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Statements to Congress.

Statements to the Congress

Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Committee on Small Business, U.S. House of Representatives, June 6, 1990.

I am pleased to be here on behalf of the Board of Governors to discuss credit availability to small businesses. The Board recognizes the important role played by small firms and commercial enterprises in providing jobs and fostering economic growth. We also recognize the responsibilities of commercial banks as major suppliers of credit to the business sector and, in particular, to many small businesses that lack the diversified funding sources or to larger ones. One of the Federal Reserve's principal objectives in its capacity as a bank supervisory agency is to promote a sound, competitive, and innovative banking system--a system that can effectively provide credit and other important banking services within the context of a strong and stable economy.

In my remarks today, I would like first to review what the relevant data suggest about the availability of credit in the economy. Then, I will address the supervisory role and objectives of the Federal Reserve and briefly discuss concerns that the supervisory or examination process, itself, may be contributing to reduced credit for certain sectors or regions of the country. At the outset, I would point out that a slowdown in lending in certain markets seems entirely warranted given current economic conditions and the need for some lenders to strengthen underwriting standards in light of higher levels of loan losses.

General Availability of Credit

Historically, commercial banks have played a key role in financing economic growth, and, obviously, they still do. In this regard, there has been much concern of late about the availability of bank credit, especially for particular sectors and regions. As I will discuss in a moment, there are clearly pockets of slowing business activity that are affecting both large and small firms. In response, banks have tightened terms and cut back lending in those sectors. The effects are most dramatic for commercial real estate and merger-related types of transactions, and it seems likely that activity in both of these areas is being affected to some extent.

Tighter terms also are evident in lending to small-and medium-sized businesses. Still, there is little evidence of a widespread overreaction to changing conditions--an overreaction that could materially worsen the situation for these firms. Growth of bank credit has slowed in recent months, but on balance it appears that the economy's credit needs are being met.

Let me review the evidence more closely. Aggregate statistics show that the flow of credit through banks to businesses and households slowed during the first five months of this year from the pace in 1989. Weak real estate markets, especially in the construction and commercial areas, have contributed to this decline. The softness reflects a combination of factors related to overbuilding, high prices in some areas, a perceived slowing of the economy, and specific market conditions. In some overbuilt areas--notably New England and the Southwest--the quality of mortgage credit has deteriorated markedly as reflected in high delinquency rates and rising loan charge-offs.

In this environment, banks should be taking a more cautious approach, and recent surveys indicate that they are. Most commonly, banks have strengthened their lending criteria, for example, by lowering their maximum loan to value ratios on construction loans, requiring more collateral, and imposing stricter covenants on loans. Many banks also have curtailed lending on income-producing properties; about 80 percent of the respondents to a recent Federal Reserve survey of senior lending officers indicated that they had tightened lending for commercial office buildings.

In contrast to their actions in commercial real estate lending, banks appear not to have pulled back from the single family housing market. While slowing some in response to higher interest rates, the growth of residential mortgage credit seems to have been reasonably maintained. Existing home sales this year are not much changed from last year's average, and spreads between home mortgage rates and other market rates, such as those on government bonds, are currently narrow by historical standards, despite the contraction in residential lending at thrift institutions. The development of the mortgage-backed securities market has undoubtedly eased much of the pressure that we might otherwise have felt in this market because of the problems of the thrift institutions by making it possible for other investors to readily fill the void.

In other areas, the most notable cutbacks have been in lending either to finance mergers and acquisitions or to defend against them. This decline reflects greater caution on the part of lenders as well as a reassessment by corporations of the benefits of restructuring in view of the problems in certain sectors and the recent difficulties of some highly leveraged borrowers. I view that slowdown as appropriate in these circumstances.

Other business lending--that is, lending unrelated to real estate or mergers--also has slowed since year-end. However, our survey suggests that this decline is related mostly to reduced credit demands, presumably caused by a slower economy. Those banks that indicated they were taking steps to tighten credit most often cited as reasons their concerns about the general economy or the prospects for particular industries, followed by concerns with the quality of their loan portfolios. Regulatory pressures were also mentioned, but less frequently.

A recent survey of small businesses conducted by the National Federation of Independent Businesses (NFIB) found less borrowing by small firms, but it supported the view that during the first quarter these firms had no unusual difficulty obtaining the credit they sought. Complaints about credit stringency in the NFIB survey remain well below the number registered during 1980-81. These results seem broadly consistent with our own survey, in which most banks reported "somewhat" rather than "much" tighter lending terms.

There are some notable exceptions to this picture. In New England, commercial bank loans fell in the first quarter more than 1.0 percent, after having adjusted for loan sales and charge-offs. This decline followed an extended period of rapid growth and lends credence to the many anecdotal stories of credit restraint in that area.

On balance, aggregate measures of credit flows, while slowing, do not show evidence of a significant change in credit availability. We recognize, however, that to the extent that terms and conditions of lending have changed, they would be expected to show through to aggregate measures of credit flows with a lag. The Federal Reserve, of course, will continue to monitor the credit markets carefully.

Supervisory Role

It is important to point out here that the tightening of credit standards that has occurred so far is appropriate from the point of view of macroeconomic stability, as well as from a supervisory perspective, if the purpose is to correct for past deficiencies or to accommodate a slower, more sustainable pace of economic growth. Nevertheless, some people have argued that the activities of bank examiners have contributed to a tightening of credit. The Federal Reserve would, of course, be concerned if the examination process resulted in an unwarranted decline in lending to creditworthy borrowers or for projects that are economically or financially sound. To address that point, I would now like to discuss briefly the Federal Reserve's supervisory activities and objectives.

The Federal Reserve has long had the view that frequent on-site examinations based on an evaluation of asset quality are central to a strong supervisory process. That approach is founded on the knowledge that credit losses have almost always been the principal cause of commercial bank failures. Accordingly, a key function of the examiners is to evaluate credits and ensure that assets are reflected in the financial statements of the banks at appropriate values. Without performing that review, examiners cannot evaluate the underlying adequacy of a bank's capital or the real profitability and solvency of its business. Such a review is also necessary to identify problems in a timely fashion and to encourage appropriate corrective actions before the problems reach a more serious stage.

When evaluating credits, examiners consider the adequacy of a borrower's cash flow, the value of any collateral, the existence of guarantees, and a variety of other factors, importantly including changes in market conditions. They review credit files containing appraisals and customer financial statements and make judgments about the nature of any expected loss. Much depends on the skill of the examiner, the information available to the bank, and the procedures used to evaluate market conditions. Loans that involve specific weaknesses or deficiencies that could jeopardize repayment or loans that involve the distinct possibility of loss are subject to examiner criticism. Such loans would generally include those that are based upon cash flow projections or collateral values not supported by current market conditions.

Examiners also evaluate loan administration and underwriting standards and internal risk control systems of the banks. Our experience suggests that these standards and controls have declined at some institutions or at least have not kept pace with the rising risks associated with certain lending activities. One of the goals of supervision is to encourage such institutions to take appropriate steps to strengthen their internal procedures. In the context of commercial lending, such steps might include requiring higher levels of borrower net worth, obtaining additional collateral or guarantees, applying more intense scrutiny to the creditworthiness of prospective borrowers, and placing greater emphasis on the adequacy of the borrower's net income and cash flow.

In carrying out their responsibilities, examiners do not attempt to allocate credit or tell bankers not to lend. That is not an examiner's role, nor is it the role of the regulatory agencies. Bankers, themselves, must determine what loans to make in recognition of their responsibilities to operate prudently while meeting legitimate credit needs of their communities.

Regulatory reviews should not cause bankers to stop lending to creditworthy borrowers or to refuse to work in a constructive fashion with borrowers who are attempting to strengthen their financial positions. Banks should frequently reassess their lending and credit review procedures, especially when economic conditions change, to ensure that their lending decisions are sound. However, they must also work with their customers to resolve problems and to permit new and emerging companies to grow. Doing so is in their own long-term interest and that of their communities.

During recent months, the media have carried numerous stories about problems that small to medium-sized businesses have had lately in getting or renewing their loans. Some companies have reported that they were required to provide more collateral than they had to in the past or were turned away altogether. Others have claimed that their banks dishonored prior commitments to lend, leaving construction projects unfinished.

While such cases no doubt exist, as a former banker, I do not believe that bankers normally deny loans to customers that they believe are creditworthy. It is certainly not good banking to do so. Most banks simply spend too much time and money building customer relationships to do that. Rather, as our survey evidence confirms, banks have tightened credit standards in view of softening real estate markets, a less favorable economic outlook for certain sectors, increased business risks, and, in some cases, rising levels of problem loans and loan losses. Undoubtedly, concerns about potential regulatory actions, or perceptions about the impact of examinations on other institutions, also have played a role in fostering a more cautious attitude toward extending credit in certain situations. Nevertheless, as I have suggested, I believe that strengthened lending standards are a reasonable and appropriate response to the economic and business conditions facing many banking organizations.

