Stephen C. Schemering, Deputy Associate Director, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System.

Statement by Stephen C. Schemering, Deputy Associate 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, May 31, 1991.

I am pleased to appear before the committee today to review the Federal Reserve's administration of its discount window activities with respect to the Madison National Bank. I will also provide the Federal Reserve's responses to the five questions contained in the committee chairman's letter of invitation dated May 21, 1991. Last week the Federal Reserve provided the committee's staff with the documents and discount window data requested in that letter.

The loans to Madison National Bank were made consistent with the Federal Reserve's overall policy governing discount window lending. In general, Federal Reserve lending is intended to be a temporary source of liquidity, and, under Board regulation, may not serve as a substitute for capital. Loans are extended when other reasonably available sources of funds have already been fully utilized. Institutions using Federal Reserve credit are expected to take actions promptly to correct the liquidity shortage and repay the loans.

Most discount window borrowing consists of short-term adjustment credit made to assist institutions in meeting unforeseen, temporary requirements for funds. Federal Reserve credit is extended for longer periods to those smaller institutions that can demonstrate a recurring seasonal pattern in funding needs based on regular intra-yearly movements in deposits or loans.

Extended credit may be advanced to troubled depository institutions that are encountering sustained liquidity pressures and are unable to access alternative sources of funds on reasonable terms and conditions. In such situations, the Federal Reserve works in close cooperation with the primary regulator, either federal or state. The Federal Reserve is particularly sensitive to the responsibilities of the Federal Deposit Insurance Corporation (FDIC) as insurer and receiver of failed depository institutions in these situations. Therefore, we keep the FDIC fully informed of the status of discount window borrowings of troubled financial institutions and consult closely with that agency in making our decision whether to extend credit.

When the Federal Reserve extends credit to troubled institutions, we do so only when the primary regulator has not determined that the institution is capital insolvent. The Federal Reserve, in consultation with the FDIC, may lend for a short period to a failing institution for the purpose of facilitating an orderly resolution of the situation that minimizes the potential for disruption to the financial system and cost to the deposit insurance fund.

In the context of these general policies, I will now respond to the questions set forth in the committee's letter of invitation about the specifics of lending to the Madison National Bank.

1. Regarding Federal Reserve loans to Madison, please provide the rationale for those loans in light of Madison National Bank's financial condition at the time of the loans.

Madison National Bank was permitted access to the discount window for adjustment credit on January 22, 1991, in the amount of $1 million and the loan was increased to $3.6 million on January 23; this loan was repaid the next day. The bank borrowed for one day on January 29 in the amount of $2.5 million. On February 12, Madison National Bank again accessed the discount window for $3 million and continuously borrowed until its failure on May 10, when the loan totaled $125 million. (On May 10 a loan was also outstanding to Madison National Bank of Virginia, an affiliate, in the amount of $16 million.) Until May 1, the bank had not been found to be insolvent by the primary regulator, and efforts were under way by new management to restructure the bank and to attract new capital.

The Office of the Comptroller of the Currency (OCC) began a full-scope examination in early February, the final results of which were made available to the Federal Reserve on May 1. The examination findings revealed that the bank was "in imminent danger of insolvency." At that point, we notified the FDIC that the Federal Reserve's discount window loans would be limited to the purpose of effecting a prompt and orderly resolution of the bank. The continuation of the Federal Reserve's discount window loan subsequent to May 1 was made in close consultation with the FDIC and enabled that agency to arrange an assisted transaction under which the institution was closed with a minimum of disruption and inconvenience to the community and the bank's customers.

2. Did Federal Reserve loans permit Madison to stay open beyond the point when it became insolvent?

The bank was not declared insolvent until its closing on May 10, although we were aware on May 1 of its imminent insolvency. Failure to extend credit from May 1 through May 10 before the FDIC was ready to effect an orderly resolution might have disrupted the local payments system, denied insured depositors access to their funds for a period of time, possibly increased the FDIC's cost of resolution, and preempted the bank's attempt to respond to an OCC request for a capital plan.

3. What steps did the Federal Reserve take to ensure that Madison was a viable institution prior to providing it with loans?

Normally, in extending credit we would not conduct a full-scope examination to determine whether the bank is viable. Rather, we ascertain the bank's solvency from supervisory information provided by the primary regulator and determine that adequate collateral is available to secure the loan. On February 5, the OCC completed a targeted review of liquidity and the adequacy of the loan-loss reserve and found the bank's viability to be questionable, but the institution was not considered to be capital insolvent. In response to this situation, the OCC immediately scheduled a full-scope examination of asset quality to determine the full extent of the bank's problems. Although the bank's viability was in doubt, the solvency question could not be fully ascertained until completion of the examination, which occurred on May 1.

4. What factors changed between the time of the Federal Reserve loans to Madison and the May 1991 takeover of Madison by federal bank regulators?

Between the initiation of Federal Reserve lending on January 22 and the May 10 closure, the OCC completed a full-scope examination of asset quality of the institution. During this period, it began to appear less likely that management's efforts to recapitalize the bank would be successful. As noted in the response to question 1, on May 1 the OCC informed the Federal Reserve that, based on the findings of the examination, the bank was "in imminent danger of insolvency." On May 1, the examination results were presented to the bank directorate and the OCC required the bank to submit a capital plan by May 8 to cure its deficit equity position. On the morning of May 10, the OCC notified the bank that the capital plan was not acceptable, and that afternoon the OCC declared the bank insolvent.

5. Did the Federal Reserve perform its own examination of Madison prior to providing it with loans, or did the Federal Reserve rely on the results of the OCC's examination?

Consistent with our practice, we relied on the examination of the primary regulator for critical information about the financial condition of the bank while the Federal Reserve was lending. As noted above, the OCC was conducting a new examination over this period.