Statement to the Congress.
I appreciate the subcommittee's invitation to discuss some of the factors influencing recent national and regional trends in bank lending as well as changes in the composition of banks' balance sheets. Traditionally, commercial banks have been central in financing economic activity. In recent years, their relative importance has diminished somewhat, as other financial intermediaries and direct market sources of funds have tended to substitute for bank credit. Nevertheless, commercial banks remain the major source of short- and intermediate-term business credit--and the dominant source of small business financing--and thus continue to have a key function in the financial system. The recent weakness in the growth of bank loans has raised the issue of how well banks have been playing their intermediation role and what their future contributions are likely to be. In view of the importance of these and related issues, I would like to commend the committee for holding these hearings.
The weakness of bank lending to businesses over the past couple of years is in some part a continuation of the trend toward a smaller banking role to which I just alluded. A much more important factor, however, has been a considerable falloff in the demand for bank credit. This decline in demand has been mainly associated with a sharp reversal of some of the balance sheet trends that developed during the 1980s. These efforts to strengthen balance sheets have had a pronounced effect on the demand for bank credit from both the household and, especially, the business sectors. A related need by banks to repair their own balance sheets has led to a tightening of banks' lending standards and terms even as demands for their loans were dropping. The resulting pattern of weak lending has been apparent across much of the United States, but the timing and severity of the slowdown have varied somewhat by region. In the remainder of my remarks, I will expand on this brief summary of recent developments.
As the data that the banking agencies have assembled for the subcommittee indicate, the pace of expansion of the assets and deposits of depository institutions has been quite slow or negative in the past few years after a considerable advance in the 1980s. The growth of loans, particularly business loans, has been sluggish, although banks and other depositories have acquired large volumes of U.S. government and agency securities.
The pattern of bank lending and the condition of banks have not been uniform across the United States and have mirrored the unevenness of economic developments. Perhaps the New England area provides the best-known regional aspect to the credit crunch. The boom in the 1980s was unusually strong in this region, particularly with respect to real estate, and the fall in the 1990s was commensurately sharp. The experience in New England points up the interconnections between the real and financial economies: As the New England economy softened and real estate prices stopped rising and began to fall, the quality of bank portfolios deteriorated rapidly, causing current and prospective declines in bank capital and generating a need to constrain lending. Of course, as the economy contracted, loan demand also fell. But the drop in loans on the books of New England banks doubtless was sharper than would have been the case had these banks felt better capitalized. As banks were intent on quickly improving capital ratios and reducing their exposure to further loss, some creditworthy borrowers appear to have been denied credit. Such problems have surfaced in other parts of the United States as well.
The regional breakdown of the banking data indicates that commercial and industrial loans have declined in the past few years in all parts of the United States but particularly in the West, Southwest, and Northeast. These areas, of course, have had pronounced economic difficulties that likely developed independently of banking conditions. In every region, construction loans also have contracted substantially. Other loan categories show more variation, however. For example, residential real estate loans expanded in the central, midwestern, and southwestern regions but contracted in the Northeast and the West in the 1990-92 period. Even commercial real estate credit exhibited strength in some areas, such as the central and midwestern regions but declined in the Southwest and on the coasts. Total lending has been weakest in the Northeast, followed by the Southwest and the West.
There are several reasons for weak loan growth. I will begin with the most important reasons: Households and businesses have opted to reverse the patterns of spending, investing, and borrowing that dominated the 1980s. As you are well aware, that decade was one in which households, businesses, and, of course, the federal government very substantially increased their use of debt. Households rapidly added to their mortgage and other loan liabilities. Businesses simultaneously acquired a very heavy debt burden. Their borrowing was in considerable part related to an unprecedented substitution of debt for equity, much of it associated with mergers, takeovers, or defenses against takeovers. During the decade ending in 1989, household debt rose at an average annual rate of about 11 percent, and growth of business debt over this period averaged only a bit less, 10 percent. The debt growth of these sectors exceeded the 8 percent average rate of expansion of nominal gross domestic product (GDP) over this period. This extraordinary exercise in leveraging by the business and household sectors was financed in no small part by banks. For example, business and consumer loans at banks both expanded at average annual rates of about 8 percent in the 1980s; for bank mortgage holdings, annual growth averaged 12 percent.