While the Federal Reserve has not changed its examination standards, examiners must apply these standards, using their own experiences and skills, in the current environment. We must recognize that an examiner's assessment of loans involves a measure of judgment and that this judgment may sometimes differ from that of bank management. Nevertheless, bankers and examiners have the common objective of ensuring that problem credits are identified and that underwriting and lending standards are prudent. Banks are subject to losses; that goes with lending funds. They have the responsibility, though, to use their funds wisely to serve their communities appropriately, protect the safety of customer deposits, and minimize undue risks to the deposit insurance system.

Current problems in real estate markets may be traced, in part, to earlier trends in credit flows. Until recently, real estate in most parts of the country has enjoyed strong growth and strong support from commercial banks. In the past four years, for example, commercial bank lending secured by nonfarm-nonresidential properties (in large part commercial office buildings) increased 123 percent, and total real estate loans virtually doubled. By comparison, total bank loans grew only 34 percent and bank assets less than that.

This increased real estate lending, combined with the lending activities of the savings and loan associations, has led to excessive office capacity in many markets throughout the country. In 1980, for example, downtown office vacancy rates in major cities averaged less than 4 percent nationwide. Currently, the average is more than 16 percent. In parts of the Northeast and Southwest, vacancy rates are much higher than that. Many banks that previously financed only the construction phase now find themselves providing medium-term financing after construction is completed because long-term investors cannot be found.

We should also recognize that several institutions need to strengthen their capital positions. That includes some banks in New England, where examinations have revealed large losses and other asset problems. Faced with a generally weak market for issuing new securities, banks there, and elsewhere, have decided to meet their capital requirements, at least partly, by curtailing new lending and selling assets.

Although reduced lending may disproportionately affect small firms with no resort to money markets or businesses without a proved credit history, it is important that regulators continue to maintain and enforce their standards, including minimum capital requirements. The thrift situation demonstrates all too vividly the adverse consequences that can flow from institutions assuming significant risks without an adequate commitment of owner or shareholder resources. Only well-managed and well-capitalized institutions will be in a position to weather market cycles and meet the long-term credit needs of their customers. Ultimately, we serve neither the banks nor the taxpayers if we fail to identify problems on a timely basis or permit undercapitalized banks to grow.


In closing, I would stress that the Federal Reserve is mindful of concerns about the availability of credit and has been watching for evidence that would validate these concerns. Lending terms have tightened in selected areas or for certain types of borrowers, but, as yet, we continue to see little indication of a process that is out of proportion with changes in underlying business conditions.

In our examination and regulation of banks, we are working to avoid actions that would prevent creditworthy borrowers from receiving loans. At the same time, we have a responsibility to foster prudent lending policies and adequate capital bases to promote stability in financial markets and to protect the taxpayer, whose credit ultimately backs insured deposits. Only in that context can we be certain of the continued vitality of our banking organizations, whose lending activities are essential to the further advance of the economy. Statement by Wayne D. Angell, and Edward W. Kelley, Jr., Members, Board of Governors of the Federal Reserve System, before the Subcommittee on Domestic Monetary Policy of the Committee on Banking, Finance and Urban Affairs of the U.S. House of Representatives, June 14, 1990. It is a pleasure for Governor Kelley and me to visit with this subcommittee today. This is the fourth time that I have had the opportunity to discuss and review the Federal Reserve System's expenses and budget with you. Today, as we look at the Federal Reserve System's budget for 1990, Governor Kelley will discuss the Board's budget and major initiatives, and my comments will focus on the Reserve Bank budgets as well as major System initiatives.

The Board has recently made available to the public and to this subcommittee copies of our publication entitled Annual Report: Budget Review, 1989-90 presenting detailed information about spending plans for 1990. The attached tables have been updated for 1989 actual experience, and, therefore, some variations exist from data in that document.(1)

In January 1990 the Board decided to reduce the approved budgets of the Federal Reserve System $4.4 million to achieve a degree of restraint in the Federal Reserve comparable to the restraint imposed on the federal government by Gramm-Rudman-Hollings. Because the budgets were approved before making the Gramm-Rudman-Hollings cuts, the Board and the Reserve Banks are responsible for meeting this overall target but were not asked to detail the reductions.

While the Federal Reserve has been concerned historically about controlling costs, the Monetary Control Act of 1980 has provided additional motivation to control costs. As a matter of law, services provided to depository institutions must meet a clear market test. Specifically, all expenses (including overhead and the imputed cost of capital and taxes) involved in providing "priced" services are covered by charges to users. The markets for these correspondent banking services, in which we operate in providing those services, are highly competitive, thereby providing a strong and direct incentive to maintain our efficiency. Given these internal and external restraints on costs, the Federal Reserve System's expenses are projected to increase by an average annual rate of 5.1 percent from 1986 through 1990. This increase includes expenses for Supervision and Regulation initiatives, Expedited Funds Availability (EFA) legislation requirements, contingency planning initiatives, and several major initiatives for the U.S. Treasury Department. I would add that it is difficult to judge the degree of restraint in an organization's budget based solely on the growth rate of expenses. Our objective is to provide services at prices that promote efficiency and to perform those responsibilities given to us by the Congress in an effective manner.

For 1990, the Federal Reserve System has budgeted operating expenses of $1.5 billion, an increase of 5.0 percent over 1989 actual expenses. Before getting to the substance of our 1990 budget, I would remind the subcommittee of two aspects of Federal Reserve System operations that affect our budget in unusual ways. First, 41 percent of System expenses arise from services provided to depository institutions for which, by law, we charge fees adequate to cover all costs. Since additional costs of these services are more than recovered by additional revenues, any increases in costs result in increased earnings returned to the U.S. Treasury Department. Second, many fiscal agency operations are provided to the Treasury Department and other agencies on a reimbursable basis. Altogether, 59 percent of our total expenses are either recovered through pricing or are reimbursable. On a net basis the cost to the public of operating the Federal Reserve System is $621 million of the total $1.5 billion budget.


It may be helpful to put the budget for 1990 in perspective by sketching the most recent ten-year history of System expenses. Between 1979 and 1989, Federal Reserve System expenses increased at an average annual rate of 6.8 percent; System employment increased at an average annual rate of 0.2 percent; and volume increased 32 percent over the ten-year period. Unit cost did increase in the early eighties as Federal Reserve Bank volumes adjusted to pricing after implementation of the Monetary Control Act. However, after the transition to pricing was completed in 1983, the composite unit cost for all functions has actually declined 0.2 percent at an annual rate, even while improvements have been made in the quality of services.

For priced services, a decline in unit cost has been particularly noticeable in the electronic payments areas. Volume growth has averaged more than 6 percent per year for funds transfers and more than 25 percent for automated clearinghouse (ACH) transactions. In commercial check processing, on the other hand, when there has been a significant effort to improve the quality of service through increased availability and improved deposit deadlines, there has been an increase in unit cost of 2.5 percent per year since 1983. In the most recent year-over-year comparison (1989 over 1988) unit cost of check processing rose 6.6 percent due primarily to implementing provisions of the Expedited Funds Availability legislation (EFA).

For nonpriced cash operations--involving the distribution of currency and coin--the decline in unit cost has also been noticeable; since 1983 the average decline has been 3.0 percent per year. Currency paying and receiving volume has increased an average rate of 6.7 percent annually since 1979. In fiscal agency operations, also nonpriced, there has been an increase in unit cost of 2.1 percent per year since 1983, reflecting new operations. Also in the nonpriced area, the Federal Reserve System has managed several initiatives for the Treasury to improve long-term efficiency in Treasury securities and savings bonds. Through 1989 the Federal Reserve has added 175 staff members and spent $42 million on these Treasury initiatives.

As for the impact of EFA on our cost structure, in 1989 we have seen an overall unit cost increase of 2.3 percent, compared with that during 1988. This increase was primarily due to the implementation of the Expedited Funds Availability legislation. This legislation required banks to provide prompt availability for check deposits and gave the Federal Reserve the authority to make improvements in the payments system to speed the collection and return of checks. Thus, the Board's Regulation CC mandated expeditious return of unpaid checks to reduce banks' risks in providing the prompt availability required by the act. To facilitate banks' compliance, the Reserve Banks implemented new returned check services for which they had to add about 600 employees throughout 1988 and 1989 and spend more than $60 million.

