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Statement to the Congress.

Statement by Richard Spillenkothen, Director, Division of Banking Supervision and Regulation, before the Subcommittee on General Oversight and Investigations of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, August 4, 1992

I am pleased to be here today to discuss the impact of recent legislative and regulatory actions on credit availability and credit terms. The Federal Reserve believes that regulatory and supervisory actions should be implemented in ways that promote an appropriate balance between adequate credit availability and the safety and soundness of our financial system. I intend to begin by providing an overview of these matters. Thereafter, I will address the issues raised by the subcommittee in its July 8 letter of invitation.


At the outset, I think it would be useful to review the series of developments that have led to current concerns regarding the availability of credit from depository institutions. Many of these developments can be traced to the real estate sector.

During the 1980s, various factors combined to promote a boom in real estate, particularly for commercial properties. At the beginning of the decade, for example, a relative shortage of residential and commercial space and the enactment of changes in the tax laws were favorable to the real estate industry. In addition, until late in the decade, expectations in many sections of the United States were sustained by the relatively strong economic growth that supported the view that demand for office space would continue to rise indefinitely. These expectations were fueled by the supposition that inflationary conditions would continue and by optimistic assumptions about future occupancy rates. All of these factors led real estate developers to believe that their properties would generate sufficient cash flow to service and repay underlying debt obligations. Some banking organizations shared these expectations and, because they were facing increasing competition in their traditional business lines, lowered their real estate lending standards. By accommodating credits they previously would have denied, banks hoped to capture a greater share of the real estate financing market as well as to improve their earnings performance through attractive fees and high interest returns.

The unfortunate results of this combination of factors are well known. Excess building space was constructed that could not be leased or sold, and some overextended borrowers were unable to service and repay their debt obligations. Consequently, many financial institutions experienced mounting losses in their real estate loan portfolios, and, as a result, some of these institutions suffered severe deterioration in their condition.

Problems in the economy and related strains on banking and financial markets, of course, have not been confined to the real estate sector. During the 1980s, many business firms were acquired on a highly leveraged basis on the assumption that the various units of the organization could be sold separately at attractive prices with the proceeds used to repay the debt. In all too many cases, such expectations were proved false. Also, over the decade, reliance on debt became widespread in other sectors of the economy. Many businesses relied increasingly on debt to finance their activities, a propensity that was matched by many households, as evidenced by the rapid growth in credit card and other consumer debt. When confronted with economic uncertainty or adversity, these borrowers, too, were forced to labor under the burden of heavy debt obligations, not always successfully.

One important effect of these problems is that demand for credit at banks has dropped substantially. This decline reflects general economic factors as well as developments in particular sectors. Leveraged buyout activity has greatly diminished. And in the face of the huge oversupply in real estate markets, demands for funds to finance new construction have declined to minimal levels. At the same time, many borrowers have been attempting to restructure and reduce their debt burden. Business customers have been reducing inventories, enjoying improved internal cash flows, and raising substantial funds in equity and bond markets, thus dampening their needs for bank credit. Indeed, a substantial amount of funds raised in capital markets has been reported to be for the purpose of repaying bank loans. Meanwhile, households have been rechannelling cash flows away from retail deposits to the repayment of consumer debt.

Although weak loan demand accounts for a major share of the slow credit growth, a more conservative approach on the part of some banks and other depository institutions to extend credit has also played a role, particularly in sections of the United States that have been most affected by the recession. Considering the heavy losses that banks have experienced in their loan portfolios, it is not surprising that they have taken decisive steps to reinstate more conservative lending policies. In addition, many institutions that suffered losses have slowed their asset growth in an effort to protect theft capital ratios or have reduced their lending activity pending restoration of their capital bases.

A return to more prudent lending standards and actions to strengthen capital positions must be considered salutary for the long-run health of the economy and the banking system. Unfortunately, however, in some cases the process of retrenchment in lending may have gone too far. Some institutions appear to have adopted policies that constrain them from meeting the needs of creditworthy borrowers--borrowers seeking funds to finance new projects and activities as well as borrowers seeking to renew or retinanee existing debt.