When some of the assumptions upon which these trends were based--especially that inflation rates would continue unabated--proved incorrect, pressures to reverse the debt buildup and leveraging of the 1980s began to emerge. In particular, a collapse in commercial real estate undermined the assumption that this market provided a good investment vehicle for borrowers and sound collateral for lenders. When the economy began to exhibit recessionary behavior, businesses and households alike initiated efforts to reduce their debt burdens and strengthen their balance sheets.
These efforts have focused not only on reducing debt levels but also on substituting equity for debt, extending maturities to enhance liquidity, and refinancing existing debt to lower interest costs. Therefore, the decline in debt owed by the business sector has been particularly focused on shorter-term instruments, including bank loans. In part, these loans have been paid down with the proceeds of equity issuance. After seven years of contraction, net funds raised in equity markets by nonfinancial firms turned around in 1991, and firms have been issuing new equity at record rates in recent quarters. Bank loans also have been paid down with funds raised in bond markets. In addition, a great deal of bond issuance has been directed toward refinancing existing high-cost bonds at lower interest rates. This process has greatly reduced the debt-service burdens on the corporate sector and has left business balance sheets considerably strengthened.
It is fair to say, then, that much of the recent weakness in commercial and industrial loans is the result of vigorous efforts by businesses to improve the health of their balance sheets. At the same time, outlays to finance inventories and capital have been less than the volume of internal funds for nonfinancial corporations in the aggregate, further limiting firms' demands for bank or other credit.
Some of the recent weakness in commercial and industrial lending by banks appears to be a continuation of a longer-term downtrend in the relative importance of this type of business credit. Reasons for this slippage include increased competition from other sources of business credit, such as finance companies and the commercial paper market. The key role played by depressed demand in explaining the recent contraction in commercial and industrial loans is pointed up by the simultaneous marked weakness or outright declines in these competing sources of short-term credit to businesses.
The weakness in bank loans to the household sector also appears to be mainly a demand side phenomenon. The sluggishness in housing prices and construction activity, for example, has likely depressed demand for mortgage credit, although the decline in home prices was nowhere near as severe as for commercial real estate. Perhaps more important, employment uncertainties that accompanied the economic downturn and the rather slow recovery caused households to take a more cautious approach to the use of debt. As a result, consumer credit outstanding contracted in 1991 and was little changed last year. In part, the anemic performance of consumer credit owed to paydowns using the proceeds of mortgages refinanced at rates that are well below consumer loan rates, particularly on an after-tax basis. In addition, weak consumer credit has been associated with the use of household financial assets, including bank deposits now yielding only 2 percent to 3 percent to pay down, or to limit, the growth of, loans.
As with businesses, these efforts, although depressing bank lending and the level of consumer debt, have contributed to a marked strengthening of household balance sheets. The use of deposits and other monetary assets to constrain household debt growth, incidentally, has contributed to the very weak performance of the broader measures of the money supply over the past two years. Thus, rather than being indicative of a restrictive monetary policy or a lack of adequate funding for the economy, slow money growth rather is the obverse of the rechanneling of credit flows out of banks and into capital markets--in large part via rapidly expanding bond and equity mutual funds.
These portfolio adjustments of households and businesses have been motivated largely, as I have suggested, by efforts to restore balance sheets that had gotten out of line in the 1980s. But the timing and pace of these restructuring activities have been related importantly to the very favorable trends we have seen in the equity and bond markets, trends that seem to have accelerated in the past few months. These developments, particularly the dramatic declines in longer-term interest rates, in turn, appear to owe heavily to the markets' perception that, at last, the federal government too is prepared to take meaningful steps toward putting its own financial house in order.