It is difficult to measure productivity improvements in the supervision and regulation area, but these activities have required significant increases in resources over the past ten years. Supervision and regulation has added 786 staff members and increased expenditures $127.2 million since 1979. These resources have been employed to strengthen the ability of the Reserve Banks to identify and address problems in the banking organizations under their jurisdiction. Obviously, the problems that the Reserve Banks have had to deal with in the past several years have increased greatly, as reflected in the record number of bank failures and problem banks, as well as in the increasingly complex issues that they have had to face in reviewing and processing regulatory applications and in developing supervisory policies to deal with new and changing banking risks.

In presenting our spending plans for 1990, I would like to mention that both the Reserve Bank budgets and the Board's budget must be approved by the Board of Governors. Reserve Bank budgets are first approved by the Banks' Boards of Directors and then reviewed by the Committee on Federal Reserve Activities before submission to the Board of Governors. Governor Kelley oversees the Board's budget, and I will turn to him for that discussion.


I am pleased to appear before this subcommittee again this year. In the past we have discussed our budget process and the comprehensive planning process that the Board has in place to ensure that we identify and accomplish key objectives in an effective and efficient manner. The Annual Report: Budget Review, 1989-90 describes these processes, discusses the Board's record of sound budget management, and provides trend data. Therefore, I will confine my testimony to the 1990 budget unless the committee has questions.

The 1990 budget posed difficult challenges. Problems in the thrift industry, which culminated in passage of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), placed substantial new pressures on our supervision and regulation program. As a result, the banking supervision program had a large increase in terms of funding. Staff increases in supervision, however, were offset by decreases elsewhere throughout the Board. Full implementation of our new compensation system also contributed to the rate of increase in the budget being above normal levels. Finally, there was a major increase in the level of resources devoted to our Inspector General Program.


The 1990 Board operating budget is composed of two components: regular operations and the Office of the Inspector General (OIG). The regular operations budget of $102.9 million represented an increase of 7.9 percent. The OIG budget of $1.7 million represented an increase of $0.8 million, or 114 percent, for operations and $0.2 million for facilities.

The initial regular operations budget submissions totaled $105,550,300. During the budget reviews, reductions of $2,380,400 lowered the approved budget to $103,169,900. Voluntary implementation of Gramm-Rudman-Hollings reductions paralleling those of other agencies further reduced the budget to $102,865,200, an increase of 7.9 percent over 1989 expenses. This increase is larger than in recent years. Growing supervisory responsibilities, including the changes brought about by the FIRREA and the implementation of our new compensation program, contributed to the increase in the 1990 budget level.

Division budget submissions minimized expenses, reallocated resources to higher priority work, and included new initiatives only as necessary to meet Board objectives. The approved budget contained sufficient funding to meet the major Board objectives in each program area and included the following: (1) funding and positions to support major increases in the work load tied to the supervision and regulation area discussed earlier; (2) resources for the continued development of the National Information Center; (3) continued investments in productivity enhancements, including office automation and an electronic Records Management initiative; and (4) funds to maintain a safe and effective working environment.

In terms of people employed, ten new positions were created to support the new and additional work requirements associated with the supervision and regulation function. This increase was offset by a reduction of eleven positions elsewhere in the budget.


Supervision and Regulation

This budget supports necessary enhancements in our ability to respond effectively to the continuing regulatory and supervisory issues caused by problems in the financial industry and to meet new obligations posed by the FIRREA legislation aimed at correcting those problems. The budget addressed these requirements in several ways.

The enactment of the Financial Institutions Reform, Recovery, and Enforcement Act and the underlying problems that required that legislation caused additional expense of $550,000. The added expense was for ten new positions, offset elsewhere in the budget, and accelerated hiring to meet the expanded work load in the areas of policy, financial analysis, and enforcement. We are also working with other agencies, through the Federal Financial Institutions Examination Council, to implement new reporting requirements of the Home Mortgage Disclosure Act and, among other things, to expand the coverage of the act to include mortgage lenders not affiliated with lending institutions. The number of records maintained will grow tenfold from 600,000 to 6,000,000 as a result of this expanded coverage.

Besides the resources added in supervision and regulation, Board resources were reallocated in the other operational areas to meet requirements of the FIRREA legislation. Our research divisions anticipated substantial work on issues relating to deposit insurance, monitoring the savings and loan industry, and support to the Chairman in his responsibilities as a member of the Oversight Board. This incremental staff effort is estimated at six work years for 1990. To repeat, the work is being accomplished by reallocating resources; no new positions were added.

Our legal staff is encountering a major work load increase in litigation and enforcement. Two of three new attorney positions added in 1989 support FIRREA-related work. Again, no new positions were added in the 1990 budget.

Other Board program areas are also feeling the effects of the FIRREA legislation. For instance, senior staff members in several areas are providing substantial start-up assistance to the real estate appraisal subcommittee of the FFIEC.

The National Information Center (NIC) is a major Systemwide standard automation project providing important support to the supervision and regulation operational area. It was established in 1988 to provide the Board and Reserve Banks with a single-source, high-quality database from which information about financial institutions will be drawn to monitor safety and soundness, process applications, and maintain accuracy of published data series. The growth of interstate banking, the acquisitions of financial institutions tied to the resolution of bank and savings and loan failures, and the growing complexity of the interrelationships between financial institutions make the establishment of a central database critical to the System's supervision and regulation function.

A significant commitment of existing resources continues in a number of the Board's divisions in support for this project. The 1990 budget requirement for data processing resources (at the Board only) is $1.6 million. This amount is slightly higher than the level of data processing resources committed in 1989. The NIC project is now scheduled to be implemented in mid-1991.


In earlier testimony and letters to this committee, Chairmen Volcker and Greenspan indicated concerns over the adequacy of our compensation system to attract and retain the type of staff required for the Board to fulfill its mission. Last year I testified that our compensation system was being revised and that there would be some significant costs as we tried to reduce the gap that had developed between staff salaries and those in the market. In 1990, the first full year of the Board's new compensation program, the budget provided approximately $3.5 million for the full, one-time cost of transition to the new salary schedule. We had anticipated phasing the increase to lessen its impact on any one budget year; however, events in the marketplace, including substantial increases at the other financial regulatory agencies, caused us to accelerate our schedule. The budget also provided $4.2 million to fund the increase in salary rates caused by increases in salaries in the marketplace during the previous year.

Inspector General

The Office of the Inspector General (OIG) was created by the Board in July 1987. Its reporting relationships, duties, and responsibilities were formalized by the Inspector General Act Amendments of 1988.

A review by the Inspector General of how his office is carrying out those duties and responsibilities led to the development of a five-year strategic plan. The plan proposes a phase-in of broader audit and investigation coverage of the Board's mission areas as well as attention to the legal requirement to review new and existing laws and regulations for their impact on the economy and efficiency of Board programs and operations.

To implement the findings of the review, a significant increase was approved for the budget of the Office of the Inspector General. The approved 1990 OIG budget is $1.7 million, an increment of $0.8 million for the mission activities of the office and $0.2 million for office space. The mission increment provides $0.4 million for six new positions. It also covers a substantial increase in travel for the IG staff and shifts the burden of travel costs for staff borrowed for reviews of Board operations to the Board from the Reserve Banks. The increment also provides for a higher level of contract support.

Contingency Processing Center (CPC)

In 1989 the Board transferred the management of the CPC, the System's backup data processing facility, to the Federal Reserve Bank of Richmond. This transfer was done to recognize a substantial increase in the Reserve Banks' utilization of the CPC for operational requirements, with corresponding requirements for equipment upgrades, while the Board's requirements for a backup capability and relocation site remained stable. The change in requirements substantially reduced the Board's share of the overall cost of the CPC. Positions added when the Board established the CPC in 1985 were deleted from the Board's budget concurrent with the transfer of management to Richmond. Although this action was not implemented as part of the 1990 budget, since it occurred in the middle of 1989, it resulted in a reduction in Board expenses in both 1989 and 1990. The total change was a reduction of approximately $1.7 million in the Board's expenses.


The Board's activities fall into four broadly defined operational areas: (1) monetary and economic policy, (2) supervision and regulation of financial institutions, (3) services to financial institutions and the public, and (4) System policy direction and oversight. I would like to take a minute to discuss the budget for each of these operational areas. Since each area was affected by general factors, such as the compensation program and the higher costs for health insurance, I will focus only on the unique factors affecting each.

Monetary and Economic Policy

This function is expected to cost $53.6 million in 1990, an increase of 6.9 percent from 1989 expenses. Besides maintaining the quality of economic forecasts and analysis, the budget reallocates resources to support FIRREA, continue development of the National Information Center, and process the data from the Survey of Consumer Finances conducted in 1989.

Supervision and Regulation

This function is expected to cost $26.8 million in 1990, an increase of 14.1 percent. This increase is the largest by operational area and reflects the seriousness of the issues facing the financial regulators. The main causes of the increase are new positions and the NIC.