A factor contributing to the tendency for lenders to overreact in adjusting their lending policies has been a concern that developed later in the decade that examiners might apply classification standards that are so restrictive that even performing loans could be subject to criticism. Although individual examiners in some instances may have adopted a more conservative approach to evaluating loans in reaction to problems they have observed arising from lax lending practices, the banking agencies have not changed their fundamental loan review standards or the guidance for applying these standards. Thus, to communicate that point to bankers and to ensure that our examiners accurately understand agency policy, officials of the Federal Reserve and the other banking agencies have issued a series of policy statements and have met on numerous occasions with bankers and bank examiners to communicate and clarify the agencies' supervisory policies. Statements were issued by the agencies in March, July, and November 1991 emphasizing the importance of banks continuing to lend in a manner consistent with sound banking practices to creditworthy customers and encouraging banks to work in a prudent fashion with troubled borrowers. In assessing real estate loans, the statements also reminded examiners to consider the stabilized capacity of income-producing properties to service their related debt obligations and not to base their evaluation of a real estate loan solely on the forced liquidation value of the collateral.

This year the Board has followed up with other initiatives that should contribute to easing the availability of bank credit. These efforts include the phasing out of the reporting of highly leveraged transactions that increase the amount of noncumulative perpetual preferred stock that bank holding companies may include in tier 1 capital and undertaking, in conjunction with other federal bank and thrift regulatory agencies, the Regulatory Uniformity Project. This effort has as its goal promoting consistency among the banking agencies and reducing regulatory burden and costs without lessening the effectiveness of bank regulation. The Board also has utilized opportunities to reiterate to our examiners the basic principles of last year's credit availability initiatives.

Having summarized what the Board has done to dispel misconceptions about our current policies and procedures, let me turn briefly to the general question of the potential impact of recent legislation, such as the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), on credit availability. Several provisions of this act and, perhaps most particularly, prompt corrective action, offer the promise of improving the safety and soundness of banks over time and of minimizing costs to the safety net. Nonetheless, several provisions of the act appear to work in the direction of reinforcing tendencies to restrict credit availability. For example, provisions that mandate the specification of standards for real estate lending and that call for the agencies to establish operating and managerial standards, including those pertaining to underwriting standards, appear likely to have that effect. And, there are various other provisions of the act, including prompt corrective action, which, by providing incentives for banks to establish and maintain strong capital, may also work in that direction, at least over the near term.

Of course, there is no way to avoid entirely the dampening effects laws and regulations that are designed to constrain bank risk-taking may have on the willingness of banks to lend. In taking steps to adopt regulations to implement FDICIA and other banking legislation, however, the Federal Reserve has endeavored to structure regulations in ways that, while being consistent with the letter and spirit of the legislation, will work to avoid undue rigidity and inflexibility that could impair the ability of banks to service the needs of their customers.

For example, in our recent efforts to implement section 304 of FDICIA regarding the establishment of real estate lending standards, the regulatory agencies have carefully explored various alternative approaches that might be adopted to achieve the desired end but that would, at the same time, minimize unneeded and unwarranted constraints on banks and their customers. The agencies are now soliciting public comment on two alternative approaches to establishing standard loan-to-value ratios and also are seeking comment on whether some other approach to real estate lending standards would be more appropriate. Because most depository institutions have historically used a loan-to-value approach to their real estate lending, the agencies proposed loan-to-value ratios only after extensive talks with industry representatives to solicit their views on appropriate levels. In addition, to provide sufficient flexibility, the agencies have specified in the proposal that real estate loans, so as not to exceed a certain percentage of total capital, need not conform to the loan-to-value standards. Also, comment is requested on whether the proposed real estate lending standards will hamper programs that institutions have established to fulfill their obligations under the Community Reinvestment Act, particularly those programs designed to provide credit to low- and moderate-income persons. In sum, the agencies are paying close attention to the potential burden that the proposed alternatives may place on financial institutions and their customers, including the possible impact on a bank's flexibility in structuring loan terms to meet borrowers' needs and the effect that any loss in such flexibility may have on credit availability.

