Statements to the Congress.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Commerce, Consumer, and Monetary Affairs of the Committee on Government Operations, U.S. House of Representatives October 3, 1990.

I am pleased to appear before the committee to discuss deposit insurance reform. The issue has increasingly come to the attention of the Congress and the media as the cost of resolution of failed thrift institutions becomes more apparent and as various government and private reports focus on the potential liabilities facing the Bank Insurance Fund. Last year the Congress mandated a study of the issues by the Treasury. This study, in which the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and other agencies will be active participants, will be published later this year or early next. But hearings on the issues now by this and several other committees of the Congress will, I hope, sharpen the focus on the need for legislation promptly after the release of the Treasury report.

Your letter of invitation, Mr. Chairman, focuses on the issues associated with the feasibility, benefits, and risks of some reduction in insurance coverage and the associated potential for enhanced depositor discipline. The Board has considered these highly complex and important questions on several occasions. My statement today will summarize our views on this approach to the problem, but the Board believes it is important for the Congress to review options other than reduced insurance coverage to address the root cause of the taxpayer exposure and the potential financial market distortions associated with our present deposit insurance and supervisory approaches.

As you know, Mr. Chairman, the Board also believes that deposit insurance reform is intimately related to the pressing need to modernize our banking system in other ways. The erosion of the domestic and international competitive position of U.S. banks must be addressed by expanded permissible activities and wider geographical branching powers, and we believe that legislation in this area should be joined with deposit insurance reform. I have presented the Board's proposals on these subjects before the Senate and House Banking committees this summer. Given the narrower focus of the hearings today, and the additional witnesses this morning, I have omitted a detailed delineation of the Board's modernization proposals, but I nevertheless want to underline their importance, with the strong endorsement that these issues should, in the Board's view, be considered jointly with deposit insurance reform by this committee and by both Houses of the Congress.

The fundamental problems with our current deposit insurance program are clearly understood and are, I believe, subject to little debate among those with drastically different prescriptions for reform. The safety net-deposit insurance, as well as the discount window--has so lowered the risks perceived by depositors as to make them relatively indifferent to the soundness of the depository recipients of their funds, except in unusual circumstances. With depositors exercising insufficient discipline through the risk premium they demand on the interest rate they receive on their deposits, the incentive of some banks' owners to control risktaking has been blunted. Profits associated with risktaking accrue to owners, while losses in excess of bank capital that would otherwise fall on depositors are absorbed by the FDIC.

Weak depositor discipline and this moral hazard of deposit insurance have two important implications. First, the implicit deposit insurance subsidy has encouraged banks to enhance their profitability by increasing their reliance on deposits rather than capital to fund their assets. In effect, the deposit insurance funds have been increasingly substituted for private capital as the cushion between the asset portfolios of insured institutions and their liabilities to depositors. A hundred years ago, the average ratio of equity capital to assets of U.S. banks was almost 25 percent, approximately four times the current level. Much of the decline over the past century no doubt reflects the growing efficiency of our financial system. But it is difficult to believe that many of the banks operating over recent decades would have been able to expand their assets so much, with so little additional investment by their owners, were it not for the depositors' perception that, despite the relatively small capital buffer, their risks were minimal. Regulatory efforts over the past ten to fifteen years have stabilized and partially reversed the sharp decline in ratios of bank equity to capital assets. This has occurred despite the sizable write-off of loans and the substantial buildup in loan-loss reserves in the last three years or so. But the capital ratios of many banks are still too low.

Second, government assurances of the liquidity and availability of deposits have enabled some banks with declining capital ratios to fund riskier asset portfolios at a lower cost and on a much larger scale, with governmental regulations and supervision, rather than market processes, the major constraint on risktaking. As a result, more resources have been allocated to finance risky projects than would have been dictated by economic efficiency.

In brief, the subsidy implicit in our current deposit insurance system has stimulated the growth of banks and thrift institutions. In the process the safety net has distorted market signals to depositors and bankers about the economics of the underlying transactions. This distortion has led depositors to be less cautious in choosing among institutions and has induced some owners and their managers to take excessive risk. In turn, the expanded lending to risky ventures has required increased effort and resources by supervisors and regulators to monitor and modify behavior.

But in reviewing the list of deficiencies of the deposit insurance system, particularly if an increased role for depositor discipline is contemplated, we should not lose sight of the contribution that deposit insurance has made to macroeconomic stability. The existence and use of the safety net have shielded the broader financial system and the real economy from instabilities in banking markets. More specifically, it has protected the economy from the risk of deposit runs, especially the risk of such runs spreading from bank to bank, disrupting credit and payment flows and the level of trade and commerce. Confidence in the stability of the banking and payments system has been the major reason why the United States has not suffered a financial panic or systemic bank run in the last half century.

There are thus important reasons to take care as we modify our deposit insurance system. Reform is required. So is caution. The ideal is an institutional framework that, to the extent possible, induces banks both to hold more capital and to be managed as if there were no safety net, while at the same time shielding unsophisticated depositors and minimizing disruptions to credit and payment flows.

The congressional increase in the deposit insurance level in 1980 from $40,000 to $100,000 was intended to permit depository institutions to have access to deposits not subject to the rate ceilings then in force. Disintermediation especially suggested the need to facilitate the access of thrift institutions to funds that would substitute for the retail deposits that were at the time bleeding off to higher-yielding market instruments at rates that thrift portfolios would not permit them to match. Large time deposits-defined by the regulators as those of more than $100,000-were exempt from rate ceilings on the thought that their size-more than twice the then--insured level-implied sophisticated holders familiar with market instruments and the evaluation of financial assets. It was argued that an increase in deposit insurance coverage to the level that would exempt such deposits from rate ceilings would open up access by smaller and weaker depository institutions to large-denomination time deposits that previously had been limited to a smaller set of depositories for whom the market was willing to provide significant uninsured funding. Such funding at market rates, it was contemplated, would not require raising yields for the retail depositors willing to remain at lower rates. The extension of deposit insurance was thus an increase in a subsidy in lieu of the removal of regulations that were phased out some time later by the Depository Institutions Deregulation Act. But, as in virtually all other cases, the subsidy remained.