Although sluggish loan growth at banks appears attributable largely to weak demand, it is clear that banks' appetite for loans has slackened over the past few years. The reason is that banks, too, found themselves in need of balance sheet restoration after the 1980s. This need was a result of the same realities their household and business customers were facing: The excessive loan liabilities of these latter groups had become the deteriorating loan assets of banks. The impact of these asset-quality problems on bank lending policies was intensified by increases in minimum acceptable capital ratios required both by regulators and by market forces.
Our periodic surveys of bank lending officers confirm that a distinct shift toward tighter standards for approving loan applications as well as stiffer lending terms began several years ago. Greater stringency was most notable with respect to commercial real estate lending, but it was quite marked as well for business lending. The tighter terms have included lower ceilings on the size of credit lines offered, increases in the cost of these lines, and additional collateral requirements. Also, the relative cost of bank loans, as measured by the unusually wide spread between the prime rate and banks' cost of funds, is high.
Although banks apparently ceased tightening in 1991, there has been little evidence of easing. In and of themselves, tighter lending standards and wider lending spreads in a time of an economic recession are not unusual. But the economy has been expanding now for two years, and the extended bout of stringency stands in some contrast to this pattern of economic growth. Besides suggesting the extent of needed balance sheet restructuring by banks, this prolonged period of adjustment may also reflect the increased costs of financial intermediation resulting from recent banking legislation.
With demand for their loans weak, banks have bid for deposits unenthusiastically. Nevertheless, deposit inflows have exceeded banks' funding needs, and, partly to accommodate their deposit customers, banks have purchased securities in volume. This phenomenon is one in which this subcommittee has expressed an interest. Historically speaking, the ratio of security holdings to loans at banks is not at a particularly high level. Indeed, it was much higher in the period from the end of World War 11 to the early 1960s. Nor is the increase in the ratio over the past few years surprising because it typically rises in periods of economic weakness. Nevertheless, some observers have blamed the recent shift from lending to acquisitions of government securities on the Basle risk-based capital standards.
As you know, banks must maintain minimum levels of two separate measures of capital: the ratio of equity capital to assets, a standard and traditional measure of leverage, and more recently, the ratios of two measures of capital to risk-adjusted assets. The latter requirements are the capital standards associated with the Basle Accord. They formally recognize what has long been known and understood--if not always acted upon--by bankers as well as their supervisors, namely that the amount of capital backing banks' assets ought to be related to the riskiness of those assets.
At first glance, the Basle Accord would appear to have had an important causative role in recent changes in banks' portfolio composition away from loans and toward securities. This interpretation would seem to follow from the observation that, in the period leading up to the full implementation of these standards in December 1992, banks acquired substantial amounts of U.S. Treasury and agency securities, which have low or zero weights in computing risk-based capital ratios and registered corresponding declines in the portfolio shares of full-risk-weight loans. Because the purpose of the risk-based capital requirements was to better align risks with capital, it would be surprising if their introduction did not have some impact on banks' portfolio composition. For the preponderance of banks, however, considerable evidence suggests that the recent trend toward increased securities holdings much more reflects lackluster loan demand as described above than efforts to boost risk-based capital ratios.
First, during this period most banks already met capital standards and thus were under no regulatory pressure to realign their portfolio. In addition, precisely the better capitalized banks in recent years have been acquiring the bulk of liquid Treasury and agency securities. This pattern, in turn, seems to reflect that it has been the banks with high risk-based capital ratios that also have had relatively high leverage ratios and have been most able to grow and accommodate deposit inflows. In an environment of depressed loan demand, deposit inflows were deployed to available assets, largely securities. A similar portfolio pattern of weak loan growth and strong security acquisitions has developed at credit unions--institutions not subject to the Basle Accord. As loan demand revives, the high levels of securities holdings at banks and other depository institutions likely will be drawn down as they were in numerous other cyclical upturns.
