carry relatively low profit margins and could be candidates for restructuring.

Third, recent research suggests that the largest Japanese corporations are increasingly choosing to finance themselves through capital market issues, and, thus, are becoming less reliant on their main banks for funding. This shift in Japanese corporate funding patterns is similar to what has happened in the United States, which resulted in some reduction in bank intermediation and slowed the growth of U.S. banks; it could affect Japanese banks, including growth in lending at their U.S. offices because, in the past, large Japanese companies have been major borrowers from the U.S. offices of Japanese banks.

Fourth, the market for consumer banking in Japan, including credit cards and other types of consumer loans, has been relatively underdeveloped, and some Japanese banks may choose to redirect their growth toward this relatively higher margin activity.

1. The attachments to this statement are available on request from Publications Services, mail stop 138, Board of Governors of the Federal Reserve System, Washington, D.C. 20551.