If we were starting from scratch, the Board believes it would be difficult to make the case that deposit insurance coverage should be as high as its current $100,000 level. However, whatever the merits of the 1980 increase in the deposit insurance level from 40,000 to 100,000, it is clear that the higher level of depositor protection has been in place long enough to be fully capitalized in the market value of depository institutions and embedded in the financial decisions of millions of households. The associated scale and cost of funding have been incorporated into a wide variety of bank and thrift decisions, including portfolio choices, staffing, branch structure, and marketing strategy. Consequently, a return to lower deposit insurance coverage-like any tightening of the safety net--would reduce insured depository market values and involve significant transition costs. It is one thing initially to offer and then to maintain a smaller degree of insurance coverage, and quite another to reimpose on the existing system a lower level of insurance, with its associated readjustment and unwinding costs. This is why the granting of subsidies by the Congress should be considered so carefully: They not only distort the allocation of resources but also are extremely difficult to eliminate, imposing substantial transition costs on the direct and indirect beneficiaries. For such reasons, the Board has concluded that, should the Congress decide to lower deposit insurance limits, a meaningful transition period would be needed.

Another relevant factor that should be considered in evaluating the $100,000 insurance limit is the distribution of deposit holders by size of account. Unfortunately, data to analyze this issue by individual account holder do not exist. However, we have been able to use data collected on an individual household basis in our 1983 Survey of Consumer Finances to estimate the distribution of account holders. While these data are seven years old, they are the best available until results from our 1989 Survey of Consumer Finances become available this fall. I have attached as an appendix to this statement summary tables and descriptive text of the 1983 survey results. (1) Briefly, the survey suggests that in 1983 between 1.0 and 1.5 percent of U.S. households held deposit balances in excess of $100,000. The demographic characteristics of these account holders suggest that they are mainly older, retired citizens with most of their financial assets in insured accounts. These characteristics of heads of households owning deposits are remarkably stable as the size of deposits declines to $50,000.

A 1988 survey of small and medium-sized businesses-described in the second appendix to this statement-suggests that 7.1 percent of such businesses had at least one account in excess of $100,000. These firms are generally of modest size: Those with uninsured deposits had median sales of $3.2 million, had less than fifty employees, and more than 10 percent of these entities were proprietorships or partnerships. The 1988 small business survey suggests a sharp drop-off in the size of firms as the maximum deposit declines to, say, $50,000.

Some have suggested a reduction of deposit insurance to that level, and the available evidence suggests that persons and small businesses with $50,000 of deposits would probably be as capable as current depositors with more than $100,000 of assessing the health of their banks or thrift institutions. As I noted, the demographics of the two household groups are similar, although the business units with balances between 50,000 and $ 1 00,000 have significantly smaller scale than those with balances of more than $100,000. In addition, it is arguable that, should the insured deposit limit be reduced to $50,000, and policies adopted that make losses by uninsured depositors much more likely than they are today, uninsured depositors with a strong preference for safety would be able to purchase evaluations of banks and thrift institutions from professional analysts. Such depositors would also have access to alternative safe investments, especially Treasury securities.

Nevertheless, the characteristics of households and small businesses with deposits between $50,000 and $100,000 do not suggest that they, compared with many other market participants, have the most resources and greatest abilities to bring market discipline to bear on depository institutions. Thus it seems reasonable to question whether such depositors should be assigned a key role in deposit insurance reform. Moreover, as discussed above, the benefits of lowering deposit insurance coverage at this time must be balanced against the readjustment and unwinding costs imposed on individuals, institutions, and markets that have adapted to the $100,000 deposit insurance level.

A decision by the Congress to leave the $100,000 limit unchanged, however, should not preclude other reforms that would reduce current inequities in, and abuses of, the deposit insurance system, often thwarting its purpose. Serious study should be devoted to the cost and effectiveness of policing the $100,000 limit so that multiple accounts are not used to obtain more protection for individual depositors than the Congress intends. We at the Federal Reserve believe that it is administratively feasible--but not costless--to establish controls on the number and dollar value of insured accounts per individual at one depository institution, at all institutions in the same holding company, and perhaps--at sharply rising cost and complexity--even across unrelated depositories. But we are concerned about the cost and administrative complexity of such schemes and would urge the careful weighing of benefits and costs before adopting any specific plan.

The same study could consider the desirability of limiting pass-through deposit insurance--under which up to 100,000 of insurance protection is now explicitly extended to each of the multiple beneficiaries of some large and otherwise uninsured deposits. Brokered accounts of less than $100,000 also have been used to abuse deposit insurance protection, particularly by undercapitalized institutions. However, the study should keep in mind the power that the Congress has already provided the agencies to constrain misuse of brokered accounts.

No matter what the Congress decides on deposit insurance limits, we must be cautious of our treatment of uninsured depositors--whether defined as those in excess of 50,000 or 100,000. Such depositors should be expected to assess the quality of their bank deposits just as they are expected to evaluate any other financial asset they purchase. Earlier I noted that our goal should be for banks to operate as much as possible as if there were no safety net. In fact, runs of uninsured deposits from banks under stress have become commonplace.