Services to Financial Institutions and the Public

This area is the smallest operational one of the Board. It is composed entirely of the System's payments functions. The 1990 budget of $2.7 million is an increase of approximately $250,000, or 10.2 percent over 1989 expenses. An important factor in the increase is the establishment of a payments risk program in mid-1989. The program coordinates the analysis of risks associated with national and international payment and settlement systems.

System Policy Direction and Oversight

This function will cost $19.7 million, an increase of 3.0 percent. Resources in lower priority areas of this category were reallocated to higher priority work in the other operational areas, thus this rate of increase was the lowest one at the Board.


Excluding the budget of the Office of the Inspector General, the 1990 budget was $7.6 million, or 7.9 percent more than 1989 expenses. The increase for salaries, $7.8 million or 12.8 percent, was the major factor in the increase. The net effect of all object classes other than salaries was a decline of $0.2 million.

Personnel Costs

The increase in salaries was closely related to the new compensation program. As mentioned earlier, $3.5 million was for the accelerated transition into the new system while an additional $4.2 million was to make up for the changes that occurred in the market during 1989. The remaining increase in salaries of $0.1 million was caused by technical factors such as promotions.

Insurance and retirement costs rose $0.6 million and $0.2 million respectively. The former rose because of increases in health insurance rates, while the latter rose because of the higher salary levels and increases in the tax rate and taxable wage base for social security.

Goods and Services

The overall cost of goods and services declined $1.0 million in 1990. The main reasons were the change in the cost sharing formula for the CPC and the completion of the Survey of Consumer Finances.


The 1990 budget authorizes 1,555 positions, a reduction of one position from 1989.

Ten new positions were added in the budget while eleven were abolished. The ten new positions support the function of supervision and regulation, eight of which are related to work stemming from FIRREA, while two positions will support implementation of the National Information Center. The eleven positions that have been abolished include eight positions at the CPC. Three additional positions will be eliminated during the 1990 budget year.


The regular operations budget increase in 1990 of 7.9 percent is larger than the compound annual rate of increase of 5.7 percent from 1980 to 1990. The pressures in the supervision and regulation area and unique 1990 costs of the new compensation program account for the size of the increase. Without the reduced expense associated with the change in utilization and cost sharing for the Contingency Processing Center, the increase in 1990 would have been larger.

The 1,555 positions approved in the 1990 regular operations budget is forty-eight fewer than the number of positions at the end of 1980. Implementation of the provisions of the Monetary Control Act and other significant legislation had increased the number of positions to 1,653 in 1984. Automation and other efforts to control expenses and improve productivity have assisted us in reducing to the current level, which did not increase over 1989 in spite of FIRREA and other pressures associated with the supervision and regulation area.


The approved capital budget was $4.0 million, which is comparable to the expenditure of $3.9 million in 1989. The largest category of expenditure is $1.6 million for important workstation, network, office automation, and records management investments. Facilities investments of $1.3 million provide funds for a new roof for the Martin Building, a replacement fire intrusion and detection system, and miscellaneous energy conservation investments. Central automation initiatives costing $0.7 million provide a system to connect distributed workstations to the mainframe, additional disk space to support the NIC and growth on the research departmental computers, and mainframe software. The remainder of the capital budget provides $0.4 million for miscellaneous small capital expenditures.


The 1990 budget was 7.9 percent higher than 1989 expenses and this increase is the largest increment since 1982; it is also larger than the average annual rate of increase of 5.7 percent over the last ten years. The large increase stems from the convergence of two unrelated actions: full implementation of our compensation program and passage of FIRREA.

This budget added positions in critical areas but eliminated them elsewhere. Excluding the Office of the Inspector General, the number of positions is 126 below the peak reached in 1984 when the Board was still reacting to the changes brought about the Monetary Control Act, International Banking Act, and Financial Institutions Deregulation and Interest Rate Control Acts, and to a deteriorating situation at that time in the banking industry.

I would be happy to address any questions you may have after Governor Angell concludes our joint testimony.


The Reserve Bank expense increase--both priced and nonpriced--was budgeted at 5.8 percent, which fell well below the 1990 budget objective of 6.1 percent. Again, the Bank's approved 1990 budget was further reduced $4.1 million in January 1990, with the restraint imposed on the federal government by Gramm-Rudman-Hollings. With this cut in place and using actual 1989 expenses instead of estimated 1989 expenses as the base, the anticipated expense increase for 1990 is now only 4.8 percent. Seven major initiatives account for almost half of the budgeted increase in Reserve Bank expenses.

A particularly noteworthy initiative in 1990 is the enhancement of fiscal agency services for the U.S. Treasury and the U.S. Department of Agriculture's Food and Nutrition Service. The effort of the U.S. Treasury involves an expenditure of $4.1 million for the nationwide expansion of a Regional Delivery System, which consolidates issuance of over-the-counter savings bonds. Systemwide implementation of the project, which began as a pilot program at the Federal Reserve Bank of Cleveland, will continue through 1993. A staff increase of 116 is expected in 1990, and a total staff increase of 350 is projected by the time the project is fully implemented. Although this initiative results in additional short-term expenses for the Federal Reserve Banks, the costs are more than offset by savings at government agencies and commercial banks.

The second 1990 fiscal agency initiative is implementation of changes requested by the Food and Nutrition Service in processing food coupons. These changes, first tested at the Memphis and Dallas offices, will add $0.6 million and increase staff members by twenty-two in 1990. Expenses for both savings bond and food coupon initiatives are fully reimbursable.

Other initiatives include improvements to facilities, many of which are aging and no longer have efficient support systems or the space to allow an efficient flow of work. Each year steady progress is made toward achieving the type of space needed for modern central bank operations.

Reserve Bank operations in today's environment require more reliable and secure computer systems, more use of office automation, extended communication networks, and the most efficient high-speed sorters and counters for checks and currency. The initiatives classified under "automation," "check operations," "currency processing," and "contingency back-up," all result from this requirement.

Also, the Reserve Banks require added resources for supervision and regulation due to current conditions in the banking industry and the greater complexity of examinations generally.

Besides these major initiatives, it may be helpful to look at 1990 budgeted expenses on the basis of our four service lines.

Expenses for services to financial institutions and the public, which include both priced and nonpriced services, are budgeted at $947.0 million and account for two-thirds of total expenses. Expenses are increasing $30.7 million, or 3.3 percent, over 1989. Staffing is budgeted at 9,335, down 87, or 0.9 percent, primarily because of reductions of fifty-two in commercial check processing, and thirty in services rendered others. The reduction in services rendered others is associated with an anticipated reduction in staff assistance provided to other agencies to address problems in the savings and loan industry. Expenses of priced services are budgeted at $622.1 million, an increase of 2.3 percent. Expenses of nonpriced services are budgeted to increase 5.4 percent.

Commercial check processing is by far the largest service ($477.8 million), comprising half the budgeted expenses of this operational area and employing 5,814 persons. The anticipated increase in expenses is $7.6 million, or 1.6 percent over 1989. Staffing levels for 1990 include a reduction of fifty-two persons resulting from the stabilization of work loads in the commercial check, check adjustment, and check return item areas. Commercial check volume is budgeted to increase 1.5 percent; the volume of return items is expected to be stable during 1990.

Expenses for the currency service are expected to increase $9.9 million, or 7.9 percent. Unit cost is expected to increase 2.6 percent. The net staffing levels will decrease by thirteen, primarily because of a staff reduction of ten in Boston resulting from a change in operating controls and a staff reduction of thirteen in New York related to a shift from medium-speed to high-speed currency processing. Volume will continue to increase in the currency areas. Other initiatives affecting this service are automation efforts in various Districts and a project to develop a second generation of high-speed currency processing equipment.

Expenses for the automated clearinghouse (ACH) service are budgeted to increase $3.8 million, or 5.1 percent, with a minimal change in staffing. There is a shift in expense growth from government ACH to commercial ACH that corresponds to the faster growth of the latter. Total ACH volume is projected to increase 14 percent in 1990. The major initiative affecting this service is Fedline II, which is the standard intelligent terminal software for access to Federal Reserve services.

Expenses associated with public programs are budgeted to increase $3.7 million, or 8.7 percent. The staff level will increase by seventeen. The increases result from a greater involvement in regional and public forums, provision of outreach programs, and additional efforts in the automation of mailing and subscription lists.

Expenses for supervision and regulation, budgeted at $214.5 million for 1990, are expected to increase $19.4 million, or 9.9 percent, over 1989. This service line now constitutes 15.1 percent of total System expenses, compared with 13.6 percent in 1985. The budgeted staff level is 2,258, an increase of 61, or 2.8 percent, over 1989.