Another important factor has been the development of the market for mortgage-backed securities, especially collateralized mortgage obligations (CMOs). The CMO market makes available mortgage-backed instruments that are more attractive to banks than standard mortgage pass-through securities because the effective maturities of some CMO tranches better match those of banks' deposit liabilities and thus serve to limit interest rate risk. Indeed, most of the growth in mortgage-related securities since 1990 has been in the form of CMOs, and acquisitions of government-backed or guaranteed mortgage-related securities have accounted for 45 percent of all purchases of U.S. government and agency securities over this period. In part, acquisitions of mortgage securities can be viewed as substituting for state and local bonds, which have run off since late 1986, when the tax-advantaged status of most of these instruments to banks was ended. Of course, bank purchases of mortgage-backed securities provide credit to mortgage markets just as do acquisitions of mortgages themselves.
Even though the Basle Accord does not seem to explain the recent trend toward securities acquisition as currently structured, it does not adequately address the issue of interest rate risk that is potentially raised in banks' holdings of securities. Our examiners do, of course, take interest rate risk into account when evaluating banks. To provide further guidance in this area to banks and examiners and to respond to requirements of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), the Board has developed a proposal for measuring interest rate risk in the context of the Basle Accord and earlier this week approved its publication for public comment.
The steps that banks have taken in recent years to rebuild their balance sheets have been considerable and may well augur an increase in the availability of bank credit. Banks are very liquid, and lending rates relative to funding costs appear quite favorable, although banks must now cover expenses associated with recent legislation that were not present earlier. Reflecting wider lending margins and banks' efforts of recent years to control costs, bank profits last year reached record levels. Capital markets, meanwhile, have improved markedly, and banks took full advantage of these conditions by issuing a record volume of capital last year. As a result of the strong growth of capital, the share of loans in the banking system at well-capitalized banks by the end of last year climbed past 85 percent, and less than 1 percent was at less than adequately capitalized banks. Bank asset quality also has improved, as delinquency rates, while still high, have headed down.
These developments suggest that banks have completed much of the adjustment necessary to attain comfortable balance sheets. Banks seem to be ready to lend when demand picks up. Indeed, there have been some tentative signs in recent months of a pickup in bank lending and a slowing in their acquisitions of securities. As funding conditions in capital markets have generally remained very favorable, business firms have continued to raise substantial volumes of funds there, and loan growth at larger banks has remained very weak. At smaller banks as a group, however, loan runoffs have ceased, and some growth has developed.
The administration's initiatives on credit availability recently announced by the Federal Reserve and the other banking agencies should provide some help in stimulating loan growth, particularly for smaller borrowers. The already announced policy that would create for stronger banks a basket of loans to small and medium-sized businesses and farms for which documentation would not be reviewed by the examiner should help quite a lot. I also anticipate policy proposals that would reduce the burden of real estate appraisal requirements for most credit to smaller borrowers to be announced shortly. These changes will be within the FDICIA framework and are designed not to affect adversely the safety and soundness of banks and thrift institutions but are expected to reduce costs and lags in the small- and medium-sized business loan market. Other steps under consideration that would lower the cost and burden of the examination process are--as announced in mid-March--under active review by the banking agencies.
To sum up, the past few years have been a difficult time for our economy and our financial institutions. During this period, the consequences of the excesses of the past decade have become apparent, along with the need to make fundamental adjustments. These adjustments have left their imprint on financial flows, particularly in the form of a slower pace of overall credit growth and, especially, restrained balance sheet expansion by depository institutions. Although this process has been trying, we are likely to emerge from it with leaner and more efficient banking institutions that are able to resume a central role in financing a growing economy.
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|Title Annotation:||John P. LaWare testimony|
|Publication:||Federal Reserve Bulletin|
|Date:||Jun 1, 1993|
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