So far, the pressure transmitted from such episodes to other banks whose strength may be in doubt has been minimal. Nevertheless, the clear response pattern of uninsured depositors to protect themselves by withdrawing their deposits from a bank under pressure raises the very real risk that in a stressful environment the flight to quality could precipitate wider financial market and payments distortions. These systemic effects could easily feed back to the real economy, no matter how open the discount window and how expansive open market operations. Thus, while deposits in excess of insurance limits should not be protected by the safety net at any bank, reforms designed to rely mainly on increased market discipline by uninsured depositors raise serious stability concerns.

An example of one such approach is depositor coinsurance or a deductible under which a depositor at a failed institution receives most, but not all, of his or her deposit in excess of a reduced (or the current) insurance limit. This option has some attractions, coupling depositor market discipline with relatively modest possible losses to depositors. The Board believes, however, that an explicit policy that requires imposition of uninsured depositor loss--no matter how small--is likely to increase the risk of depositor runs and to exacerbate the depositor response to rumors.

Another option to rely more on private-market incentives without necessarily reducing the size of insurance coverage is the use of private deposit insurance as a replacement for FDIC insurance. This option would require, of course, that all relevant supervisory information--much of which is now held confidential--be shared with private insurers who would be obligated to use that information only to evaluate the risk of depositor insurance and not for the purposes of adjusting any of their own portfolio options. In addition, it is clearly unreasonable to impose on private insurers any macrostability responsibilities in their commercial underwriting of deposit insurance. Private insurers' withdrawal of coverage in a weakening economy, or their unwillingness to forebear in such circumstances would be understandable but counterproductive. Private insurers' inability to meet their obligations after an underwriting error would be disruptive at best and involve taxpayer responsibility at worst. Private insurance and public responsibility unfortunately are not always compatible. Many of these concerns are mitigated if private insurance is used as a supplement to FDIC insurance, say to cover a coinsurance portion above some minimum. However, we would remain concerned about mutual assurance among groups of banks who would seek to evaluate each other's risk exposure and discipline overly risky entities by expulsion from their mutual guarantee syndicate. In addition, a system of mutual guarantees by banks could raise serious anticompetitive issues.

There has also been support for the increased use of subordinated debentures in the capital structure of banking organizations. Intriguing attractions of this option are the thoughts that nonrunnable, but serially maturing, debt would provide both enhanced market discipline and a periodic market evaluation of the bank. The Board continues to support the use of subordinated debt for these reasons, as well as the fact that it provides supplementary capital to act as an additional buffer to the FDIC over and above that provided by the owners' equity capital. But, in our view, subordinated debentures can only be supporting players and cannot be awarded the central role in reform. This is a limited source of capital and one that may prove difficult and expensive to obtain when advertised as having limited returns like debt, but whose holders are expected to absorb losses for the FDIC like equity. Adding features to make it more attractive adds complications that perhaps are best met directly by additional pure equity and other reforms.

A promising approach that seeks to simulate market discipline with minimal stability implications is the application of risk-based deposit insurance premiums by the FDIC. The idea is to make the price of insurance a function of the bank's risk, reducing the subsidy to risktaking and spreading the cost of insurance more fairly across depository institutions. In principle, this approach has many attractive characteristics, and could be designed to augment risk-based capital. For example, banks with high risk-based capital ratios might be charged lower insurance premiums. But the range of premiums necessary to induce genuine behavioral changes in portfolio management might well be many multiples of the existing premium, thereby raising practical concerns about its application. Risk-based premiums also would have to be designed with some degree of complexity if they are to be fair and if unintended incentives are to be avoided. In any event, the potential additional benefits on top of an internationally negotiated risk-based capital system, while positive, require further evaluation.

Another approach that has induced increasing interest is the insured narrow bank. Such an institution would invest only in high quality, short-maturity, liquid investments, recovering its costs for checking accounts and wire transfers from user fees. The narrow bank would thus require drastic institutional changes, especially for thousands of our smaller banks and for virtually all households using checking accounts. Movement from the present structure for delivery of many bank services would be difficult and costly, placing U.S. banks at a disadvantage internationally. In addition, this approach might shift and possibly focus systemic risk on larger banks. Banking organizations would have to locate their business and household credit operations in nonbank affiliates funded by uninsured deposits and borrowings raised in money and capital markets. Only larger organizations could fund in this way, and these units, unless financed longer term than banks today, would, even with the likely higher capital ratio imposed on them by the market, be subject to the same risks of creditor runs that face uninsured banks, with all of the associated systemic implications. If this were the case, we might end up with the same set of challenges we face today, refocused on a different set of institutions. We at the Board believe that while the notion of a narrow bank to insulate the insurance fund is intriguing, in our judgment further study of these systemic and operational implications is required.

If, in fact, proposals that rely on uninsured depositor discipline, private insurance, subordinated debentures, risk-based premiums, and structural changes in the delivery of bank services raise significant difficulties, reform should then look to other ways to curb banks' risk appetites, and to limit the likelihood that the deposit insurance fund, and possibly the taxpayer, will be called on to protect depositors. The Board believes that the most promising approach is to reform both bank capital and supervisory policies. This would build upon the groundwork laid in the Financial Institution Reform, Recovery, and Enforcement Act of 1989 (FIRREA), in which the Congress recognized as key components of a sound banking system the essentiality of strong capital plus effective supervisory controls. Both would be designed to reduce the value of the insurance subsidy. Neither would rule out either concurrent or subsequent additions to deposit insurance reform, such as the changes discussed previously, other proposals, or new approaches that may emerge in the years ahead. In fact, higher capital, by reducing the need for, and thereby the value of, deposit insurance would make subsequent reform easier. There would be less at stake for the participants in the system.