The increase in expense reflects the additional staff and increases in compensation, travel, training, and automation. Most Districts project an increase in the number and complexity of examinations in 1990. Also, the number of supervised institutions is increasing in some Districts. Examinations deferred during 1989 because of the reallocation of resources to assist other agencies with the savings and loan crisis will be rescheduled for 1990. Another factor contributing to the expense increase is the program on daylight overdraft pricing.

Expenses for services to the U.S. Treasury and other government agencies are budgeted at $158.6 million, an increase of $13.1 million, or 9.0 percent, from 1989, and represent approximately 11 percent of the Reserve Banks' total operating costs. Staffing levels are budgeted to increase 119, or 6.7 percent. The major initiatives, as discussed earlier, driving the increases in both expenses and staff levels are the nationwide expansion of the Regional Delivery System, which consolidates issuance of over-the-counter savings bonds at one office within each District, and the nationwide expansion of changes in the requirements for processing food coupons.

By the end of 1993, the Regional Delivery System is scheduled to replace the existing network of issuing agents. Under the system, applications for savings bonds are accepted at various financial institutions and forwarded to the Federal Reserve, where the inscription data for the bond are entered into a computer database, transmittals are balanced, accounting entries made, and the bonds are printed and mailed to the customers. During 1990 the program will expand to cover all or parts of eight Districts.

The changes in the processing of food coupons requested by the Food and Nutrition Service of the U.S. Department of Agriculture require Federal Reserve Banks to verify that the value of redemption certificates and the value of food coupons match in each deposit. Financial institutions are also required to encode the redemption certificates to allow their processing on check equipment and the transmittal of the data to the Minneapolis data center of the Food and Nutrition Service via FRCS-80, the Federal Reserve's data communications system. These procedures were successfully tested in the Dallas and Memphis territories for the six months ending March 1989.

Expenses in 1990 for the conduct of monetary and economic policy at the Federal Reserve Banks total $98.9 million and account for 7.0 percent of their budgets. The increase of $5.3 million, or 5.7 percent, from 1989 expenses reflects staff increases, salary administration actions, and additional equipment and data processing costs associated with automation initiatives. Employment at 786 is an increase of three over 1989. The 1989 employment is below the approved budget for 1989 because of the Banks' inability to fill all positions authorized. The number of authorized positions is the same for both 1989 and 1990.

A brief review of Reserve Bank expenses on an object of expense basis also might be useful to the subcommittee.

Operating expenses for personnel comprise officer and employee salaries, other compensation to personnel, and retirement and other benefits. Total personnel costs account for 63.8 percent of Reserve Bank expenses and are expected to increase 6.3 percent in 1990.

Salaries and other personnel expenses account for nearly 52 percent of 1990 budgeted expenses and are expected to be $36.5 million, or 5.2 percent, above 1989 expenses. Salaries are budgeted to increase $41.3 million, or 6.1 percent, and will be partially offset by a decline in other personnel expenses of $4.8 million, or 32.2 percent. The decrease in other personnel expenses results from a declining use of personnel agencies. Merit pay increases of $34.7 million, or 5.0 percent, are the primary reasons for salary expense growth. Also contributing to additional salary expenses are promotions, reclassifications, structure adjustments, and staffing level increases. These increases are partially offset by short-term position vacancies and reduced overtime.

Expenses for retirement and other benefits, which account for 11.8 percent of Reserve Bank budgets, are anticipated to increase $17.0 million, or 11.3 percent, in 1990. This increase is the result of continued escalation in hospital and medical costs and a rise in the social security tax.

Nonpersonnel expenses account for 36.2 percent of Reserve Bank expenses and are projected to increase 3.0 percent in 1990. Equipment expenses are expected to increase 9.2 percent and to account for 12.2 percent of total costs in 1990. Most of the increase is for depreciation, resulting from acquisitions to expand data processing and data communications capability to handle increased work loads, and the full-year effect of equipment purchased in 1989.

Shipping costs (primarily for checks) account for 6.0 percent of the 1990 budget and are projected to increase 2.8 percent in 1990. The increase is primarily the result of rate increases by contract carriers and carriers supporting the Interdistrict Transportation System. Partially offsetting the 1990 increase is the reduction in postage expense due to a lower projected volume in the fiscal area.

Building expenses, which account for 9.2 percent of total expenses, are expected to increase 8.8 percent in 1990. The newly renovated Chicago office, an Atlanta addition and renovation, and the full-year effects of the new Charlotte Branch contribute to higher costs for property depreciation and utilities. These projects, along with a Dallas building project, are expected to increase real estate taxes $5.5 million, or 23.6 percent. The decline of $1.2 million in other building expenses is the result of the completion of renovations at the New York Bank.

Recoveries are expected to increase $2.9 million, or 8.4 percent, in 1990, primarily because of new leases with outside organizations in the New York and Chicago offices.

By their nature, capital outlays vary greatly from year to year. Outlays for buildings and for data processing and communications equipment continue to dominate Reserve Bank capital budgets.


I would like to mention briefly several initiatives intended to provide long-range benefits to the Federal Reserve System, the banking industry, and the public at large. Because spending on such projects is relatively high and short-term, the Federal Reserve System accounts for it separately from its operating expenses but includes it in its total budget. The budget for "Special Projects" in 1990 is $6.7 million, or $0.8 million less than expenses in 1989. About 35 percent of the $6.7 million will be recovered through prices.

A major inefficiency of the present check system is that settlement depends on presentment of physical checks. The process could be made more efficient by a transition to collection based on transmission of an electronic image. We expect that, in the future, checks will undergo a transition from paper delivery to electronic delivery. In mid-1985 the System began testing of digital image technologies to produce high quality images of check documents in a sustained high-speed check processing environment. The primary applications chosen for the testing were truncation of government checks and the processing of return items. Both these check processes provide rigorous tests for image technology in that they require the storage of large amounts of data and require a high level of quality in the retrieved image. Total expenses in 1990 associated with this project are estimated to be $1.6 million.

In 1990, the project will complete the testing of a prototype system integrated with existing highspeed check processors at two Federal Reserve Bank sites. Given the positive results to date, the project will continue to focus on government checks and return items. A request for a proposal will be issued in late 1990 for a pilot test involving government check processing.

In 1988, the Federal Reserve initiated a special project for the development of an optical counterfeit-detection system (OCDS). During 1989 and continuing in 1990 the project will be expanded to include other means of authentication. The 1990 special project budget includes $3.2 million in support of these developmental efforts.

In 1990, the Federal Reserve will request proposals from vendors to share the costs of continued development and testing a prototype OCDS. This effort and several others, both long-term and short-term, are designed to produce conterfeit detection devices to be placed on the Federal Reserve's high-speed currency processing equipment.

A study by the Federal Reserve has indicated that the System will need to extend the number of hours and improve the reliability of electronic payments services to control risk better in the payments system. The study also indicated that users of electronic payments will need more flexibility in the range of services offered as well as cost effectiveness.

The Federal Reserve is evaluating the use of nonstop, fault-tolerant equipment, known as the electronic payments processor (EPP), for processing electronic payments, including funds and securities transfers and ACH transactions. This approach is of the type frequently used by commercial banks for transaction processing. The Federal Reserve should complete its evaluation of this approach by September 1990 at a 1990 cost of $1.9 million.

The Federal Reserve knows that a rigorous budget process is only one part of financial management. We are equally concerned about other areas of financial integrity. The structure of the Federal Reserve System provides for appropriate segregation of responsibilities; a reasonable accounting control over assets, liabilities, revenues, and expenses; and an organizational structure that establishes responsibilities for audit and oversight of the objectives and goals of the Federal Reserve System.

It is the policy of the Federal Reserve System that the Board and each Reserve Bank maintain a system of internal controls that is designed to ensure that objectives of each are achieved and that they each operate in compliance with all prescribed rules, regulations, and policies. The management of each is responsible for maintaining adequate internal financial, custody, and data security controls over all aspects of their respective operations.

To ensure that these controls are operating in an effective manner at the Federal Reserve Banks, the following procedures have been set in place:

(1) An internal audit function at each Reserve Bank is responsible for assessing practices and procedures for soundness and conformity with regulations in accordance with professional auditing standards.

(2) The Board of Governors' examiners conduct financial, operational, and procedural reviews at each of the Banks.

(3) A CPA firm reviews the procedures and practices of the Board's examination program.

(4) The Board specialists review the effectiveness of each Reserve Bank's internal audit function. We believe that these measures, although not fail-safe, offer excellent protection against financial impropriety.