Let me conclude these general remarks by saying that the Board is sensitive to the potential impact of supervisory policies and procedures on banks' willingness to lend to creditworthy borrowers. Concerns over credit availability arise from several factors that have caused lenders to become decidedly more cautious in their lending policies and practices. The regulatory agencies have, as I have emphasized, implemented several steps designed to counteract these tendencies to the extent that they are traceable to any misperceptions about our policies. The Board also has been sensitive to the potential impact that FDICIA may be having on banks' willingness to lend and, thus, in our efforts to adopt regulations to implement this legislation, the Board is endeavoring to structure these regulations in ways that will work to minimize any adverse effects on credit availability.


The first two issues listed in your letter pertain to the general standards and policies for regulatory loan review and classification practices for new, existing, and rollover business credits at depository institutions. I am addressing these issues together because our policies with respect to the loan review function and the classification of these loans are the same. Each credit, whether new or seasoned, is to be individually evaluated based on its own merits.

As reiterated in the agencies' November 1991 policy statement on commercial real estate loans, the focus of the examiner's review is on the ability of the loan to be repaid, and the evaluation of these repayment prospects determines whether and how a loan should be classified. The principal factors that bear on this analysis are the character, overall financial condition and resources, and payment record of the borrower; the prospects for support from any financially responsible guarantors; and the nature and degree of protection provided by the cash flow and value of the underlying collateral. The importance of the collateral's value in the analysis of the loan necessarily increases as the sources of repayment for a troubled loan become inadequate over time.

I would like to emphasize that, although the Board does not differentiate between new and existing credits for loan review and classification purposes, one advantage a seasoned loan has in the assessment process is that the payment performance record of the borrower has been established. Because new loans do not have an established payment record, the examiner must rely instead on projections of future performance in evaluating the credit quality of the loan.

Regarding the regulatory loan review for rollover business credits, it has long been our belief that the act of refinancing or renewing loans to sound borrowers should generally not be subject to supervisory criticism in the absence of well-defined weaknesses that jeopardize the repayment of the loan. This policy was reiterated in a July 1991 examination circular discussing the importance of banks' refinancing or renewing loans to sound borrowers, especially those in the real estate sector. This statement was issued to remind examiners that financial institutions may determine that the most desirable and prudent course is to roll over or renew loans to those borrowers who have demonstrated an ability to pay interest on their debts but who may not be in a position to obtain long-term financing.

I would like to point out that one important element of our efforts to make certain that our policies are properly understood has been to clarify that banks that do not meet the minimum capital standards are not necessarily required to stop making sound loans to creditworthy borrowers, provided these banks have reasonable and effective plans in place to achieve adequate capital levels. In addition, the agencies have stated that banks with concentrations in certain economic sectors need not automatically refuse to make loans to creditworthy borrowers in these sectors as long as the bank's underwriting standards are sound, prudent risk controls are in place, and the bank has an adequate plan in place to reduce any concentrations over time.


Your letter of invitation also inquired about the effectiveness and burden of specific regulatory criteria on particular types of loans in ensuring the safety and soundness of institutions. I infer that this question is directed to section 304 of FDICIA, which calls for the specification of regulatory standards for real estate loans, the only section of the act directly concerned with setting standards for a particular category of loans. I have, of course, already reviewed the basic approach the agencies have been taking in our preliminary efforts to implement this section.

Let me, therefore, reemphasize that in structuring the proposal on which the Board is seeking comment, close attention was paid to the possible burden these alternatives may place on financial institutions and their customers, including the possible impact of a loss of flexibility in structuring loan terms to meet borrowers' needs and the effect that may have on credit availability. For example, in determining what range of possible loan-to-value limits the agencies should propose, current banking practices and traditional real estate lending rules of thumb were taken into account, and the agencies believe that the ratios proposed for public comment are generally consistent with these standards.

Of course, by requiring limits, whether they are to be established by the depository institution under general regulatory guidance or to be specified directly by the regulatory agencies, the agencies recognize that they restrict to some degree the flexibility of lending institutions to meet specific credit terms requested by their customers and may be viewed as a deterrent to credit availability. To counteract at least a part of that effect, the proposal would permit each bank to extend a portion of its real estate loans, not to exceed a certain percentage of total capital, on terms that do not conform to the regulatory standards as long as the bank can otherwise demonstrate the prudence and safety of the loan.