At the end of this year, the phase-in to the International Capital Standards under the Basle Accord will begin. This risk-based capital approach provides a framework for incorporating portfolio and off-balance-sheet risk into capital calculations. Most U.S. banks have already made the adjustment required for the fully phased-in standard that will be effective at the end of 1992. However, the prospect of an increasingly competitive environment suggests that the minimum level of capital called for by the 1992 requirements may not be adequate, especially for institutions that want to take on additional activities. As a result of the safety net, too many banking organizations, in our judgment, have traveled too far down the road of operating with modest capital levels. It may well be necessary to retrace our steps and begin purposefully to move to capital requirements that would, over time, be more consistent with what the market would require if the safety net were more modest. The argument for more capital is strengthened by the necessity to provide banking organizations with a wider range of service options in an increasingly competitive world. Indeed, projections of the competitive pressures only intensify the view that if our financial institutions are to be among the strongest in the world, let alone avoid an extension of the taxpayers' obligation to even more institutions, we must increase capital requirements. Our international agreements under the Basle Accord permit us to do so.

There are three objectives of a higher capital requirement. First, higher capital would strengthen the incentives of bank owners and managers to evaluate more prudently the risks and benefits of portfolio choices because more of their money would be at risk. In effect, the moral hazard risk of deposit insurance would be reduced. Second, higher capital levels would create a larger buffer between the mistakes of bank owners and managers and the need to draw on the deposit insurance fund. For too many institutions, that buffer has been too low in recent years. The key to creating incentives to behave as the market would dictate, and at the same time creating these buffers or shock absorbers, is to require that those who would profit from an institution's success have the appropriate amount of their own capital at risk. Third, requiring higher capital imposes on bank managers an additional market test. They must convince investors that the expected returns justify the commitment of risk capital. Those banks unable to do so would not be able to expand.

We are in the process in the Federal Reserve System of developing more specific capital proposals, including appropriate transition arrangements designed to minimize disruptions. However, at the outset I would like to anticipate several criticisms. For many banks, raising significant new capital will be neither easy nor cheap. Maintaining return on equity will be more difficult, and those foreign banks that only adhere to the Basle minimums may have lower capital costs relative to some U.S. banks. Higher capital requirements also will tend to accelerate the move toward bank consolidation and slow bank asset growth. However, these concerns must be balanced against the increasing need for reform now, the difficulties with all the other options, and both the desire of and necessity for banking organizations to broaden their scope of activities to operate successfully.

More generally, many of the arguments about the competitive disadvantages of higher capital requirements are shortsighted. Highly leveraged banks are less able to respond to rapidly changing situations. In fact, well-capitalized banks are the ones best positioned to be successful in the establishment of domestic and foreign long-term relationships, to be the most attractive counter-parties for a large number of financial transactions and guarantees, and to expand their business activities to meet new opportunities and changing circumstances. Indeed, many successful U.S. and foreign institutions would today meet substantially increased risk-based capital standards. In addition, the evidence of recent years suggests that U.S. banks can raise sizable equity. The dollar volume of new stock issues by banking organizations has grown at a greater rate since the late 1970s than the total dollar volume of new issues by all domestic corporate firms. The recent declines in bank stock prices, reflecting market concerns about the quality of bank assets, will make the capital building process more difficult and costly. However, over time, banks with sound management policies will be able to continue to build their capital base.

Higher capital standards should go a long way toward inducing marketlike behavior by banks. However, the Board believes that, so long as a significant safety net exists, additional inducements will be needed through an intensification of supervisory efforts to deter banks from maintaining return on equity by acquiring riskier assets. When it is not already the practice, full in-bank supervisory reviews--focusing on asset portfolios and off-balance-sheet commitments--should occur at least annually, and the results of such examinations should promptly be shared with the board of directors of the bank and used to evaluate the adequacy of the bank's capital. The examiner should be convinced after a rigorous and deliberate review that the loan-loss reserves are consistent with the quality of the portfolio. If they are not, the examiner should insist that additional reserves be created with an associated reduction in the earnings or equity capital of the bank.

This method of adjusting and measuring capital by reliance on examiner loan evaluations does not depend on market value accounting to adjust the quality of the assets. Some day, perhaps, we may be able to apply generally accepted market value accounting precepts to both the assets and liabilities of a financial going concern with a wide spectrum of financial assets and liabilities. But the Board is not comfortable with the process as it has developed so far, either regarding the ability of market value accounting to reflect accurately market values over reasonable periods or to avoid being overly sensitive to short-run events. For most banks, loans are the predominant asset, assets that do not have ready secondary markets but that the examiners can evaluate in each of the proposed annual in-bank supervisory reviews. We at the Federal Reserve believe that the examiners' classification of loan quality should, as I noted, be fully reflected in the banks' loan-loss reserves by a diversion of earnings or a reduction in capital. If the resultant capital is not consistent with minimum capital standards, the board of directors and the bank's regulators should begin the process of requiring the bank either to reduce those assets or to rebuild equity capital.

If credible capital-raising commitments are not forthcoming, and if those commitments are not promptly met, the authorities should pursue such responses as lowered dividends, slower asset growth or perhaps even asset contraction, restrictions on the use of insured brokered deposits, if any, and divestiture of affiliates with the resources used to recapitalize the bank. What is important is that the supervisory responses occur promptly and firmly and that they be anticipated by the bank. This progressive discipline or prompt corrective action of a bank with inadequate capital builds on our current bank supervisory procedures and is designed to simulate market pressures from risktaking--to link more closely excessive risktaking with its costs--without creating market disruptions. It is also intended to help preserve the franchise value of a going concern by acting early and quickly to restore a depository to financial health. In this way, the precipitous drop in value that normally occurs when a firm is placed in conservatorship or receivership would, for the large majority of cases, be avoided.

While some flexibility is certainly required in this approach, the Board believes that there must be a prescribed set of responses and a presumption that these responses will be applied unless the regulator determines that the circumstances do not warrant them. Even though prompt corrective action implies some limit on the discretion of supervisors to delay for reasons that they perceive to be in the public interest, the Board is of the opinion that it would be a mistake to eliminate completely the discretion of the regulator.