We thank you for this opportunity to address the subcommittee on the Federal Reserve System budget. The existing budget processes are working well in controlling costs, while at the same time encouraging quality improvements. We welcome your comments and would be pleased to address any questions you may have on our budget.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, June 21, 1990. Mr. Chairman and members of the Banking Committee, I welcome this opportunity to discuss the issue of credit availability--whether it has changed and, if so, why--and its effects on the health of the economy. We at the Federal Reserve have for some time been monitoring various indicators of credit supply and have been assessing implications for the economic expansion. To date, we have found that lenders have tightened their standards in certain sectors and locales but that there has not, so far at least, been a broad-based squeeze on credit, and lenders are generally not retreating from lending opportunities. Nonetheless, significant problems cannot be ruled out in the period ahead, and we will continue to devote close attention to credit conditions.

The topic of credit availability is intertwined with the issue of the asset quality of depository institutions. Let me preface my remarks today by emphasizing the necessity of a stable, efficient financial system, including sound depository institutions, for satisfactory economic performance. Healthy commercial banks and thrift institutions promote growth by providing a ready source of loans, especially to households and smaller businesses that lack direct access to credit markets. By exercising sound credit judgments, deposit intermediaries direct funds to productive uses, and by offering secure, liquid deposits to the public, they encourage thrift.

Doubts about the soundness of depositories can disturb this process. When depositors and investors become reluctant to entrust their funds to these institutions, access to depository credit can be curtailed or become more expensive. Vigilant, consistent supervision, strong capital positions, as well as actions by lenders to avoid excessive exposure when new risks appear, are all essential to retaining public trust in our depository system.

The efforts of our examiners reflect this dictum. When examiners visit a bank, they determine whether it has adequate systems in place to measure and control its risk exposure. In addition, they ascertain whether borrowers have sufficient collateral and cash flow, given local market conditions, to service their loans. Our standards in these areas have not been tightened, though they may, because of deteriorating conditions in certain markets, be catching more doubtful loans than before. This process may cause difficult, short-run adjustments in those markets, but these adjustments must be viewed as reactions to changing circumstances and a correction of earlier overenthusiasm on the part of lenders. Ultimately this process should prove to be a positive force for the economy by preserving the health of our commercial banking system.

Of course, anecdotal reports suggest that some bankers and their regulators have become overly cautious and have thereby exacerbated the very problems that they have been trying to avoid. It is difficult to get hard evidence to assess the extent of this problem, but I suspect that, since many loan extensions of recent years are now nonperforming, it is inconceivable that bankers and their regulators would not currently have turned cautious, either consciously or subconsciously. To believe otherwise presumes a change in human nature. Although some increased caution unquestionably is prudent in current circumstances, the issue is whether, owing to an overreaction on the part of some lenders or regulators, creditworthy borrowers are being denied funds. Potentially, such unwarranted caution can put downward pressures on asset values, stunt investment or spending more generally, and curtail employment.

To date, however, whatever overreaction may have occurred does not appear to have been widespread, and access to credit has not been reduced to an extent that has had a significant damping influence on the American economy overall. On balance, the economy appears to be growing at a subdued pace so far this year, in line with the recent slower growth of our labor force, thus keeping the unemployment rate around 5 1/4 percent. In several sectors conditions have been difficult to read, owing to distortions such as last winter's unusual weather. But, available indicators suggest that overall activity remains on a slow uptrend.

Indeed, moderate growth is inevitable at this stage of the expansion given that we no longer have considerable slack in resources to be taken up. Late last year, indications that a slowdown was in train led to concerns that the weakness would cumulate to a recession. Now those concerns seem to have less basis. One reason is that producers and distributors apparently trimmed their inventories rather promptly this winter, most notably in the auto industry, but elsewhere as well. With this period of adjustment complete, factory output in recent months has picked up a bit, and, at this stage, inventories appear to present no impediment to further growth in production.

Some sectors of the economy, however, are stronger than others, and pertinent to the topic of these hearings, particular weakness is apparent in some real estate markets. In the residential market, unusually favorable weather early this year temporarily boosted housing starts, but more recent monthly numbers appear to reveal some underlying softness in this market. The most substantial adjustments have been under way for some time in the commercial real estate and construction industry. Construction of office buildings and other commercial structures is down from last year's pace. There are, of course, regional differences to the real estate slowdown. Nonetheless, in the aggregate, the statistics clearly indicate considerable softness. And forward-looking measures, such as contract awards and building permits, suggest that this weakness is likely to continue a while.

The cause of this weakness almost surely rests in the excesses of earlier years. Developers and their equity partners built housing and commercial structures at a more rapid pace than could be supported by economic fundamentals. The overbuilding was supported in part by the ready availability of credit from thrift institutions and banks that, in hindsight, partly reflected lax lending standards and, unfortunately, insufficient attention by supervisors. Speculation, fed by visions of ever-rising prices, also led to new construction that simply outpaced demand in many markets. When properties were completed, there were not enough buyers willing to pay prices that covered construction costs or tenants willing to pay enough rent to cover mortgage payments and operating costs. The most obvious signs of this overshoot are the high vacancy rates for office buildings, rental apartments, and condominiums. For example, the average office vacancy rate for downtown areas increased from near 5 percent at the start of the 1980s to more than 16 percent by the end of the decade, and has reached 25 percent to 30 percent in some parts of New England and the Southwest. Residential markets also have been affected, though less severely, with prices leveling off and even falling in some markets, in sales of new homes at their lowest rate since 1982.

Paralleling the softness in activity, lending by depository institutions for real estate purposes has slowed this year. In large measure, this slowing reflects the absolute contraction of the assets of thrift institutions, which, historically, specialized in this market. And, while banks' real estate lending has slowed only slightly, they have been unwilling to fill all of the void left by thrift institutions. Both banks and thrift institutions appear to be reacting to the worsened prospects for real estate projects and, particularly for thrift institutions, a more stringent regulatory environment.

In the case of savings and loan associations, provisions of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) legislation limited the amount a thrift institution could lend to one borrower. This limitation reportedly had a marked effect on construction financing in many markets, and some developers have been forced to find new sources of credit. Commercial banks also have pulled back from commercial real estate lending. Data for all commercial banks show a small contraction in credit for construction and land development in the first quarter of 1990, and a reduced rate of expansion in mortgages on existing commercial properties. In the several surveys of senior bank lending officers we have conducted this year, a large majority consistently have indicated that they were very reluctant to extend credit in these areas.

A falloff in credit demand and deteriorating conditions in the real estate sector appear to lie behind much of banks' reduced lending. In one survey taken last January, almost all banks that had pulled back from construction lending did so because of a less favorable economic outlook. In addition, half of them cited problems with such credits in their own portfolios as a factor. These concerns are substantiated in an increased delinquency rate for real estate loans, which, in the first quarter, reached its highest level since 1984. Only a minority of bankers have reported to us that increased regulatory pressure or tighter capital requirements caused them to curb their supply of credit.

In contrast to the situation with commercial real estate, credit market conditions appear more resilient in the market for residential property. This market was the main one of the savings and loan industry, and residential mortgage credit has accounted for the bulk of their asset reductions. Nevertheless, there are no indications that permanent financing for the purchase of an existing home has become more difficult to obtain. Interest rates charged on home loans have not risen on balance relative to other long-term rates, and lenders generally have not tightened downpayment requirements. A recent trade association survey of mortgage bankers concluded that ample funds were available for home buying, and, indeed, the volume of existing home sales, which is sensitive to credit availability, so far this year has held close to the pace of last year.

The continued flow of credit in residential mortgage markets probably owes to the many alternatives to depository credit. The securitization of home mortgages has become a routine financial transaction, with about $1 trillion in mortgage debt held in that form. Buyers of these securities, such as pension funds, insurance companies, and mutual funds, have stepped up to acquire assets shed by thrift institutions and to fund new lending. Commercial banks have been avid purchasers as well, even while they have slowed the pace of their direct residential mortgage lending.

Outside the real estate sector, one area where banks unquestionably have made credit less available is the financing of corporate mergers and restructuring. Banking regulators have specifically instructed banks to review their procedures in this area, and a majority of bank lending officers surveyed in January reported that they had tightened their standards for loans to highly leveraged borrowers. This sector is one in which the decisions of banks can be corroborated by financial markets more generally. As you well know, the market for junk bonds slumped badly earlier this year, and new issuance has slowed to a trickle.

A pullback from lending to highly leveraged borrowers has contributed to recent sluggish growth in commercial lending, though it is not the only factor. In last month's survey, senior lending officers reported weakness in commercial lending to all sizes of borrowers. In the case of larger borrowers, reduced demands for credit were cited by survey respondents as the primary reasons for the slower pace of lending, while more stringent credit standards and tighter loan terms were quoted more frequently than reduced demand for smaller borrowers. Recent surveys of small businesses do reveal some near-term reduction in credit availability. However, small businesses consistently report difficulties in obtaining loans, and credit conditions have not become appreciably tighter relative to a year ago.