The agencies hope that the comments received will help them to determine the appropriateness of using loan-to-value ratios, as well as the ratio limits, if any, that should be set. The Federal Reserve believes that supervisory guidance on these ratios should assist in protecting the safety and soundness of depository institutions by curtailing abusive real estate lending practices in the form of unreasonably large loans relative to the value of the underlying real estate collateral. Also, the Board believes that such guidance, if properly structured, need not unduly limit the availability of credit to prudent real estate developers.


It has always been, and remains, the responsibility of the institution's management to establish and maintain loan-loss reserves at an appropriate level. The methods used by management in fulfilling this responsibility are carefully reviewed by examiners to ensure that these methods have adequately considered all factors relevant to the collectibility of the portfolio.

In evaluating the adequacy of a bank's loanloss reserve, the examiner considers the level and severity of loan classifications. As I have previously mentioned, the classification process takes into account several factors including the ability of the borrower to repay the loan out of cash flow generated from the project financed as well as from other reliable sources and the protection provided by any collateral. The examiner assigns an appropriate classification based on the 1oan's identified weaknesses and the potential loss exposure to the bank. I would like to point out that the November 1991 interagency policy statement stated that, although the value of collateral is a relevant factor in the evaluation of a loan, supervisory policies do not require automatic increases to the loan-loss reserve solely because the value of the collateral supporting a performing loan has declined to an amount less than the loan balance as long as there are no weaknesses that jeopardize repayment of the credit.


First, I should acknowledge that differences among the individual regulatory agencies may stem from legislation and to a certain degree from their respective cultures that have developed over the years. However, there are several mechanisms, both formal and informal, that are used by the agencies to coordinate the development and implementation of general supervisory policies and procedures, and much has been accomplished in this area. And, in particular, the agencies' fundamental objectives and supervisory policies pertaining to credit availability are uniform. In this regard, I would like to emphasize that the March and November 1991 policy statements were issued on a joint intragency basis. Considerable efforts have been, and are being, taken to ensure that our supervisory policies continue to be consistent. In this process, the agencies are also seeking to assure themselves that these policies are balanced, fair, and prudent so that they will neither permit unsound lending practices nor discourage banks from lending to creditworthy borrowers.

To foster the objectives I have just described, the four federal banking agencies jointly organized the National Examiners' Conference in Baltimore in December 1991. In particular, the purpose of the conference was to make sure that senior examiners and their supervisors fully understood the substance and purpose of the agencies' initiatives. Furthermore, the Federal Reserve has participated in numerous interagency training efforts to provide uniform interpretations of these interagency policy statements.

In addition, the efforts of the recently announced Regulatory Uniformity Project are designed to promote consistency among the agencies and to reduce regulatory burdens and costs without lessening the effectiveness of regulation and supervision of federally insured depository institutions. In particular, the project encourages the development, to the extent possible, of common definitions, policies, and standards for the classification and valuation of assets. Furthermore, the agencies are seeking to reduce or eliminate any differences or inconsistencies in accounting issues and in certain other examination areas. Another effort is to further standardize examiner training, in part through conducting such training on an interagency basis.


I would like to assure the subcommittee that the Federal Reserve recognizes the need for banks to meet legitimate credit demands and that it is doing all that it believes it can do at this time to increase the availability of credit to sound borrowers in a prudent and responsible manner. The intent of our efforts is to contribute to a climate in which banks make loans, consistent with safe and sound banking practices, to creditworthy borrowers and work constructively with borrowers experiencing financial difficulties. In all these efforts, the Board has been guided by the premise that prudent lending standards and effective and timely supervision should not inhibit banking organizations from playing an active role in meeting legitimate demands for credit.

The Board looks forward to working with the subcommittee and the Congress in ensuring that sound borrowers have access to credit while at the same time maintaining a safe and sound financial system.
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Title Annotation:Federal Reserve Division of Banking Supervision and Regulation director Richard Spillenkothen's remarks to the House Banking Committee's subcommittee on general oversight and investigations
Publication:Federal Reserve Bulletin
Article Type:Transcript
Date:Oct 1, 1992
Previous Article:Treasury and Federal Reserve foreign exchange operations.
Next Article:Record of policy actions of the Federal Open Market Committee.

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