Accordingly, the Board believes that a system that combined a statutorily prescribed course of action with an allowance for regulatory flexibility would result in meaningful prompt resolution. For example, if a depository institution failed to meet minimum capital requirements established by its primary regulatory agency, the agency might be required by statute to take certain remedial action unless it determined on the basis of particular circumstances that such action was not required. The presumption would thus be shifted toward supervisory action, and delay would require an affirmative act by the regulatory agency.

The prescribed remedial action required in a given case would be dependent upon the adequacy of the institution's capital. As the capital fell below established levels, the supervisor could be required, for example, to order the institution to formulate a capital plan, limit its growth, limit or eliminate dividends, or divest certain nonbank affiliates. If capital were seriously depleted, the supervisor could require a merger, sale, conservatorship, or liquidation.

In adopting such a statutory framework, the Congress should consider designing the system so that forced mergers, divestitures, and, when necessary, conservatorships could be required while there is still positive equity capital in the depository institution. While existing stockholders should be given a reasonable period of time to correct deteriorating capital positions, the Congress should specifically provide the bank regulators with the clear authority, and therefore explicit support, to act well before technical insolvency to minimize the ultimate resolution costs. The presence of positive equity capital, even if at low levels, when combined with any tier 2 capital, would limit reorganization and liquidation costs.

In the Board's view, most of the remedial actions discussed above can be taken, and have been taken, by bank regulators under the current legal framework. Under current law, however, action is discretionary and dependent upon a showing of unsafe or unsound conditions or a violation of law, and implementation of a supervisory remedial action can be extended over a protracted period of time when the depository institution contests the regulator's determination. What is needed is legislation that would permit a systematic program of progressive action based on the capital of the institution, instead of requiring the regulator to determine on a case-by-case basis, as a precondition to remedial action, that an unsafe or unsound practice exists. This program would introduce a greater level of consistency of treatment into the supervisory process, place investors and managers on notice regarding the expected supervisory response to falling capital levels, and reduce the likelihood of protracted administrative actions challenging the regulator's actions.

The Board is in the process of developing the parameters, processes, and procedures for prompt corrective action. One of the principles guiding our efforts is the need to balance rules with discretion. In addition, as is the case for higher capital standards, the Board is mindful of the need for an appropriate transition period before fully implementing such a change in supervisory policy.

Higher capital and prompt corrective action would increase the cost and reduce the availability of credit from insured institutions to riskier borrowers. In effect, our proposal would reduce the incentive some banks currently have to over-invest in risky credits at loan rates that do not fully reflect the risks involved. This implies that the organizers of speculative and riskier ventures will have to restructure their borrowing plans, including possibly paying more for their credit, or seek financing from noninsured entities. Some borrowers may find their proposals no longer viable. However, it is just such financing by some insured institutions that has caused so many of the current difficulties, and it is one of the objectives of our proposals to cause depositories to reconsider the economics of such credits. As insured institutions reevaluate the risk-return tradeoff, they are likely to be more interested in credit extensions to less risky borrowers, increasing the economic efficiency of our resource allocation.

Despite their tendency to raise the average level of bank asset quality, higher capital requirements and prompt corrective action will not eliminate bank failures. An insurance fund will still be needed, but we believe that, with a fund of reasonable size, the risk to taxpayers should be reduced substantially. As I have noted, higher capital requirements and prompt corrective action imply greater caution in bank asset choices and a higher cushion to the FDIC to absorb bank losses. In addition, an enhanced supervisory approach will not permit deteriorating positions to accumulate.

But until these procedures have been adopted and the banking system has adjusted to them, circumstances could put the existing insurance fund under severe pressure. As Chairman Seidman has indicated, the fund is already operating under stress, as its reserves have declined in recent years and now stand, as a percentage of insured deposits, at their lowest level in history. At the same time, there remain all too many problems in the banking system, problems that have been growing of late as many banks, including many larger banks, have been experiencing a deterioration in the quality of their loan portfolios, particularly real estate loans. It thus seems clear that the insurance fund likely will remain under stress for some time to come. Moreover, pressures would intensify if real estate market conditions were to weaken further or a recession were to develop in the general economy.

It should, however, be clearly underlined that the size or adequacy of the insurance fund does not change the quality of the deposit insurance guarantee made by the federal government; it does allocate the cost of meeting any guarantee between the banking industry, which pays the insurance premiums, and the taxpayers as a whole. It should, in our view, be the policy of the government to minimize the risk to taxpayers of the deposit insurance guarantee, and we believe that our proposal does that. While some increase in insurance premiums is in all likelihood necessary, we must be concerned that attempts to accomplish this end by substantially higher insurance premiums may well end up-especially if accompanied by higher capital requirements--simply making deposits so unattractive that banks are unable to compete. Indeed, the Board is concerned that the levels of premiums contemplated in some quarters will exacerbate both the short- and the long-run problem by reducing the profitability of banks, and hence their ability to attract capital. Avoiding taxpayer costs and maintaining a competitive banking system are just two more reasons why basic deposit insurance reform is so urgent.

Among the deposit insurance reforms that might be considered on the basis of both strengthening the insurance fund and fairness to smaller and regional banks is the assessment of insurance premiums on the foreign branch deposits of U.S. banks. A substantial proportion of the deposits of the largest U.S. banks are booked at branches outside the United States, including offshore centers in the Caribbean. Assessing such deposits could yield significant revenue for the FDIC. However, foreign deposits may be quite sensitive to a small decline in their yields. Thus imposing premiums on them could lead to deposit withdrawals and funding problems at some U.S. banking organizations and possibly inhibit the ability of these organizations to raise capital.