Greater caution with regard to commercial lending probably is warranted in the current economic environment. The decade of the 1980s was a period of rapid leveraging of many corporations, and the resulting debt burdens probably made some deterioration of credit quality all but inevitable. Indeed, banks are reporting increased delinquency rates on commercial lending.

Nonetheless, with the exception, perhaps, of the troublesome situation in the New England region, credit availability more broadly appears not to be significantly impaired. Banks reportedly remain ready to make loans to larger and more creditworthy commercial borrowers, and they consistently have reported increases in their willingness to extend credit to consumers. Moreover, it is worth noting that while banks are principal suppliers of credit to certain classes of borrowers, they supply less than a quarter of total net borrowing in the broader economy. Other credit conduits generally show little or no stress. For example, the volume of issuance in most securities markets, smoothing through the volatility, generally has been well maintained. In addition, spreads of interest rates on private over government issues in these markets have remained quite narrow. If reluctance by banks and thrift institutions to make loans were inhibiting the overall flow of credit in the economy, it should be visible in conditions in credit markets, including higher yield spreads.

The pace of aggregate credit flows upholds this impression. Credit growth has eased, but debt still appears to be growing about as fast as gross national product, a relationship typical of the three decades before the 1980s. In part, at least, the economy may be seeing the cessation of the unusually heavy borrowing pace of the 1980s, certainly a salutary development to the extent that it promises lower leverage and healthier balance sheets.

Of course, the link between current debt growth and economic activity is a loose one. Indeed, it is plausible to expect that impaired credit availability would have lagged effects on debt and spending, as first commitments are cut back, then actual lending, and finally consumption and investment. Naturally we are alert to this possibility and are complementing our attention to debt and credit flows with close scrutiny of a full panoply of related indicators.

The monetary aggregates are among such indicators, containing, as they often do, portents of future spending trends. Both M2 and M3 have slowed to relatively low growth rates this year, more so than we had anticipated last February. The massive redirection of credit flows that has accompanied the government's program to close insolvent savings and loan institutions appears to have depressed growth of M2 as well as M3, somewhat degrading the value of both aggregates as indicators. On net, commercial banks are taking up relatively little of the lending forgone by the shrinking thrift industry; the resultant cutback in total lending by depository institutions has slashed their needs for funds, showing through directly to M3. Even at the M2 level, the reduced need for funds by both commercial banks and thrift institutions appears great enough to have reduced the aggressiveness with which these institutions have pursued deposits. Terms offered on deposits have become less generous, and depositors have been turning to alternative financial assets. At least some of the recent weakness of M2 has come from this channel. However, there is still some unexplained weakness in M2 and M3 that will require continuing scrutiny.


All things considered, continued modest economic growth remains the most likely outcome, and looking at the economy as a whole, enough credit appears to be available to fuel this growth. Certain sectors or individual borrowers appear to be having trouble obtaining credit, but these specific difficulties are largely consistent with lenders' and regulators' reactions to shifting risks. We are attentive to the possibility that this more cautious stance in the granting of credit could cumulate to threaten the economic expansion and are closely monitoring the evolving complex interrelationships between credit availability and economic expansion.

Statement by William Taylor, Staff Director, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System, in Houston, Texas, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, June 22, 1990. I welcome the opportunity to appear before this committee to discuss the condition of Texas banks and their ability to meet the existing and potential credit demands of the Texas economy. In my remarks today, I will review briefly the financial problems experienced by Texas banks during the 1980s, discuss the current financial condition of Texas banks, address the question of whether these banks have the ability to play a significant role in financing economic recovery in the state, and finally, offer some general observations regarding the asset disposition policies and practices of the Resolution Trust Corporation (RTC).


At the beginning of the 1980s, Texas banking institutions were considered by most observers to be among the strongest in the nation. In general, they reported good earnings and capital positions, and little in the way of unusual or severe asset quality problems. Their prospects looked bright. The world in 1979 had just experienced the second "oil shock," sending the price of oil, which had been hovering around $10.00 a barrel, to as high as $40.00. This development, combined with widely held expectations that prices would continue to rise, induced a sharp acceleration in the demand for exploration and production of domestic oil. Texas banks financed a major portion of the growth in energy and energy-related activities that initially added to the general prosperity in the state's economy.

As we all know, this situation soon reversed itself. In 1982, oil markets became glutted, and the price of oil, instead of soaring to new heights, dropped to less than $30.00 a barrel. This collapse triggered a major retrenchment in energy and energy-related business and translated into high loss rates on the more speculative bank energy loans.

In response to these losses and to declining demands for credit to finance energy-related activities, Texas banking institutions pulled back from energy lending and began to channel loanable funds to other sectors that still looked relatively attractive, primarily the then-booming real estate sector. Real estate lending at Texas banks grew sharply, climbing from $13.5 billion outstanding at year-end 1981 to $46.5 billion by the end of 1986. This situation, too, came to an end in the mid-1980s as oil prices dropped sharply again--falling to as low as $10.00 before heading back up to the $15.00 to $20.00 range--and economic activity slowed.

As a result of these developments, real estate markets in the major cities of the state grew progressively weaker. Prices for both residential and commercial properties declined, and unsold inventories increased sharply. The oversupply in the commercial sector was considerable. Downtown office vacancy rates in Houston and Dallas, which had been on the rise since late 1982, reached peak levels in mid-1987 of approximately 25 percent. The downtown Austin area was even more adversely affected, with a peak office vacancy rate of almost 40 percent in spring 1988. As a consequence of the generally deteriorated condition in the real estate sector, Texas banks have experienced heavy losses on real estate in each year since 1985.

Economic factors were not the only cause of trouble experienced by Texas banks and thrift institutions. Another very strong contributing element was the fact that loans were often predicated on overly optimistic cash flow projections, rather than on what economic and market conditions would support at the time these loans were made. The assumption was that oil and then real estate would increase in value at rates that were not necessarily tied to the current returns available in the market place. Given such a "sure thing," down payments or project equity became a thing of the past. Thus, lax underwriting standards and lending decisions contributed to the energy loan problems and the overbuilding in real estate markets. Moreover, the use of brokered deposits enabled institutions in less than satisfactory condition to raise funds to finance highly risky ventures, primarily real estate loans and investments.

A review of the causes of problems of financial institutions in the state of Texas would not be complete without reference to criminal misconduct. While it is sometimes difficult to determine the extent to which criminal misconduct has been the cause of financial institution failures, there is little doubt that in several cases criminal misconduct became a major contributing factor.

The collapse of the energy and real estate sectors created serious dislocations in the Texas banking system. The severity of those dislocations is evident in the number of Texas banks that failed in the past decade. In 1980, not a single bank in Texas failed. By contrast, in 1989, there were 133 failures--the largest number of failures for the state during the 1980s. From 1980 to 1989, 349 Texas banks, with assets of $63 billion, failed. This represents more than one-third of the 1,008 U.S. banks that failed in the decade. More striking still, failed Texas banks accounted for roughly 70 percent of the total assets of all banks that failed in the 1980s. From 1985 to the end of the decade, aggregate assets of Texas banks contracted $35 billion, or 17 percent. Bank lending during this period declined even more--$43 billion, or 35 percent.

The structure of banking in Texas was also affected by other developments. Besides outright failures, the problems of some large institutions in Texas were addressed through open bank assistance by the Federal Deposit Insurance Corporation (FDIC) assistance. Indeed, of the top ten Texas banking organizations in 1985, nine either subsequently failed, received open bank assistance, or were acquired and recapitalized by out-of-state institutions.(1) These nine institutions in 1985 represented 59 percent of total Texas banking assets.

Although the decade of the 1980s took a severe toll on the banks operating in Texas, the toll on the state's thrift industry was worse. Over the decade, the number of commercial banks in Texas declined from approximately 1,500 to approximately 1,300, or 14 percent. This decline occurred even though 682 new banks were chartered in the state during this period. Failures, of course, contributed to the drop, but mergers also contributed as banks took advantage of their new ability to branch statewide. The number of thrift institutions in the state declined during the 1980s from 318 to 197, or nearly 40 percent. Moreover, from the beginning of 1986 through year-end 1989, thrift institutions in Texas reported aggregate losses of roughly $17 billion, compared with losses of $5 billion for Texas banks over this period. The fact that thrift losses were more than triple those of banks during the last four years of the decade is striking in view of the fact that in 1986 the state's thrift industry was a little less than half the size of its banking industry in terms of aggregate assets. Finally, it should be noted that the losses experienced by thrift institutions in Texas have caused the aggregate net worth of these institutions, including those in conservatorship, to fall to a deficit of $9.4 billion at year-end 1989.