Even if no adjustment is made in the insurance assessment on foreign deposits, held almost solely by large banks, other deposit insurance reforms should be equally applicable to banks of all sizes. No observer is comfortable with the inequities and adverse incentives of an explicit or implicit program that penalizes depositors, creditors, and owners of smaller banks more than those of larger ones. The Board believes that no bank should assume that its scale insulates it from market discipline, nor should any depositor with deposits in excess of the insurance limit at the largest of U.S. banks assume that he or she faces no loss should their bank fail.

Nevertheless, it is clear that there may be some banks, at some particular times, whose collapse and liquidation would be excessively disruptive to the financial system. But it is only under the very special conditions, which should be relatively rare, of significant and unavoidable risk to the financial system that our policies for resolving failed or failing institutions should be relaxed. The benefits from the avoidance of a contagious loss of confidence in the financial system accrue to us all. But included in the cost of such action is the loss of market discipline that would result if large banks and their customers presume a kind of exemption from loss of their funds. The Board's policies of prompt corrective action and higher capital are designed to minimize these costs. Under these policies, the presumption should always be that prompt and predictable supervisory action will be taken. For no bank is ever too large or too small to escape the application of the same prompt corrective action standards applied to other banks. Any bank can be required to rebuild its capital to adequate levels and, if it does not, be required to contract its assets, divest affiliates, cut its dividends, change its management, sell or close offices, and the resultant smaller entity can be merged or sold to another institution with the resources to recapitalize it. If this is not possible, the entity can be placed in conservatorship until it is.

It is, by the way, the largest U.S. banks that would be required under our proposals to raise the most additional capital, both absolutely and proportionally. Most banks with assets of less than $1 billion already meet capital requirements considerably above the fully phased-in Basle Capital Accord minimums. Also, it bears emphasizing that no deposit insurance reform that truly reduces the subsidy existing in the current system will be costless for banks. The issue really is one of achieving maximum benefit from reform at minimum cost. We believe that our proposals achieve this goal. In summary, events have made it clear that we ought not to permit banks, because of their access to the safety net, to take excessive risk with inadequate capital. Even if we were to ignore the potential taxpayer costs, we ought not to permit a system that is so inconsistent with efficient market behavior. In the process of reform, however, we should be certain we consider carefully the implications for macroeconomic stability. The Board believes that higher capital and prompt corrective action by supervisors to resolve problems will go a long way to eliminate excessive risktaking by insured institutions, and would not preclude additional deposit insurance reform, now or later. Finally, in considering all proposals, we should remind ourselves that our objective is a strong and stable financial system that can deliver the best services at the lowest cost and compete around the world without taxpayer support. This requires the modernization of our financial system and the weaning of some institutions from the unintended benefits that accompany the safety net. Higher capital requirements may well mean a relatively leaner and more efficient banking system, and they will certainly mean one with reduced inclinations toward risk.

As I noted in my opening remarks, the Board believes that these reforms should be coupled with the modernization of our financial system. As we address reductions in the subsidy to banks from deposit insurance, we should also authorize wider activities for well-capitalized banking organizations and eliminate the outdated statutes that prohibit banks from delivering interstate services in the most cost-effective way--through branching. These combined reforms will go a long way toward ensuring a safer and more efficient financial system and lay the groundwork for other modifications in the safety net in the

years ahead.

Footnote 

1. The attachments to this statement are available upon request from Publications Services, mail stop 138, Board of Governors of the Federal Reserve System, Washington, D.C. 20051.

Statement by William Taylor, Staff Director, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, October 16, 1990.

I appreciate the opportunity to testify on the role of the Federal Reserve in the supervision of foreign banks operating in the United States. The testimony of the Federal Reserve Bank of Atlanta discusses in some detail the actions taken by the Federal Reserve to deal with the problems at the Atlanta agency of Banca Nazionale del Lavoro (BNL). Therefore, I will focus more generally on the Federal Reserve's role in supervising the U.S. operations of foreign banks, referring to the BNL case to show how this authority was actually used in a particular situation.

The Federal Reserve's authority and responsibility for supervising the U.S. operations of foreign banks are derived primarily from two statutes, the Bank Holding Company Act and the International Banking Act of 1978 (IBA). Any foreign bank that owns a U.S. bank is subject to the Bank Holding Company Act. The IBA for the first time established federal jurisdiction over the U.S. operations of foreign banks that have branches or agencies in the United States but do not own a U.S. bank and applied certain provisions of the Bank Holding Company Act to these organizations. Thus, the IBA established an overall framework for regulating the full range of activities of foreign banks in the United States and provided for a federal role in the supervision of branches and agencies of foreign banks. Before the passage of the IBA, the operations of U.S. branches and agencies of foreign banks were licensed and supervised solely by state banking authorities.

Since I have been asked to focus on the supervision of branches and agencies, I will discuss principally the Board's responsibilities under the IBA. However, the two acts need to be looked at in tandem. For example, besides operating branches and agencies in the United States, BNL was a large issuer of commercial paper through a U.S. nonbank subsidiary. In the case of this company, the Federal Reserve's supervisory authority arose from the application by the IBA of part of the Bank Holding Company Act to BNL. With the enactment of the IBA, the Congress established a federal role in the licensing and supervision of branches and agencies of foreign banks that paralleled the federal government's role in the dual banking system. Foreign banks were given the option of establishing a banking office in the United States by obtaining either a federal license from the Office of the Comptroller of the Currency (OCC) or a license from one of the various states. The IBA permits multiple offices to be established using either state or federal licenses or both.

Federally licensed offices are supervised by the OCC and state-licensed offices by the states. As is the case with banks, state-licensed offices are also subject to some federal supervision, by the Federal Deposit Insurance Corporation (FDIC), if the branches have insured deposits, or the Federal Reserve for uninsured state-licensed offices. It should be noted, however, that unlike banks, the vast majority of branches and agencies of foreign banks, including those of BNL, are not insured by the FDIC and do not accept consumer deposits.

The Congress recognized at the time of enactment of the IBA that many foreign banks already operated branches or agencies in a number of states and that the trend of operating under a number of different licenses could be expected to continue. Therefore, the Congress determined that there should be one agency responsible for overseeing the totality of a foreign bank's operations in the United States. The Federal Reserve was given this umbrella supervisory authority. To carry out this responsibility, the Federal Reserve was given residual examination authority over all U.S. branches and agencies and the authority to obtain information from the foreign parent. The Federal Reserve also has the authority to undertake necessary supervisory actions against the foreign banking organization and its various U.S. offices.

The Congress, nevertheless, instructed the Board to rely to the maximum extent possible upon the examinations conducted by the appropriate licensing authority and the FDIC. The Federal Reserve has made extensive use of the examination reports of other supervisors, and there is a high degree of cooperation and consultation among the various supervisory agencies at both the state and federal levels. The Federal Reserve has exercised its authority by establishing a regular reporting system that covers all of the U.S. banking operations of foreign banks, working with the other supervisors to set examination standards, reviewing all examination reports of branches and agencies, obtaining information on the condition of the parent bank, meeting on a regular basis with the foreign banks operating in the United States, and taking enforcement actions when necessary. The Federal Reserve has also worked with the other federal bank regulatory agencies and the various states to establish a common examination format and with their cooperation has sought to assure that each foreign branch or agency is examined at least once every eighteen months, a schedule that is basically being followed.

The Federal Reserve receives and reviews all examination reports conducted by the other federal and state bank supervisors. It collects and analyzes quarterly reports of condition and reports on foreign credit exposure from all branches and agencies of foreign banks. Through these and other means, the Federal Reserve tracks the condition of all U.S. offices of a foreign bank to assess the foreign bank's performance on a nationwide basis. The Federal Reserve also monitors the actions taken by other supervisors to require foreign banks to correct problems in particular offices, and undertakes enforcement or other corrective actions of its own when appropriate. In some cases, the Federal Reserve conducts examinations itself or participates in examinations conducted by other supervisory agencies. In the case of BNL, our practice had been to assign an examiner to the examinations conducted by the State of Georgia.

The Federal Reserve's direct role in the examination process varies from state to state. Its role depends on such factors as the importance of foreign banks in a particular state, the examination resources of the states, and the experience of the states in this area. For example, in California the Federal Reserve Bank of San Francisco and the state banking authority share the examination work load by each conducting examinations of particular offices in alternate years. In New York, on the other hand, the examinations are currently conducted almost exclusively by the State of New York. In Texas the Federal Reserve Bank of Dallas conducts joint examinations with the state. Similarly, in other states various arrangements have been made depending on the circumstances. In some states with a very small foreign presence there is currently no direct Federal Reserve participation in the examination process.

The Federal Reserve also directly supervises the U.S. nonbank financial operations of foreign banks. Such activities require Board approval under the Bank Holding Company Act. In acting on such applications the Board reviews the condition of the foreign bank to make certain that it can be a source of strength to its U.S. operations. In addition, the Board reviews all of the existing U.S. operations of the foreign bank in an effort to assure that the overall operations of the foreign bank in the United States are in satisfactory condition.

The Federal Reserve staff meets on a regular basis with the management of foreign banks operating in this country to discuss overall operations and to address problem areas. In addition, the Federal Reserve discusses problems with the home country supervisors.

It is important to keep in mind that branches and agencies are not U.S. banks. A branch or agency is an integral part of a foreign bank. The operations of the U.S. branches and agencies directly affect the condition of the whole bank and in turn are affected by developments at the head office and other branches. The Basle Concordat on supervising international banks recognizes this interdependence and emphasizes the responsibility of the home country authority to supervise the foreign branches and agencies of its banks. The home country regulator is the authority most capable of supervising the overall solvency and activities of the foreign bank.

To summarize, in the BNL Atlanta case, the State of Georgia examined the Atlanta agency of BNL, with participation by the Federal Reserve. The Federal Reserve was further responsible for supervising the overall U.S. activities of BNL; and the bank of Italy provided BNL with worldwide supervision.

I would now like to discuss how the Federal Reserve used its umbrella oversight authority in resolving the BNL problem in an orderly manner, and how it interacted with other supervisory authorities. (1) Let me say at the outset that once we became aware of the possible size of the illicit operations at BNL Atlanta, we recognized the potential for a significant disruption of banking markets. Therefore, cooperation among the authorities, both here and abroad, was essential in dealing effectively with this case.

As to the origin and growth of the illicit operations in BNL Atlanta, this was a situation that involved massive fraud in which a large number of employees acted together to conceal the operation and deceive auditors and examiners. Books and records concerning the illicit operations were removed from the office by employees during examinations and audits. Much of the work associated with these transactions was conducted from employees' homes, and, of course, the office did not report the illicit activities on reports filed with the supervisory agencies.

The physical segregation of records, together with the concerted efforts of key employees, makes it extremely difficult for examiners to uncover this type of illicit and fraudulent activity. Examiners also rely to a considerable extent on internal and external auditors. In the BNL Atlanta case, neither the internal auditors nor the large U.S. accounting firm conducting the external audit uncovered the large off-book lending and funding operation, although a 1988 audit report by the New York branch of BNL did criticize procedures at the Atlanta office.