The difficult conditions experienced by Texas banks in the last decade continue to have a significant effect on their performance as they enter the 1990s. Of the 89 U.S. banks that failed through June 15th of this year, 58 were located in Texas. As of year-end 1989, nonperforming asset ratios of Texas banks remain higher than the national average, with real estate loans and foreclosed real estate representing more than half of total nonperforming assets.

But while failure rates at Texas banks remain at high levels and asset quality problems have not been fully resolved, there are many indications that the outlook for recovery is favorable. In general, the loan quality of Texas banks appears to be improving. Their nonperforming asset ratios have declined materially since 1987, dropping from 11.2 percent to 6.9 percent by March 31, 1990.

Although total net income of all Texas banks was a negative $500 million in 1989, this loss is an improvement over the 1987 and 1988 losses of $2.7 billion and $2.1 billion respectively. It is also encouraging to note that, for the first quarter of 1990, the state's banks reported aggregate profits of $166 million.

Another factor indicative of improving trends at Texas banks is that the capital positions of the largest Texas banks have been strengthened. Aggregate equity capital of Texas banks, as a percentage of their total assets, increased to 5.8 percent in the first quarter of 1990, after having declined every year since 1985. The FDIC has provided in excess of $6 billion of financial assistance to close or assist Texas commercial banking organizations over the past several years. Besides this assistance, private sources and out-of-state financial institutions have injected in excess of $2 billion of equity into Texas banks.

The liquidity of Texas banks has improved in recent years. For example, liquid assets of banks in the state at the end of the first quarter stood at $76.4 billion, or 45 percent of total banking assets. While this figure exceeds the nationwide average of 32 percent, it should be viewed in relation to the very difficult problems experienced by Texas banks and the economy in the 1980s. On the liability side, Texas banks have decreased their reliance on volatile sources of funds since 1987. For example, the more stable core deposits have risen from $105 billion, or 56 percent of assets, to $115 billion, or 68 percent of assets--a level in line with the nationwide average.(2) By these measures of liquidity, Texas banks now compare favorably, or at least are consistent, with banks in the rest of the nation.

As the proportion of liquid assets to total assets of Texas banks increased, the proportion of loans to total assets decreased. Over the second half of the decade, total loans as a percentage of total assets declined to 47 percent from 60 percent. As a result of problem loan write-offs and reduced lending activity, total loans declined during this period $43 billion, or 35 percent. Commercial and industrial lending fell 42 percent, or $20 billion. Construction and land development lending by Texas banks decreased 76 percent, or $13 billion from 1985 to 1989. Commercial real estate loans fell 8 percent, or $1.1 billion. During the period, aggregate home mortgage lending by banks remained virtually unchanged and actually increased relative to total lending by banks in the state.

Although the difficult conditions experienced by Texas banks in the 1980s have resulted in a lower level of loans to total assets than the national average, the composition of Texas bank loan portfolios is not out of line with the national picture. As of March 31, 1990, nonresidential real estate loans represented 21 percent of Texas represented 14 percent, and commercial and industrial loans, 35 percent. Comparable figures of the nation's banks as a whole are 19 percent for nonresidential real estate, 17 percent for residential mortgages, and 30 percent for commercial and industrial loans.


The recent restructuring of bank asset portfolios to those categories generally considered inherently less risky, and the overall contraction of credit extended by Texas banks during the period, are no doubt a result of a decline in both the supply of and demand for credit. A drop-off of credit demand is a natural consequence of a slowing regional economy and widespread weakness in real estate markets. But, a tightening of supply resulting from strengthened credit standards, the need to address existing asset quality problems, and the need to restore capital positions would also appear to be important factors.

That Texas banks have strengthened credit standards should come as no surprise. Experience over the past decade has underscored the importance of sound credit analysis. This renewed sense of prudence and conservatism, when viewed in the context of the aggressive lending practices of the recent past, is a positive development--one that can build a strong base for renewed expansion with the turnaround of the Texas economy.

Against this background, questions have arisen about both the ability and willingness of Texas banks to perform their appropriate role in financing economic activity in the state. To be sure, there have been instances in which inadequately capitalized banks have been forced to curtail lending to meet regulatory capital requirements. Growth by inadequately capitalized institutions should be curtailed, and indeed must be curtailed, if we are to maintain the soundness of our banking system. Moreover, the asset quality problems of some institutions have put them in a position in which they are no longer able to satisfy fully the credit needs of their borrowers. However, it would be a mistake to conclude that the needs of creditworthy borrowers in Texas cannot be met by our banking system. There are adequately capitalized banks and lending institutions in Texas and elsewhere that have the capacity to make sound loans for economically viable business purposes.

I would stress that the Federal Reserve is mindful of, and sensitive to, concerns about the availability of credit and has been watching for evidence that would validate these concerns. We are aware of anecdotal evidence indicating that, in some instances, firms may have experienced a decline of credit availability to carry out their business activities. We have endeavored to be cognizant of these concerns in our supervision and regulation of banks, and we are working to avoid regulatory actions that would prevent creditworthy borrowers from receiving loans. indeed, we feel it is in the banks' interest to make sound loans to creditworthy customers and to work in a constructive and prudent fashion with troubled borrowers who are attempting to strengthen their financial positions. At the same time, we have a responsibility to foster sound lending policies to promote stability in financial markets and to protect the taxpayer, whose credit ultimately backs insured deposits. Only in that context can we be certain of the continued vitality of our banking organizations, whose lending activities are essential to the strength of our economy. Lending terms have tightened in selected areas or for certain types of borrowers; but, as yet, we continue to see little indication of a process that is out of proportion with changes in the underlying banking conditions or the regional economy.


Clearly, there is a trade-off with regard to the RTC's disposition of troubled assets. One view is that if properties are forced onto the market, general real estate prices and market conditions could be adversely affected. On the other hand, if assets are held off the market, the lingering ovrhang, by fostering uncertainty about the effects of future asset liquidations and real estate prices, could also tend to depress prices. Moreover, not disposing of assets in a timely manner puts the government in the potentially costly position of managing and financing large real estate holdings and speculating on future real estate prices. This position can also have an adverse effect on the competitive vitality necessary for markets to function effectively. Obviously, this is not a desirable situation.

Consistent with the RTC's charge to dispose of assets on an expeditious basis, securitization and bulk sales will be essential if the RTC is to maximize recovery on its assets. Indeed, the RTC is pursuing these avenues, including ways to use the auction process creatively to dispose of large volumes of assets. The RTC is also working to ensure that its assets are fully inventoried and that information on these assets is readily available to all prospective buyers. The aim, of course, is to move assets into private hands, reduce the role of the government as a competitor with the private sector, and let markets function efficiently.

Obviously, adequate financing is important to a successful asset disposition program. The RTC recognizes this situation and recently announced that it will provide up to $1 billion in revolving short-term credit to finance its asset sales. Other steps have also been taken. For example, the RTC has reduced the downpayment necessary, under certain circumstances, to facilitate the sales of assets. Private sector financing is also important. Certainly, recent efforts, of which I am aware, by the Houston Clearing House to structure financing for the RTC's affordable housing inventory in the Houston area speak well for the local banks' desire to participate in the asset disposition process while responding to the needs of their communities.

The disposition of real estate assests by the RTC will no doubt complicate the management of bank lending activities, particularly as it relates to real estate loans. Prices in various segments of the real estate market will be affected, and managers of lending institutions will have to monitor carefully the potential impact on their institutions' loan portfolios. The result may well be that the full resolution of problems related to real estate may take longer than it otherwise would. Moreover, in their lending activities, bank lenders will have to place greater emphasis on a property's cash generating capacity under prevailing market conditions and less on the assumption of expectation of continually rising real estate prices. While creating difficulties in the short run, this adjustment process is necessary if the economy and financial institutions are to be in a position to respond adequately to future growth opportunities.

In sum, the disposition of failed thrift assets will be a difficult and challeging process that will take several years to complete. During this period, we must continue to explore all prudent and financially sound methods for advancing this process. To be sure, we must be ever mindful of the potential impact of the disposition of assets on the local economy and its financial institutions. Most important, however, we must be guided by the need to minimize the government's losses--losses that, as we all know, are ultimately borne by the U.S. taxpayer.

(1) The nine include Interfirst, which was merged into First Republic in 1987 without federal assistance; the latter was subsequently acquired by an out-of-state organization, with federal assistance. (2) Core deposits are defined as total deposits less certificates of deposit greater than or equal to $100,000, minus brokered deposits.
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Title Annotation:policy statements by members of the Federal Reserve System
Author:Kelley, Edward W., Jr.
Publication:Federal Reserve Bulletin
Date:Aug 1, 1990
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