Once the Federal Reserve became aware of the problem in BNL Atlanta, it initiated actions to determine the full scope of the problem, to assist federal law enforcement personnel, and to ensure that the problem did not disrupt the financial system. After discussions with law enforcement personnel, a decision was made to have the Federal Bureau of Investigation (FBI) seize the records of the Atlanta office late in the day on Friday, August 4, 1989. The FBI agents were accompanied by Federal Reserve examiners who acted as technical advisors to the agents. The Federal Reserve also began an examination of the Atlanta agency on that date. At approximately the same time, Federal Reserve examiners began examinations of the other U.S. offices of BNL and its commercial paper operation. State regulatory agencies were informed that these examinations had commenced and that there were problems in the Atlanta office of BNL.

Earlier in the week, the Federal Reserve informed the Bank of Italy that there was an urgent matter that the Federal Reserve needed to discuss. Senior Federal Reserve officials were dispatched to Rome to meet with officials of the Bank of Italy. The Bank of Italy was notified that it was likely that the Atlanta office of BNL had a large unreported business and that federal authorities were going to intervene on Friday, August 4. The Federal Reserve also advised the Bank of Italy of its concern that events might affect the dollar liquidity of BNL. The need for secrecy was emphasized so as not to jeopardize the seizure of the records by law enforcement personnel.

The Bank of Italy immediately undertook measures to make certain that the head office of BNL took appropriate actions once the seizure of the records was completed. The BNL official in charge of operations for the whole bank was sent to Atlanta and arrived on Sunday, August 6. Other BNL personnel from Italy and New York were also immediately dispatched to Atlanta. BNL began marshalling dollar liquidity and transferring liquid dollar assets to the New York branch to meet any funding contingencies that might arise. The Bank of Italy closely supervised BNL's actions and dispatched its senior examination officers to Atlanta immediately.

To summarize, the Federal Reserve was able to use the supervisory authority conferred by the IBA to conduct simultaneous nationwide examinations of BNL's branches and agencies and to inspect its commercial paper subsidiary. These actions were taken on short notice and in a manner consistent with the need to maintain the secrecy necessary for the criminal investigation. The Federal Reserve was able to discuss the specific supervisory problem and its systemic implications with the Bank of Italy in order for Italian officials to make certain that BNL had sufficient dollar liquidity to service all of its dollar liabilities. I might note that no Federal Reserve funds were advanced to BNL. Through the Bank of Italy, the Federal Reserve was able to ensure that BNL acted promptly to place new management in the Atlanta office and to contain the problem. Once initial actions were taken, the Board worked with the Bank of Italy and state examination agencies to document the full scope of the problem and to identify the weaknesses in BNL's internal controls that enabled the illicit operations to develop undetected. In cooperation with the Bank of Italy and state supervisory authorities, corrective actions for BNL's U.S. offices were identified and implemented. The Federal Reserve has also continued to provide assistance to federal law enforcement personnel when requested. You have asked what additional authority the Federal Reserve might need in this area. As the actions described above illustrate, the IBA and other statutes provide the Federal Reserve with the broad authority needed to supervise the U.S. operations of foreign banks and to respond to potential crises. No further authority seems necessary in this area.

While audit and internal control standards can be improved as the result of lessons learned from the BNL experience, the operation of BNL Atlanta involved massive fraud accompanied by false entries on the agency's books and false reporting to the federal authorities. Good controls can generally defend against this type of fraud by a single individual or a few individuals, but when a number of people within an organization conspire to "cook the books" it becomes much more problematic. More intensive monitoring and audits will help, but it is also important to deter this type of activity by successful prosecution and punishment of those involved.

In this regard it has come to our attention that some of the federal laws related to fraudulent actions in banks of the type involved in this case are not applicable to uninsured state licensed branches and agencies of foreign banks. The Federal Reserve believes that this situation should be corrected and has already furnished your committee with proposed legislation in this area. I would urge that such legislation be promptly adopted. This is not to say, however, that examination procedures can remain static. Over the past few years the Federal Reserve has been increasing its role in the supervision of branches and agencies as these entities have become more important factors in the U.S. banking market. The testimony of the Federal Reserve Bank of Atlanta describes how that Reserve Bank has increased its examination efforts in Florida and Georgia, two states in which the presence of branches and agencies of foreign banks has grown rapidly. The Federal Reserve Bank of New York is increasing its examination resources to enable it to expand its role as well. In addition, state authorities have taken actions to increase their ability to supervise branches and agencies of foreign banks. A special committee has been established under the auspices of the Conference of State Bank Supervisors to review state policies and to increase cooperation in this area among supervisors. The Federal Reserve has met with members of this committee to discuss examination matters of mutual interest. There are plans next year to have concurrent examinations of an of the U.S. branches and agencies of a select group of large foreign banks to determine if there are significant benefits to be derived from this type of examination format. In the international context, the Basle Committee on Banking Supervision has discussed the BNL case and its implications for the supervision of banks operating internationally.

The Federal Reserve intends to monitor closely the effectiveness of all of these efforts in view of the growing presence of foreign banks in U.S. financial markets. Historically, as you are no doubt aware, the principal focus of U.S. regulators has been on insured U.S. institutions given the presence of the federal safety net and the potential liability represented by the existence of federal deposit insurance. As the role of foreign banks in our markets evolves, however, we need to continually review the adequacy of the resources devoted to supervising these entities. The Federal Reserve will continue to work closely with the other federal and state regulators to ensure an adequate supervisory framework for foreign banks in this country. If necessary and appropriate, we will not hesitate to propose and adopt further steps to strengthen federal oversight of the U.S. activities of foreign banks. F]

Footnotes

1. The committee has requested information on the examination of U.S. offices of BNL and the Federal Reserve's role in those examinations. Since 1985, there have been twenty-five examinations of BNL's offices in the United States. Eight of these are Federal Reserve reports (including a joint report with the State of New York) and seventeen are state reports. Before the discovery of the recent fraud, the Atlanta office was examined every year by the State of Georgia with limited participation by the Federal Reserve Bank of Atlanta.